In-efficient market hypothesis?

This highly entertaining article courtesy of Johh Mauldin's weekly newsletter takes a no-nonsense look at the current debacle that is the credit crisis. I especially like the references to Efficient Market Hypothesis.

Enjoy,

J


Five Delectable Examples of "Stein's Law"

by H. "Woody" Brock

The most basic statement of Stein's Law says: "If something cannot go on forever, it will stop". More specifically, the late Herb Stein stressed that, when a trend cannot go on, it always stops--even when nothing is done about it. This yardstick of common sense is particularly apposite today, as we see in the following five examples of trends whose time has come and gone.

1. Mean Reversion in US Wealth Growth: A March 7 front page headline of the Financial Times proclaimed, "Fed Data Alarms Markets - Wealth of US Households Contracts". We have written about "mean reversion in national wealth growth" for the past five years, and explained why it would soon have to occur. In this regard, one of the most fundamental of all theorems in economics tells us that national wealth must (and empirically does) grow over the long run at the rate of GDP growth.

Well, wealth reversion has now arrived, and will be with us for far longer than most anyone expects. First, wealth has already contracted by $500 billion in 2007. Second, wealth contraction will continue to occur until mid-2009 when house prices reach their trough. And third, wealth growth will probably be sluggish up to and beyond 2020, running at about 3%. One reason why is that most baby boomers have their money in their houses--not in traditional defined benefit pension plans. Accordingly, the only way they will be able to retire in the style they expect is to sell their houses to one another. Next joke.

How remarkably this new 2.5% wealth growth regime of 2007-2020 will differ from the previous regime of 1981-2006! During that period, US net worth soared from $10 trillion to $57 trillion--an arithmetic average growth rate of 18% and a compound annual growth rate of 7.2%. For readers who doubt what we are arguing, note that the average growth of wealth across the two regimes being analyzed compounds at exactly 5.5%. This is precisely the long-run growth of nominal GDP. And all the Golden Rule Theorems in Growth Theory require that wealth growth and GDP growth converge to the same growth rate in the long-run.

This will fundamentally change both American politics and daily life. In particular, it will be the final nail in the coffin of hopes of early retirement for most baby-boomers. In short, "wealth reversion" is finally coming home to roost. What cannot go on does not go on.

2. Financial Services: The growth, profitability and excessive pay in this sector were always too good to be true, and now much of this excess may be over. Between (i) the deleveraging of bank balance sheets, (ii) the loss of confidence in exotic "financial products" by the investing public, and (iii) the need for banks to repay the Fed (or whomever) for existing and prospective bailouts, tepid growth and reduced profitability lie ahead for this sector during the next 5 years. For an analogy, look back on the growth and profitability of the telecom sector between the years 1991-2007, and in particular on the breakpoint of the late 1990s. What could not go on in telecom ceased to go on, and so shall it be in "finance".

3. The 2002-2009 US Housing Bubble and Burst: Many people suspected that the housing boom was indeed a bubble. There is no longer any doubt that it was, and for the following ex post reason: For house prices to have fallen as much as they have--and to do so with no interest rate shock--is proof positive that a pure bubble was in play. It was a speculative bubble fueled by excess credit creation and lax lending standards. What could not go on did not go on.

4. Excess Leverage: Commentaries about and explanations of today's credit market implosion continue to roll in from luminaries everywhere. Martin Feldstein of Harvard (allegedly the most important macroeconomist in the world) concludes that blame lies with the failure of Fed regulators to properly supervise the banks within their purview. Others blame the incompetence of those charged with "risk assessment" for dramatically underestimating risk. They claim that the solution to today's troubles lies in instituting much more effective risk management procedures.

Still others call for greater market transparency, truth in lending, and incentives to guarantee more of both. Finally, there are repeated complaints about the extent of greed on Wall Street. Yes, we have all become shockingly greedy!

