Cognitive Dissonance: Associating MENA Political Crisis Or Oil Prices With Weak EM Equities

Listening to media and to their “experts” or to mainstream chitchats will give you a false impression of what’s been happening.

Some would claim the Middle East has been causing market turmoil.

On the other hand, others will claim rising oil prices has hurt the EM equity markets.

Let’s put into perspective the reality of the current situation as seen by the above chart. (pls pay close heed)

By the way, here is the time line of the MENA’s (Middle East and North Africa) revolt against autocracy.

The best view for this interactive chart is to go the Wall Street Journal here

The important point is to show you WHEN all these began—January 9^th. (you may want to include Algeria’s food riot 3 days earlier)

So what do all these tell us?

-The fall of emerging market equity prices began last December as OIL prices in general continued to climb. In fact, the initial downturn of EM equities coincided with the WEAKENING of oil prices. But oil reversed and rallied.

-Emerging equity markets has been on a decline WAY BEFORE the domino like political crisis in the Middle East and Africa (marked by the blue vertical line).

-Oil prices have been on the rise WAY BEFORE the MENA Political crisis

-The US S&P 500 has been on a winning streak and only materially declined yesterday.

So has rising oil prices and or the Middle East crisis has caused the decline in EEM? The answer is clearly NO!

The correlationship of the Middle East crisis, oil and Emerging markets appear to be tenuous, i.e. correlations have been starkly weak.

Yet to argue that Middle East or High Oil Prices equals WEAK global equities is no more than cognitive dissonance or in my terminology popular “superstitions” or in Taleb’s lingo, “Negative Knowledge”.

People are simply trying to grope for an explanation and would take any events to confirm or to read by the market’s action.

Instead the role played by the Middle East Crisis to the current EM equity infirmities has been as an AGGRAVATING CIRCUMSTANCE to an already existing condition.

Those who took action because of the alleged Tunisia-Oil-Equity relations are plain LUCKY, for the simple reason that to argue base on this premise has been simply false.

I’d like to further add that to my observation NO EXPERT PREDICTED this MENA political crisis to happen or unfold as it has today.

While the MENA crisis has been long overdue, and has been predictable, as current political structures and system are simply unsustainable, what has been unforeseen is the timing and the scale of contagion.

Take for instance, Dr. Marc Faber, as previously pointed out, rightly predicted on the weakening of the emerging market stocks in the end of 2010. But he didn’t foresee this political crisis unfold (although his prediction of an Israel-US air strike on Iran since has not materialized. Generally speaking, he’s been spot on).

So current conditions have only coincided or buttressed Dr. Marc Faber’s general perspective of the weakening of emerging market equities.

Bottom line: the MENA crisis serves only an aggravating circumstance, not the cause of weakening EM equities.

I’d like to add that MENA political crisis is an upheaval against dictatorship regimes whom had been US puppets.

Yet violence is likely to remain local, as the incumbent autocracy will stubbornly resist relinquishing power which they see as an endowed entitlement.

Nevertheless, it is a positive outlook to see people start to be appreciative of freedom or liberty, even if many have misplaced ideas about what constitutes genuine liberty.

In watching a live interview broadcast in Aljazzera, two Middle East experts seem to acquiesce on the root of the unrest: economics—where the current system has only channelled wealth redistribution to the privileged political class at the cost of the public.

However, in contrast to common impression about Islam Dr. Mark LeVine says that he’s been amazed by how Islam authorities have been urging people to revolt peacefully in spite of government actions.

So while there may be some risks of a militant Islam theocracy taking over, he thinks that this may be overrated.

I agree, people are starting to learn about the difference between top-down and bottom up political structures. Thus, this is no reason to be bearish.

Note: People believe whatever they want to, some to the point of deluding themselves.

I am interested in positive knowledge or what works. This means reading through all the facts rather than selectively taking in facts that only conforms to a preconceived conclusion.

