Tuesday Readings

Below are a few articles I’ve read so far this week:

The Market Could Soon Bottom and Nobody Knows It – Dave Banister

Relative Strength and Market Volatility – Systematic Relative Strength

Minimum Variance Portfolios – Crossing Wall Street

What Would It Take to Save Europe? Baseline Scenario

Market Undergoing Huge Change – Mark Hulbert

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Disclaimer: No current positions in stocks mentioned. Please note that Scott’s Investments is not a financial adviser. Please consult your own investment adviser and do your own due diligence before making any investment decisions. Please read the full disclaimer at the bottom of Scott’s Investments.

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Disclaimer: Stock Loon LLC, Scott's Investments and its author is not a financial adviser. Stock Loon LLC, Scott's Investments and its author does not offer recommendations or personal investment advice to any specific person for any particular purpose. Please consult your own investment adviser and do your own due diligence before making any investment decisions. Please read the full disclaimer at the bottom of www.scottsinvestments.com

Weekend Reading

Last post before the weekend – if you have not visited The Baseline Scenario, I recommend it. It is focused more on economics and policy then investing. Two recent posts caught my interest, the first being The Problem That Won’t Go Away [foreclosures] and the second which I will paste below, How To Blow A Bubble, by Simon Johnson, former International Monetary Fund’s Economic Counsellor (chief economist):

Matt Taibbi has rightly directed our attention towards the talent, organization, and power that together produce damaging (for us) yet profitable (for a few) bubbles. Most of Taibbi’s best points are about market microstructure – not the technological variety usually studied in mainstream finance, but more the politics of how you construct a multi-billion dollar opportunity so that you can get in, pull others after you, and then get out before it all collapses. (This is also, by the way, how things work in Pakistan.)

In addition, of course, all good bubble-blowing needs ideology. Someone needs to persuade policymakers and the investing public that we are looking at a change in fundamentals, rather than an unsustainable and dangerous surge in the price of some assets.

It used to be that the Federal Reserve was the bubble-maker-in-chief. In the Big Housing Boom/Bust, Alan Greenspan was ably assisted by Ben Bernanke – culminating in the latter’s argument to cut interest rates to zero in August 2003 and to state that interest rates would be held low for “a considerable period”. (David Wessel’s new book is very good on this period and the Bernanke-Greenspan relationship.)

Now it seems the ideological initiative may be shifting towards Goldman Sachs.

As Bloomberg reported on August 5th, “Goldman economists, led by Jan Hatzius in New York, now see a 3 percent increase in gross domestic product at an annual rate in the last six months of this year, versus a previous estimate of 1 percent. The new projections were included in a research note e-mailed to clients.”

Goldman’s public thinking, of course, has been that we face such slow growth that interest rates should be kept low indefinitely. There is, in their view, no risk of inflation – and no such thing as potentially new bubbles (e.g., in emerging markets). The adjustment process will go well, as long as monetary policy stays very loose – it’s back to Bernanke’s 2003 line of thinking.

This line of reasoning has been very influential – reinforcing Bernanke’s commitment not to tighten monetary policy in the foreseeable future and fitting in very much with the Summers model of crisis recovery. Just a couple of weeks ago, in his July 14 report, Jan Hatzius argued, “further stimulus remains appropriate” and “the appropriate debate is not whether fiscal and monetary expansion is appropriate in principle but whether it has been sufficiently aggressive.” I don’t know if he has revised this line in the light of the big upward revision in his growth forecast or whether he is still saying, “Ultimately, we do expect further stimulus, but it may take significant disappointments in the economic data and the financial markets before policymakers move further in this direction.”

Much faster growth than expected is, of course, in today’s context a good thing. But it also brings complications. If you keep monetary policy this loose for much longer, you will feed bubbles. And if you encourage even looser monetary and fiscal policy, there will be a costly reckoning not too far down the road.

Monetary policy orthodoxy under Greenspan did not care about bubbles in the least. Now we (led by Greenspan) have massively damaged our financial system, our real economy, and our job prospects, this view is under revision.

Of course, in principle you should tighten regulation around lending but, just like 2003-2007, who is really going to do that: the US, China, the G20? On this point, all our economic leadership is letting us down – although they are getting a powerful assist from people like Goldman (and Citi and JP Morgan and almost everyone else on Wall Street.)

Next time, our big banks will take another massive hit – quite possibly bigger than what we saw in 2008. Goldman and its insiders are ready for this. Are you?