Yet almost no one singles out the distinctive role of excess leverage not only as the principal culprit, but perhaps the only variable than can and should be regulated by government--as it once was. Indeed, in his lengthy and much discussed March 17 Op-Ed piece in the Financial Times, former Fed Chairman Alan Greenspan never once cited the role of leverage in wreaking today's havoc. This oversight is as irresponsible as it was unbelievable, but it epitomizes the deficient analyses of consensus pundits.

Chapters II-IV of our February 2008 PROFILE report explained how excessive leverage has exacerbated today's crisis, and why leverage is the principal "control variable" that must be managed in the future. More specifically,

• The Fed has no direct control over institutions that now make over 70% of all loans. As Chairman Bernanke has stressed in recent months, the Fed's powers are thus limited in dealing with the kind of crisis now at hand.
• The risks that allegedly should be "properly assessed" are largely endogenous in nature. The joint probability distribution characterizing such risk is often non-knowable. Think Heisenberg Uncertainty Principle! Because of this non-knowability, glib assertions that recent happenings are "four sigma events" are wholly invalid. For to state that an event is four-sigma implies knowledge of an underlying probability distribution that in fact does not exist and thus cannot be assessed!
• Human nature never changes, and hoping that people will become less greedy and optimally transparent is unrealistic.
• Leverage, however, is controllable. Moreover, since it exponentially amplifies endogenous risk, and in doing so creates "perfect storms" like that of today, the regulation of leverage can accomplish a very great deal, at least in circumstances when such measures are called for.

To sum up, those writing about today's morass seem as ignorant of the reality that excess leverage is largely responsible for what has happened as they are that much reduced leverage is the appropriate remedy for the future. Perhaps this oversight is no accident. After all, those who now run our major financial institutions increasingly owe their own fabled fortunes to the utilization of leverage subsidized by the public. Moreover, those financial economists who are handsomely paid to report today's developments happen almost exclusively to be employees of the very same institutions that have created, peddled and profited from toxic CDOs and SIVs.

In short, are we not forced to ask whether the foxes are finally guarding the chicken coop? If they are not, you would never know it. This author is frankly appalled by the failure of those who should know better to single out and stress the all-important role of excess leverage in creating today's crisis. Leverage will end up hurting millions of innocent bystanders far more than any other factor will have done. Hyman Minsky: Where are you when we need you most? And where for that matter are Wisdom and Common Sense?

This is a deep observation that constitutes a paradox within the very foundations of modern financial theory: The irrationally high levels of leverage justified by the Efficient Market Theory via its dramatic underestimation of risk becomes the source of Economic Inefficiency in the precise and revolutionary sense first proposed by Kenneth Arrow in 1953: a misallocation of risk itself. [Recall the reason why the EMT necessarily underestimates risk: It implies zero endogenous risk.]

Yet just as Stein's Law predicts, this trend too has had its day. Stay tuned for that large-scale deleveraging of Wall Street and indeed of the consumer that is just commencing.

5. Modern Financial Theory: Modern financial theory as applied ranks with string theory in physics as one of the greatest intellectual frauds of our time. Whereas the vacuous pretensions of string theory have finally been exposed (we now know that the theory never generated a single falsifiable prediction), those of "financial engineering" are just beginning to be exposed both in the press and in lawsuits alike.

What is remarkable to us is how this masquerade has continued for as long as it has both at a practical and at a theoretical level.

• At a practical level, it finally dawned on succored investors that you cannot transform a sow's ear into a golden purse. That is, in an era of 3.5% risk-free yields, investors should never have expected that securities yielding 6% could have been "AAA" in the first place. They have now learned that such a risk/return transformation is indeed impossible, notwithstanding claims to the contrary by modern alchemists of finance.
  
  Investors have also been discovering the vacuity of the longstanding claim that "the market correctly prices every security"--arguably the central tenet of the Efficient Market Theory. When the Chairman of the Federal Reserve Board stands up at lunch in New York and asks a packed audience, "Could someone please tell me what this stuff (mortgage-backed securities) is worth?"--then you know the game is over.
  
  The same holds true for the growing realization of the complete inadequacy of today's models of risk assessment. Indeed, this is one of the main points made by Alan Greenspan in his March 17 column. [Greenspan as always is allergic to good theory, so his analysis falls back upon "data analysis problems". But he is on the right track in admitting the sorry state of today's models.]

