Investing for Sustainable Gains

Stimulated by this post at A Dash of Insight by Jeff Miller.

Yesterday’s Twitter-induced “flash crash” and last week’s “gold smash” illustrate why using stop loss orders and trailing buy orders can be a really bad way to play in the markets.

Folks with a “shopping list” and trailing buy orders in the S&P yesterday might have gotten a bonus by getting their orders executed during the dip, but it’s a risky way to trade. Consider those folks with trailing buy orders for gold last week – they were hammered by getting their orders filled at prices which soon proved to be well above the market price! That sudden dip isn’t always buyable…

But there’s a broader conclusion to both the gold-smash bear raid and the flash crashes: any time you send a stop-loss order to your broker, you’re giving Mr. Market a free option to liquidate your shares at a loss to you (and thus a profit for Mr. Market). In the old days a “flash crash” was called a “Bear Raid” or “running stops”, and it was one of the ways the marketeers fleeced the muppets so that the brokers could have their yachts…

Conversely, any time you leave a trailing buy order out there, you’re giving Mr. Market an option to dump his shares on you, at a price which might have been fair when you entered the order, but it very likely won’t be fair when you get your execution!

All options have at least some value. Why give value away for free? Folks shouldn’t be giving those stop-loss and limit-order options away to the market, unless they’re getting good value in return. Maybe the peace of mind is worth it, but it seems like Mr. Market is collecting a lot of rent from those unwilling to hold their positions with conviction. And maybe sometimes those sudden dips prove profitable, but it sure looks a lot like collecting pennies in front of a steamroller.

From a discussion at Economist’s View, I submit the following on the topic of “more exploration of non-wage paths to rising incomes and living standards.”

Another possibility to improve living standards would be to minimize the rentier / interest-earning fraction of the population (who are effectively a tax on the working, indebted population) and help those individuals find more productive (or at least, less-extractive) roles. This issue has both generational-conflict and class-conflict dimensions, but there are non-conflict alternative solutions that no one talks about. A shift in cultural values could lead the seniors to think less in terms of a pure-leisure “retirement” and more in terms of “aging gracefully” while still contributing as much as possible to family and to society. A second shift could lead the “rentier class” to be stigmatized for engaging in consumer lending (a tax on the borrowers) while socially rewarding those who actually engage in investment behavior (formation of true sustainable capital, rather than consumption).

Lowering prices, or at least the rate of increase of prices, would improve living standards (at least in a ceteris paribus world). The inflation goal could be 0%, not 2%, and in fact “stable” is the statutory goal in the Federal Reserve Act. The debt-funded sectors (housing, healthcare and education) all need to become less expensive in order for living standards to rise. Here are the tips on traveling on a college budget, which allow them to explore the world without sacrificing their future prospects.

A third way of increasing living standards would be to encourage job growth in sectors that actually improve living standards, while minimizing jobs (and other costs) in sectors that don’t really contribute. I mentioned the broken healthcare sector above. If we could find a new “peace dividend” (improved international diplomacy resulting in a reduction in military and homeland security staff), that would allow perhaps another million potentially-productive members of society to actually produce goods and services (that would improve living standards), rather than defending against harm (which consumes resources that perhaps could be better used elsewhere).

The options exist. We just need to get people thinking about them, instead of wasting their time on divisive non-solutions.

In response to Mark Thoma’s repost of Shiller’s “beauty contest” article in the NYT two weeks ago:

Shiller’s two-week old “frantic beauty contest” argument wasn’t worth the paper it wasn’t printed on.

The market crash was led by and dominated by problems in Europe and had very little to do with the S&P downgrade, other than as an illustration that the U.S. government also hasn’t got a clue, much less a plan, for returning to solvency… The S&P news might have been the proverbial “wings of the butterfly” driving the chaotic “market-weather” system wild, but it WAS “hurricane season” and if not S&P, something else would’ve started the storm.

The stock market tail is being wagged by the huge bond market dogs. We are reaching the end of a 30-year bull market in bonds.  Interest rates have been falling consistently from 1982-present, but now have almost no room to fall further.  The much smaller stock market is being wagged violently because a whole bunch of bondholders at the Emperor’s dinner party have finally conceded that he really doesn’t look good with no clothes on, and they now fear losing the shirts off their backs to cover his new wardrobe bill.

As a result of this belated realization that the Eurozone financial sector is once more deeply insolvent… that our 21st-century Titanic really is going to sink despite all the hubristic “financial engineering”… credit seized up when everyone jumped into the non-Euro lifeboats. Mountains of money (literally, if you think of it in terms of printed $1 bills or 1-Euro coins!) are jumping all over the world.  Some are seeking safe-haven shelters, others need to cover rampaging liquidity problems.  Totally “unexpected” (yet obvious in hindsight) events are catching huge numbers of traders and hedge funds off guard, causing margin-call collateral damage across a number of markets.

And that’s just the most immediate list of crisis issues!  We live in interesting times…

Even the bondholders who emerge with their principal intact can expect only minimal interest, and also only minimal capital gains over the next decade. Particularly relative to the gains typical during the 1982-2010 period, the near future looks very grim.  And those receiving their principal back from their “certificates of confiscation” will be the lucky ones!  The market desperately needs a cleansing wave of defaults to dissuade lenders from taking even more foolish risks in the future.  Some folks, who have made themselves examples of how not to lend, will have to be exposed for the frauds that they are, so that others will learn.