Graphic: Contrast Principle

Below is a nice graphical rendition of the contrast principle, courtesy of Jessica Hagy’s Indexed, or seeing the difference between things and not absolute measures (changing minds.com) or best represented by the axiom “what you see depends on where you stand”

Blind Faith Analysis

Arguing political or economic issues based on biases, in my view, seems similar to layman’s argument in the context of religion.

They are hardly grounded from reasoning but from ‘blind’ faith.

Well, it’s interesting to know that in surveys, a vast number adherents of world religions fundamentally know less about their ‘beliefs’.

This from Pew Research

More than four-in-ten Catholics in the United States (45%) do not know that their church teaches that the bread and wine used in Communion do not merely symbolize but actually become the body and blood of Christ. About half of Protestants (53%) cannot correctly identify Martin Luther as the person whose writings and actions inspired the Protestant Reformation, which made their religion a separate branch of Christianity. Roughly four-in-ten Jews (43%) do not recognize that Maimonides, one of the most venerated rabbis in history, was Jewish.

In addition, fewer than half of Americans (47%) know that the Dalai Lama is Buddhist. Fewer than four-in-ten (38%) correctly associate Vishnu and Shiva with Hinduism. And only about a quarter of all Americans (27%) correctly answer that most people in Indonesia – the country with the world’s largest Muslim population – are Muslims.

Professor Bryan Caplan adds a brain twister to what he calls rationally ignorant,

Now consider: If people sincerely believed that their eternal fates hinged on their knowledge of religion, their ignorance wouldn't be rational. If you could save your soul with 40 hours of your time, you'd be mad to watch t.v. instead. Unfortunately for religious believers, this leaves them with two unpalatable options:

1. Option #1: Deep-down, most religious believers believe that death is the end. (This is consistent with the fact that even the pious mourn their loved ones at funerals, instead of celebrating the good fortune of the deceased). Even if this covert atheism is mistaken, the idea that most of the people in church aren't true believers seems threatening.

2. Option #2: Most religious believers are so stupid and/or impulsive that they'll knowingly give up eternal bliss for trivial mortal pleasures. But why then do so many believers show intelligence and self-control in other areas of life?

Strange or self contradictory as this is, rational ignorance only goes to show that what most people believe in runs in contrast to their actions.

And applied to economic and political analysis, blind faith analysis is simply cart before the horse logic; of which the common characteristics are: they are full of factual errors, the frequent use of logical fallacies, deliberately misinterpretation of theories, ambiguous definitions and data mining or selective application of evidence.

Prospective Philippine Stock Market 'Decoupling' Due To "Economic Success"?

One suggestion is that a "decoupling" of the Philippine assets with the US is likely for reasons of relative "economic success".

I doubt the cogency of this premise, for the simple reason that the rigidities from the current political economic structure has been rendering the Philippines as "less competitive", which equally translates to a high "hurdle rate" for investors.

The table from CATO.org, reveals that economic freedom has lagged or has marginally regressed in 2007 compared to the earlier years.

And worst, the Philippines ranked in the bottom half among 141 nations in the CATO study, particularly on the aspects of Legal Structure & Security of Property Rights (91th) and Regulation of Credit, Labor, and Business (102nd).

Where property rights isn't secured, the risk premium is high. That's because investment returns may be subject to political appropriation.

And the labyrinth of regulations similarly translates to high transaction and business costs.

So rigidities from an "unfree" economy results to a big informal or shadow economy and the inefficiency of wealth distribution which are mostly skewed towards the minority who operate in the ambit of the political class. This called crony capitalism.

And according to the following charts from CATO, economic freedom has been strongly correlated with.....

economic growth and

per capita income

Yet one should not mistaken rising stock markets as signs of "economic success". That's because equities may rise even if the economy slumps or is in a recession, as in the recent case of Hungary or Venezuela which was discussed earlier. Or as in the case of Zimbabwe in 2008 or in Weimar Germany in the early 1920s.