• At a theoretical level, are those professors of finance and CFA curriculum officials who have peddled efficient market dogma for decades aware of what is really happening? Do they understand that they are witnessing the collapse-in-disgrace of the fundamental theoretical conceit that has landed us in today's quagmire, namely: "Armed with portfolio theory, options pricing theory, Arbitrage Pricing Theory, reams of data, and banks of computers, we the Wizards of Wall Street can now optimally assess, price, slice, dice, and manage risk. Government happily is no longer needed to save us from ourselves in times of irrational exuberance."
  
  In Chapter II of our February 2008 report, we discussed what went wrong in the evolution of financial economics. In particular, we retraced the way in which Kenneth Arrow's original 1953 conception of the Economics of Uncertainty was bastardized by the Chicago School a quarter of a century later. Whereas Arrow's theory assumed that agents had diverse opinions about the future and were thus regularly wrong in their forecasts--wrong, not irrational--the Chicago School imposed the dogma of Rational Expectation: Agents all know and agree upon the true probability distribution of future news, and are thus never wrong. Moreover, they are assumed to know how to price all such news perfectly, with the result that markets are blithely assumed to price all assets correctly. Assumed, not demonstrated. Yes, assumed, not demonstrated.

• This was the origin of the theory of Economics Without Mistakes (our phrase) that lies at the heart of what has gone wrong in global markets. In particular, this was the origin of a family of theories predicting that financial market risk is very small, is fully assessable, is fully priceable, and thus is fully manageable. And this in turn was what intellectually justified today's extremely dangerous levels of leverage. [An agent of a given risk tolerance will be "excessively leveraged" if his models significantly underestimate the true risks at hand. In the real world, some 80% of total risk is endogenous, not exogenous. Yet in Efficient Market Theory models, there can be no endogenous risk at all.
• Having discussed all this in past commentaries, we conclude on a somewhat lighter vein with a proposal for improved pedagogy in financial theory in the future. In doing so, we express our own version of Stein's Law: Teachings that are absurd are eventually recognized to be absurd, and will cease to be taught to tomorrow's young

Everything you Needed To Know About a Crisis in The Making - by John Mauldin

After reading John Mauldlin's weekly newsletter this morning I thought you might want to read through his summary of the current credit crisis, the US employment data and his usual nod to the historical inevitability of these events unfolding. You can find his weekly articles at his website http://www.frontlinethoughts.com/.

Its on the long side but well worth the time.



Thoughts on the Continuing Crisis
by John Mauldin


There is so much that is happening each and every day as the Continuing Crisis moves slowly into month 8, so much news to follow, so many details that need to be followed up that it can get a little overwhelming.

Where to begin? Maybe with a "minor" change of the rules on how we value assets, then a look at the proposed changes in regulations, some comments to my hedge fund friends, a quick look at the employment and ISM numbers which are clearly showing we are in a recession and then finish up with some thoughts as to what it all means. There is a lot of ground to cover, so we will jump right in without a "but first" today.

If the Rules are Inconvenient, Change the Rules

Several times in the past few months I have reminded readers of the problem that developed in 1980 when every major American bank was technically bankrupt. They had made massive loans all over Latin America because the loans were so profitable. And everyone knows that governments pay their loans. Where was the risk? This stuff was rated AAA. Except that the borrowers decided they could not afford to make the payments and defaulted on the loans. Argentina, Brazil and all the rest put the US banking system in jeopardy of grinding to a halt.
The amount of the loans exceeded the required capitalization of the US banks.

Not all that different from today, expect the problem is defaulting US homeowners. So what did they do then? The Fed allowed the banks to carry the Latin American loans at face value rather than at market value. Over the course of the next six years, the banks increased their capital ratios by a combination of earnings and selling stock. Then when they were adequately capitalized, one by one they wrote off their Latin American loans, beginning with Citibank in 1986.