By Simon Johnson

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Simon Johnson: Bank Lobbyists and Obama

Simon Johnson asks an important question, Did Bank Lobbyists Write Obama’s Reform Proposal? Johnson’s conclusion is a resounding yes…

What is the essence of the problem with our financial system–what brought us into deep crisis, what scared us most in September/October of last year, and what was the toughest problem in the early days of the Obama administration?

The issue was definitely not that banks and non-banks could fail in general. We’re good at handling some kinds of financial failure. The problem was: a relatively small number of troubled banks were so large that their failure could imperil both our financial system and the world economy. And–at least in the view of Treasury–these banks were so large that they couldn’t be taken over in a normal FDIC-type receivership. (The notion that the government lacked legal authority to act is smokescreen; please tell me which statute authorized the removal of Rick Wagoner from GM.)

But instead of defining this core problem, explaining its origins, emphasizing the dangers, and addressing it directly, what do we get in yesterday’s 101 pages of regulatory reform proposals?

  1. A passive voice throughout the explanation of what happened (e.g., this preamble). No one did anything wrong and banks, in particular, are absolved from all responsibility for what has transpired.

  2. A Financial Services Oversight Council, which sounds like a recipe for interagency feuding, with the Treasury as the referee and–most important–provider of the staff. The bureaucratic principle is: if you hold the pen, you have the power.
  3. Some of the largest banks (“Tier 1 Financial Holding Companies”, or Tier 1 FHCs) will now be subject to supervision by the Federal Reserve Board–although under the confusing jurisdiction also of the Financial Services Oversight Council in many regards (e.g., in the key setting of material prudential standards) and subsidiaries can have other regulators.
  4. Tier 1 FHC should have higher prudential standards (capital, liquidity, and risk management), but “given the important role of Tier 1 FHCs in the financial system and the economy, setting their prudential standards too high could constrain long-term financial and economic development.” Sounds like a banker drafted that sentence. None of the important details/numbers are specified, although the Fed should use “severe stress scenarios” to assess capital adequacy. Is that the same kind of actually-quite-mild stress scenario they used earlier this year?
  5. In terms of risk management, “Tier 1 FHCs must be able to identify aggregate exposures quickly on a firm-wide basis.” There is no notion here that risk management at these big banks has failed completely and repeatedly over the past two years. How exactly will FHCs be able to identify such risks and how will the Fed (or anyone else) assess such identification?
  6. In case you weren’t sufficiently confused by the overlapping regulatory authorities in this plan, we’ll also get a National Bank Supervisor (NBS) within Treasury. Regulatory arbitrage is not gone, just relabeled (slightly).
  7. There is no greater transparency or public accountability in the regulatory process. We still will not know exactly what regulators decided and on what basis. Such secrecy, at this stage in our financial history, clearly prevents proper governance of our supervisory system.
  8. There appears to be no mention that corporate governance within these large banks failed totally. How on earth can you expect these banks to operate in a responsible manner unless and until you address the reckless manner in which they (a) compensate themselves, (b) destroy shareholder value, (c) treat boards of directors as toothless wonders? The profound silence on this point from the administration–including some of our finest economic, financial, and legal thinkers–is breathtaking.

There’s of course more in these proposals, which I review elsewhere and Secretary Geithner’s appearances on Capitol Hill today may be informative–although only if his definition of the underlying “too big to fail” issue uses much stronger language than yesterday’s written proposals.

But based on what we see so far, there is little reason to be encouraged. The reform process appears to be have been captured at an early stage–by design the lobbyists were let into the executive branch’s working, so we don’t even get to have a transparent debate or to hear specious arguments about why we really need big banks.

Writing in the New York Times today, Joe Nocera sums up, “If Mr. Obama hopes to create a regulatory environment that stands for another six decades, he is going to have to do what Roosevelt did once upon a time. He is going to have make some bankers mad.”

Good point–but Nocera is thinking about the wrong Roosevelt (FDR). In order to get to the point where you can reform like FDR, you first have to break the political power of the big banks, and that requires substantially reducing their economic power–the moment calls more for Teddy Roosevelt-type trustbusting, and it appears that is exactly what we will not get.

[Cross-posted at The Baseline Scenario.]

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Disclaimer: Stock Loon LLC, Scott's Investments and its author is not a financial adviser. Stock Loon LLC, Scott's Investments and its author does not offer recommendations or personal investment advice to any specific person for any particular purpose. Please consult your own investment adviser and do your own due diligence before making any investment decisions. Please read the full disclaimer at the bottom of www.scottsinvestments.com