The reason is that equity prices in such instances were driven MAINLY by inflation. Equity assets, thereby, assimilate the function of money's "store of value" as governments ravage by stealth society's wealth by debasing currency's purchasing power during these circumstances.

As spelled out in my last post "Why The Philippine Phisix Will Climb The Global Wall Of Worries", decoupling is a relative term.

Barring another bout of liquidity seizure from a banking crisis elsewhere, the reason the Philippines (as well as major ASEAN economies) have been manifesting signs of partial decoupling is that the local markets and the economy seem to be more receptive to current globally coordinated "inflationist" policies.

Relative to globalization, the lack of depth in global integration appears to amplify local developments, which overshadows international events, since the country's shortcomings have turned into "blessings" by virtue of being less to susceptible to extraneous shocks.

So we may be witnessing the ramifications of inflationist policies overwhelming developments abroad where relative liquidity is proving more beneficial to the domestic asset class.

Although as we have earlier pointed out the ASEAN Free Trade Agreement along with China and major Asian nations should help bolster economic reforms and increase the breadth of market activities that should be beneficial to the Philippine economy in the long run. Again this is a medium to long term proposition and will depend on the new adminstration's willingness to abide by the pact.

Moreover, another prospect for a decoupling to occur is when Americans become ostensibly cognizant of inflationist policies that would send their local investors scampering for a safehaven outside their currency. But that has hardly been the case today yet. There is indeed a debt problem in the US (chart below from Bloomberg), but prospective policies will determine the outcome.

In short, this is an ex-ante proposition. Therefore the outcome hasn't been fixed.

Besides, what happens in this scenario is merely a transference of one bubble to another, which hardly makes the case for a sound paradigm of "economic success".

Japan, for instance, was deemed as an "economic success" story in the early 80s, until the illusion from inflationism was popped which only revealed the false sense of prosperity.

Major ASEAN nations also benefited from the bust in Japan's bubble as Japanese money reportedly sought returns in ASEAN assets, which was accommodated by loose policies in the region as well as abroad. The boom eventually imploded in 1997, popularly known as the Asian Crisis.

In sum: Economic success comes with more economic freedom. Inflationism doesn't exhibit signs of a sound and sustainable economic growth. Stock market activities don't necessarily reflect on the health of the economy. And economic development will depend on the prospective direction of policies.

Thus, the assumption that the Philippines will diverge from the US based on relative economic performance could be seen more from an angle of endowment effect- "where people place a higher value on objects they own than objects that they do not" or a form of cognitive bias rather than an objective assessment.

Hemline Index And Bear Markets

People are truly hardwired to seek patterns to rationalize desired outcome/s.

And some even take a cue from evolving fashions...

According to the Daily Reckoning,

``The "Hemline Index" was first developed by technical analyst/economist George Taylor in 1926. It gained popularity around the 1929 stock market crash. The theory states that the stock market rises and falls with women's hemlines. Below is a famous graphic depicting the stock market and hemlines from 1897 to 1990 constructed by Alan Shaw's legendary technical analysis group at Smith Barney."

``If this theory still holds, the story below is a bearish indicator for the stock market."

Why so? Because today's fashion reveal of the return of "lengthy" hemlines as shown by the New York Times article

The New York Times, “There is definitely a movement to a very lengthy look, especially among the young,” said Nevena Borissova, a partner in Curve, a progressive retailer with stores in New York, Los Angeles and Miami. Ms. Borissova favors radically stretched-out skirts and dresses that “drag on the floor, with raw edges, and worn with combat boots,” she said. And as she pointed out, these myriad calf- or ankle-grazing iterations of the milelong skirt bear no relation to “Big Love” or, for that matter, the Summer of Love."

Well, I wouldn't know of anyone who would buy or sell of financial securities solely based on "fashion" trends. And I don't think people buy or sell securities because they wake up on the right/wrong side of the bed too.