MEANWHILE, back in Shiller’s home country, there’s the emerging data that the U.S. economy recently slid back into recession.  Businesses can feel it and astute traders can see it in the emerging data, but America’s economists and political leaders haven’t got a clue, much less a politically viable plan.  So now we face huge new series of crises, at a time when we haven’t even seriously started to address the fundamental, structural economic problems that were exposed 3-5 years ago.  One can only hope that this time, sensible voters get educated and demand real reforms, rather than letting the financial elites squander another crisis.

Amidst all of this, the S&P downgrade had nothing to do with anything, except in the minds of some politicians and economists.  The T-bond markets totally ignored the news, except for TIPS pricing in an inflationary recession rather than a deflationary one.
The wonder is not whether there’s a volatile beauty contest going on in the absence of news.  The wonder is that this market is as stable as it has been!

Had even one of these issues been on the radar in, say, 2004-2005, it alone would’ve dominated the news cycle and the markets would have swooned as much as they have so far.

As things stand, the two most obvious solutions facing policymakers are, on the one hand, to let bonds default and deflate the government-credit bubble directly at the direct expense of mismanaged capital, or on the other hand to print money and inflate everything away primarily at the expense of labor.  The implications of those two choice result in starkly different valuations for corporate stocks, and the market can be expected to veer up and down wildly until the political outcome becomes more certain.  It could be years yet.

So methinks Shiller should stop grasping at explanatory straws and get ready for the deluge…

Both the Vanguard and Fidelity bond sites show no TIPS available for sale with maturities under 10 years.  Why?  (Is it impossible to offer bonds for sale with negative effective yields for some reason?)

Can the bond market’s “implied inflation expectations” be accurate if the TIPS market is totally broken?

One might infer that if sellers were able to raise their prices, there would be a price at which someone would make offers.  In that case TIPS are currently underpriced (yields too high) and the implied inflation expectations are too low (spread to Treasury yields too small).

Another way of saying it is that the supply of 5 and 10-year TIPS is inadequate and the government is, in effect, manipulating perceived inflation expectations to the downside. One would be tempted to consider this a policy choice, but it could just be that no one remembers that supply matters.

Hope to update this later after learning more.

Update 9/13:  Same situation again today. It wasn’t a one-off thing.  It would be interesting to know whether the situation changes after the upcoming 10-year TIPS auction later this month, and again with the 5-year in October…  But with the market this jittery, it seems a lot could happen between now and then!

America’s leaders need to quit farting around with this “default on the debt” nonsense.  It’s time to fix the deficit already!  And no, failure to raise the debt ceiling does not imply a default on the national debt!

Two years in a row, I ran the handy online simulations of the California budget balancing, and was done in an hour or less each time.  The budget could be balanced.  It required some tough choices but the value of the balanced budget exceeded the costs of those choices.  And the state government eventually did more or less the same thing.

Now it’s Uncle Sam’s turn to go on a fiscal diet. Today we read that a U.S. Representative actually seriously suggested that we void $1.6T in Treasury debt held by the Federal Reserve bank?  And that “Serious Economists” actually gave it consideration???

What have we done to this country???

The fact that we are even having discussions of this sort would have horrified anyone in the country just 5 or 10 years ago.  Go back 20 or 30 years, and the populace would have relegated those responsible for creating the situation to deep everlasting public shame!  How is it that those who blindly created the mess through terrible policies are still in charge?  Perhaps that same blindness is a large part of the reason why they can’t see how to fix it?

There WILL be vast unintended consequences, if we don’t point the ship of state back in a sustainable direction.

If the duly selected “leaders” of this country cannot put their heads together and chart a sustainable fiscal course, the $1.6T at the Fed is irrelevant.  Given the 3-year leadup to the current situation, including the longstanding Icelandic, Irish, Portuguese, Spanish and Greek dramas, the claim that we somehow need more time to put our heads together is rubbish.

Fix the budget now, and we don’t need to risk the consequences of defaulting on the Fed’s asset base.

After 3 years of horrific policy response to an economic crisis resulting from terrible policy, Lady Justice is in tears, and the social contract is deeply in question.  Breaking the Full Faith and Credit of the U.S. Government in ANY fashion, aside from being unconstitutional, will fracture what little remains of that social contract.

The state governments have shown that it’s possible to bring spending in line with revenue, by actually sitting down and prioritizing both spending and revenue options, and making tough choices.  There has been pain but the world has not ended.  If 50 states can do this individually, so can the national government!

The time has come for the Federal Government to take its medicine as well.  We are long overdue to slaughter the sacred cows of both parties.

We don’t NEED two wars, a military-industrial-complex larger than the rest of the world’s combined, a Medicare system that pays out to treat patients who are already terminally ill and which is subject to rampant fraud and abuse, a health-care system that costs twice as much as anyone else’s but doesn’t deliver better outcomes, and a Federal Government that has in so many ways accumulated so much power  that it frequently disregards its own Constitution. I do think we need Social Security, at least the retirement income portion, but it’s time to raise the retirement age again, and we need to give people some notice that those retiring in 10 years might only get 90% of the benefits.

And you know, I don’t think the world would end if overall total tax rates gradually reverted to historically normal levels, provided the deficit was eliminated.  There are a lot of loopholes to be closed, deductions to be phased out, and rates that could be a shade or two higher.It also wouldn’t hurt to go back to the last time the federal budget was balanced, and figure out why it worked then and whether it would work again now.

It is time for shared sacrifices for the greater good.

None of this is hard to do, we just have to decide to JUST DO IT.