The change in the rule allowed the banks to buy time in order to avoid a crisis. It did not change the nature of the collateral. They still had to eventually take their losses, but the rule change allowed both the banks and the system to survive. I have made the point that the Fed and the regulators would do whatever it has to do to manage the crisis.

All the major new multi-hundred billion dollar auctions at the Fed where the Fed is taking asset backed paper as collateral for US government bonds does not make the collateral any better, of course. It just buys time for the institutions to raise capital and make enough profits to eventually be able to write off the losses.

Thus it should not come as a surprise to you, gentle reader, that the rules have been changed in much the same way as in 1980. In an opinion letter posted on the SEC website last weekend clarifying how banks are supposed to mark their assets to market prices is this little gem (emphasis mine): "Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability."

(The full letter is at http://www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm.)

So, now banks can simply say that the low market prices for assets they hold on their books are actually due to a forced liquidation or distress sale and don't reflect what we believe is the true value of the asset. Therefore we are going to give it a better price based on our models, experience, judgment or whatever. In today's Continuing Crisis, nearly every type of debt and its price can be classified as a forced liquidation or distressed sale.

Does this make the asset any better? Of course not. But it buys time for the bank to raise capital or make enough profits to eventually take whatever losses they must. And who knows, maybe they will get lucky and the price actually rises?

There are two problems with this rule. First, it clearly creates a lack of transparency. The whole reason to require banks to mark their assets to market price rather than mark to model was to provide shareholders and other lenders transparency as to the real capital assets of a bank or company. Second, can a forced liquidation or distress sale be from a margin call? Obviousy the answer is yes. But as Barry Ritholtz points out, this opens the door for some rather blatant potential manipulation. If a bank makes a margin call to hedge funds or their clients to make the last price of a similar derivative on their own books look like a forced liquidation, do they then get to not have to value the paper at its market price? Is this not an incentive to make margin calls? One price for my customers and a different one for the shareholders? If a hedge fund was forced to sell assets and then they find out that the investment bank is valuing them differently on their books than the price at which they were forced to sell, there will be some very upset managers and investors.

Cue the lawyers.

Is this a bad ruling? Of course. But is it maybe necessary? It just might be. My first reaction was that this tells us things are much worse than we think. The struggle to get the mark to market ruling only to abrogate it in certain circumstances less than a year later has to gall a lot of responsible parties. It seems like it is 1980 and Latin America all over again. Let me repeat: The Fed and the Treasury (who oversees the SEC) will do what it takes to keep the game and the system going.

So, let's sum it up. The problem is so severe with the financial companies assets that the SEC is going to allow some of them to "cook the books" so they can survive. That means there are going to be large and continuing write-downs for many quarters to come. There is a minimum of another $3-400 billion in write-downs (and maybe a lot more) coming from mortgage related assets, not to mention credit cards and other consumer related debt. And the investment banks may be forced to reduce their leverage and thus their profitability?

Putting money in the major financial stocks is not investing. It is gambling on a very uncertain future. There is simply no way to know what the value of the franchise is. There are other places to put your money.

More Fun in the Unemployment Numbers

Payrolls tumbled by 80,000 today, more than forecast and the third monthly decline, the Labor Department said today in Washington. The unemployment rate rose to 5.1%, the highest level since September 2005, from 4.8%. The household survey shows the number of unemployed people rose by 438,000. (That is not a typo!) In March, the number of persons unemployed because they lost jobs increased by 300,000 to 4.2 million. Over the past 12 months, the number of unemployed job losers has increased by 914,000.And of course, when you look into the numbers it is worse than the headlines implies.

Prediction: we will see 6% unemployment before the end of the year.

There were negative revisions totaling 67,000 job losses for the last two months, making those months even worse. This means that the Bureau of Labor Statistics (BLS) is clearly over-estimating the number of jobs in the first announcement. That is because they have to extrapolate based on recent past data. And as I continually point out, as the economy softens, they are going to continue to overestimate the number of jobs. It's one of the problems of using past performance to predict future results.

Job losses since December are now at 286,000 in the private sector and 232,000 overall, counting for growth in government. What was up? Health care (23,000) and bars and restaurants (23,000 also). Initial unemployment claims are up by almost 25% for the last four weeks over last year, and this week were over 400,000. Given the job losses, this is not surprising.