This makes the above correlations more coincidental and subject to the flaws of "cognitive bias". Nevertheless, an amusing anecdote.

Beware Of Economists Bearing Predictions From Models

Max Borders explains (emphasis added)

"So what do all these macroeconomic models have in common?

-They’re rendered either in impenetrable math or with sophisticated computers, requiring a lot of popular (and political) faith.

-Politicians and policy wizards hide behind this impenetrability, both to evade public scrutiny and to secure their status as elites.

-Models vaguely resemble the real-world phenomena they’re meant to explain but often fail to track with reality when the evidence comes in.

-They’re meant to model complex systems, but such systems resist modeling. Complexity makes things inherently hard to predict and forecast.

-They’re used by people who fancy themselves planners—not just predictors or describers—of complex phenomena."

The point is, according to Richard Ebeling, ``The inability of the economics profession to grasp the mainsprings of human action has resulted from the adoption of economic models totally outside of reality. In the models put forth as explanations of market phenomena, equilibrium — that point at which all market activities come to rest and all market participants possess perfect knowledge with unchanging tastes and preferences — has become the cornerstone of most economic theory."

Yet many people stubbornly refuse to learn from the lessons of the last crisis.

The mainstream hardly saw the last crisis from ever occurring:

This is why the Queen of England in 2009 censured the profession's failure to anticipate the crisis.

This also why US investment banks became an extinct species in 2008 as remnant banks were converted into holding companies, as losses strained the industry's balance sheets, which forced these banks into the government's arms.

This also why Ponzi artist Bernard Madoff gypped, not only gullible wealthy individuals but importantly a slew of international financial companies.

And this is also why contrarian John Paulson was able to capitalize on shorting the housing bubble via Goldman Sachs, which became a recent controversy, because the other side of the trade had been 'sophisticated' financial companies.

In retrospect, not only was the mainstream composed of highly specialized institutions, which were not only model oriented, but had an organization composed of an army of experts that have not seen, anticipated, predicted or expected these adverse events.

It is also important to point out that not only are the models unrealistic but those making these models are people with the same frailties whom they attempt to model. These people are also subject to the same biases that helped skew the models, which they try to oversimplify or see constancy in a dynamic world. They are also subject to Groupthink and the influences of Dopamine in their decision making process.

Adds Mr. Borders, (emphasis added)

``What does this mean for economics as a discipline? I think it’s time we admit many economists are just soothsayers. They keep their jobs for a host of reasons that have less to do with accuracy and more to do with politics and obscurantism. Indeed, where do you find them but in bureaucracies—those great shelters from reality’s storms? Governments and universities are places where big brains go to be grand and weave speculative webs for the benefit of the few.

``And yet “ideas have consequences.” Bureaucracies are power centers. So we have a big job ahead of us. We’ve got to do a seemingly contradictory thing and make the very idea of complex systems simple. How best to say it? Economists aren’t oracles? Soothsaying is not science? Ecosystems can’t be designed?

“The very term ‘model’ is a pretentious borrowing of the architect’s or engineer’s replica, down-to-scale of something physical,” says Barron’s economics editor, Gene Epstein. “These are not models at all, but just equations that link various numbers, maybe occasionally shedding light, but often not.”

Bottom line: Incentives and stakeholdings largely determine the mainstream's fixation to models.

Many are driven by ego (desire to be seen as superior to the rest), others are driven by politics (use math models to justify securing the interests of particular groups), some by groupthink (the need to be seen in the comfort of crowds), some because of personal benefits (defense of political or academic career, stakeholdings in institutions or markets or businesses) and possibly others just for the plain obsession to mathematical formalism.

At the end of the day, logic and sound reasoning prevails.

SEC-Goldman Sachs: Hindsight Bias, Staged For Political Advantage

This looks like a nice flowchart illustration from Wall Street Journal of the controversial Goldman Sachs-John Paulson deal.

We find new information from the dispute from the Wall Street Journal Editorial: (bold highlights mine)

``More fundamentally, the investment at issue did not hold mortgages, or even mortgage-backed securities. This is why it is called a "synthetic" CDO, which means it is a financial instrument that lets investors bet on the future value of certain mortgage-backed securities without actually owning them.

``Yet much of the SEC complaint is written as if the offering included actual pools of mortgages, rather than a collection of bets against them. Why would the SEC not offer a clearer description? Perhaps the SEC's enforcement division doesn't understand the difference between a cash CDO—which contains slices of mortgage-backed securities—and a synthetic CDO containing bets against these securities.

``More likely, the SEC knows the distinction but muddied up the complaint language to confuse journalists and the public about what investors clearly would have known: That by definition such a CDO transaction is a bet for and against securities backed by subprime mortgages. The existence of a short bet wasn't Goldman's dark secret. It was the very premise of the transaction."

Like us, the Wall Street Journal finds this as reeking with sensationalism.

``Did Goldman have an obligation to tell everyone that Mr. Paulson was the one shorting subprime? Goldman insists it is "normal business practice" for a market maker like itself not to disclose the parties to a transaction, and one question is why it would have made any difference. Mr. Paulson has since become famous for this mortgage gamble, from which he made $1 billion. But at the time of the trade he was just another hedge-fund trader, and no long-side investor would have felt this was like betting against Warren Buffett."...

[my comment:

People become attracted or conscious about full disclosure ex-post.

When the bubble blossomed no one essentially cared. This is an example of time constancy-interpretation of information depending on the conditions of that period, ergo full disclosure may not have been significant at all.

Heck, lots of institutions fell for pyramiding and Ponzi schemes like Bernard Madoff!

If the public have been circumspect fraudulent get rich schemes as PONZI and PYRAMIDING won't have existed at all. The fact is that there are just too many intellectual patsies out there.

And just piggybacking on the skyrocketing prices mattered then. Would there have been a crash if there had been no antecedent boom?

Besides, I have hardly seen any argument which stated that the counterparties which had been big financial institutions have a battery of lawyers, economists, accountants, statisticians, quants, security analysts, financial analysts and other experts who would have had the power from preventing this to happen. The so called losers (no they are not victims) were not gullible individuals.

So what stopped them? A stasis in thinking?! A mental blackout?

The fact is that these institutions fell for the seduction of the inflation boom, which after all was generated by the government. Expert or no expert they paid the price for falling into the trap set up by their own cognitive biases ]

``By the way, Goldman was also one of the losers here. Although the firm received a $15 million fee for putting the deal together, Goldman says it ended up losing $90 million on the transaction itself, because it ultimately decided to bet alongside ACA and IKB. In other words, the SEC is suing Goldman for deceiving long-side investors in a transaction in which Goldman also took the long side. So Goldman conspired to defraud . . . itself?...

[my comment: see Hyman Minsky quote in prior post]

``Perhaps the SEC has more evidence than it presented in its complaint, but on the record so far the government and media seem to be engaged in an exercise in hindsight bias. Three years later, after the mortgage market has blown up and after the panic and recession, the political class is looking for legal cases to prove its preferred explanation that the entire mess was Wall Street's fault. Goldman makes a convenient villain. But judging by this complaint, the real story is how little villainy the feds have found."

[my comment: Oops, " an exercise in hindsight bias" seems representative of our "fait accompli argument".]

Bill Sardi in Lewrockwell.com argues that additional regulatory lapses had been part of the story,

``the Commodities Futures Modernization Act which Congress passed a decade ago, opened the door for trades like John Paulson’s. This legislation eliminated the long-standing rule that derivatives bets made outside regulated exchanges are legally enforceable only if one the parties involved in the bet were hedging against a pre-existing risk. Prior regulations said the only people who can bet against an investment actually have to own shares in it. Here is Paulson betting against an investment he had no ownership in."