This month the BLS hypothecates 142,000 jobs being created in their birth/death model. You can guarantee this will be revised down. For instance, they assume the creation of 28,000 new construction jobs as the construction industry is imploding. Total construction spending has fallen for the last four months in a row. Somehow they estimate 6,000 new jobs in the finance industries. Does anyone really think we saw a rise in employment in mortgage and investment banks?

Buried in the data is a picture of a squeezed consumer. Inflation is now running ahead of the growth in wages. As the chart below shows, average hourly earnings were up just 3.6%, but inflation was 4.5%. That means consumers must struggle to maintain their standard of living. No wonder retail stores shed 12,000 jobs last month. Light vehicle retail sales are down by 20% form last year. This all paints a picture of a very challenged consumer.

A Muddle Through Recession

The business sector is clearly in recession. The ISM manufacturing index came in at 48.6. Anything below 50 means manufacturing is in decline. There was a sharp drop in new orders. New orders have been below 50 for four months. Employment has been below 50 for four months. Backlog of orders has been well below 50 for six months. Yesterday the ISM service index was again below 50 for the month of March.

Given all the data, why then do I still think we will not see a deep recession? Because corporate America is in much better shape than in the beginning of past recessions. Lower inventories, better cash to debt ratios, not as much as excess capacity, and so on. As Peter Bernstein notes in his latest letter, nonfinancial corporate debt is at its lowest level in 50 years, and four standard deviations below the average from 1960 to 2000.

The recession we are now in is a consumer spending led recession driven by a falling housing market which is infecting the entire country. Can anyone still claim that the subprime problems would be contained as many did just last summer? Consumer spending is going to fall even more as credit becomes harder to get.

The situation is neatly summer up by Bernstein:

"The debate over whether we are or are not in a recession continues.
There is, however, no debate about resumption of rapid economic growth in the
near future. That's without question the most unlikely outcome. Yes, there are
some bright spots, such as exports in the governmental largess that lies just
ahead - and the likelihood of additional government assistance in some form. The
Federal Reserve is also doing its part to lubricate the snarls in the financial
markets.

But the household sector is in deep trouble and will remain in trouble
for an extended period of time. The combination of falling home prices, the
complex problems in the mortgage area, limited financial resources and high debt
levels, new constraints and higher costs on consumer installment credit, and
probably rising unemployment already sluggish growth and jobs tend to restrain
spending by the largest and most important sector of the economy.

"Imagine what would happen if all of these adverse forces struck a business
sector stuffed with inventories, busy installing a massive amount of new
productive capacity, with labor costs rising and productivity falling, and an
overload of new debt to service. A difficult situation in the rest of the
economy could be rapidly converted into a deep recession. But the business
sector has kept inventory accumulation to a moderate pace, has limited in
capacity growth, and has been conservative in adding to debts outstanding. How
lucky can you get?

"Some observers are convinced that we are heading toward a
deep depression in any case. We are not so sure. We believe the likely duration
of these troubles is a greater concern than the depths the system might reach.
The condition of the business sector as pictured above is the primary reason for
this more hopeful outlook."

I continue to predict more disappointment for corporations that are tied to consumer spending and industries that are associated with housing.

S&P analysts continue to project earnings to be up by 15% in the third quarter of this year and by almost 100% for the fourth quarter this year over last year. Yes, I know there are a lot of one time charges and write-offs in the last two quarters of last year which make comparisons difficult. But in a recession and a slow recovery, how likely is it that we will not see even more "one-time" write-offs. And as noted above, there are more than twice as much subprime losses in our future as we have written off as of yet.

As I have written about at length in past issues, bear markets are made by continued earnings disappointments. It typically takes at least three difficult quarters to truly disappoint investors. We are just in the early stages. The recent drop in the stock market has been primarily caused by the Continuing Crisis in the credit markets, and only modestly by disappointing earnings. We need a few more quarters of disappointment to really get to a bottom in the stock market. It could be a long summer