Like us, Mr. Sardi believes that this is being "staged for political advantage" of the administration in preparation for the Mid term elections.

``For sure, the Administration in Washington DC will be portrayed in coming months as the hero, rescuing the public from the blood-suckers on Wall Street. Be it government to save us all from problems it created and then pin a badge of honor on itself. The current and former administrations in Washington DC are, and have been, so tightly controlled and managed by Wall Street, even with its ex-CEOs strategically implanted within the Executive Branch, as to call all alleged reforms and sanctions into question. These are just for show...

``Goldman Sachs knows it has to make the President look good or there will be unending SEC prosecution. The public wants to know whose side is the President is on, the financial titans on Wall Street or the unemployed on Main Street? It will be scripted from the beginning.

``And now a final question – will Goldman Sachs be the fall guy in exchange for future favors from the government? If fines are handed out and nobody goes to jail, you will know this was likely preplanned."

We have long known that the global financial system have been "gamed" by the elite in cahoots with politicians. And part of the game is the borrow and spend policies, that actually benefits the banking cartel.

As we earlier said, it won't take long for this political masquerade to be unraveled.

Perhaps if the markets continue to stumble more and deeper, then there will "compromises" (via fines), which ends the US government part of the story.

But the unintended consequence could be the potential follow on class suits by other private parties. It's like opening the Pandora's box. The ultimate risk here is that the incentives to remove the profit and loss mechanism in the markets will lead to a total market malfunction.

Update:

Just to be clear, nowhere in this blog space (as well as in my earlier post) did I say that the political implication here is for the US Government to take over Wall Street. Nationalization betrays the essence of the banking cartel.

What I have been saying is that this has been a political ruse meant to either shore up somebody's electoral image or an attempt to control the gold markets.

How Myths As Market Guide Can Lead To Catastrophe

``This is how humans are: we question all our beliefs, except for the ones we really believe, and those we never think to question.” -Orson Scott Card

If I told you that the global financial markets have been simply looking for reasons to correct from its overbought position, would you buy this argument?

For many the answer is no. People look for news to fill this vacuum or what is known as a “last illusion bias” or “the belief that someone must know what is going on[1]”.

Because it is the proclivity of man to seek more complicated explanations, the Occam Razor’s rule[2]-the simplest solution is usually the correct one- is usually perceived as inadequate. Yet even if profit taking is a real phenomenon on the individual level, outside of the realm of statistics or news linkages, this is usually deemed as inconceivable by an information starved mind.

I would surmise that such a human dynamic could be a function of esteem based reputational incentives, or the need to seek self-comfort in being seen as “sophisticated”.

And stumbling from one cognitive bias to another, this camp usually associates cause and effects to “availability heuristic” or what we simplistically call “available bias” or the practice of “estimating the frequency of an event according to the ease with which the instances of the event can be recalled”[3]. And this is so prevalent in newspaper based accounts of how the markets performed over a given period.

Though we can’t discount some influences from news on a day-to-day basis, they may contribute to what we call as “noise”, since they represent tangential forces that are distant to the genuine “signals” that truly undergirds market actions.

In other words, people frequently mistake noise for signals.

And worst, for financial market practitioners scourged by an innate “dogma” bias, a characteristic seen among the extremes, particularly in the Pollyanna and Perma Bear camps, the attempt to connect the cause and effects of market actions and the political economy is largely predicated on spotty reasoning; specifically what I call as “Cart Before the Horse” reasoning - where X is the desired conclusion, therefore event A results to X.

This can actually be read as combining both logical fallacies (Begging the Question and Post Hoc Ergo Propter Hoc) and cognitive biases, particularly Belief bias or the “evaluation of the logical strength of an argument is biased by their belief in the truth or falsity of the conclusion[4]”, from which they apply behavioral decision making errors by selective perception or choosing data that fits into their desired conclusion (while omitting the rest), by the focusing effect or placing too much emphasis on one or two aspects of an event (at the expense of the aspects) and by the Blind Spot bias or reasoning that fails to account of their personal prejudices.

In short, the deliberate misperception of reality is a representation of distorted beliefs on how the world ought to be.

Clearing Cobwebs Of Cognitive Biases and Logical Fallacies

Let apply this into today’s market actions.

In the US equity markets, the bulls have fallen short of SEVEN CONSECUTIVE[5] weeks of broad market gains following Friday’s SEC-Goldman Sachs related sell-off as the week closed mixed for key US bellwethers.

The S&P 500 was the sole spoiler among the big three benchmark, where the Dow Jones Industrials and the technology rich Nasdaq still managed to tally seven straight weeks of advances (despite Google’s 7.59% loss prior to the Goldman Sach’s news).

Yet in spite of Friday’s selloffs, the week-on-week performance by the different sectors constituting the S&P had been also been mixed (see figure 1).

Figure 1 US Global Investor: Weekly Sectoral Performance and stockcharts.com: S&P 500 Financial Sector

This means that while Friday’s market selloff had been broad based, it wasn’t enough to reverse the general trend over the broader market, even considering the largely overheated pace of the ascent for the overall markets. Yes, we have been expecting a correction[6] and perhaps this could be the start of the natural phase of any market cycle.

Moreover, while the SEC-Goldman Sachs (explanation in the below article) news may have triggered the selloff on Friday, the largest loss over the week had been in the materials and telecom sectors with the Financial, where Goldman Sachs belongs, took up the fourth position.

Considering that the S&P Financial Index took a severe drubbing on Friday (down 3.81%-see left window), this only exhibits that the sector’s muted loss on a weekly basis had been an outcome of an earlier steep climb or an upside spike!

In short, in whatever technical indicator (MACD, moving averages, or Relative Strength Index) one would look at, the US financial sector has been severely in overstretched and overbought conditions which have been looking for the right opportunity for a snapback. Apparently, the SEC-Goldman event merely provided the window for this to happen.

Perma Bears: Broken Clock Is Right Twice A Day

Now for the Perma bear camp, whom have been nearly entirely wrong since the crash of 2008, seems to have nestled on the current hoopla over the SEC-Goldman Sachs as the next issue to bring the house down.

And like a broken clock that is right only twice a day, never has it occurred to them that since markets don’t move in a straight line, they can be coincidentally ‘right’ for misplaced causal reasons.

Their horrible track record in projecting a market crash early this year predicated on the US dollar carry trade bubble and the Greek Debt Crisis has only manifested events to the contrary of their expectation in terms of both the markets and the political economy. Instead, what seem to be happening are the scenarios which we have had pointed out[7].

Here is Oxford Analytica on the US dollar carry trade[8], ``As financial markets possess a demonstrable tendency to overshoot expectations, the carry trade probably is stoking market euphoria in certain places. However, this may only be partially significant, as underlying fundamentals still inform a large cross-section of investment activities.” (bold emphasis mine).

As you can see the deepening lack of correlation, which highlights on the glaring lapses in causality linkages, from which the 2008 crash became a paradigm for the mainstream, is now being accepted as “reality”. The rear-view mirror syndrome or the anchoring bias is becoming exposed as what it is: A fundamental heuristical flaw, which cosmetically had been supported by misleading reasoning.

And as for the Greek Tragedy, the resolution is increasingly becoming a bailout option. Writes the Businessweek-Bloomberg, ``The euro may receive a temporary boost to $1.38 when Greece accesses a 45 billion euro ($61 billion) bailout plan before traders reestablish bets that the shared currency will decline, according to UBS AG.[9]”

And Morgan Stanley’s Joachim Fels, who among the mainstream analysts we respect, decries the prospective action, ``The bail-out and the ECB's softer collateral stance set a bad precedent for other euro area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time.[10]” (bold highlights mine)

The difference between us and Mr. Fels is that we look at the political incentives that impels the decision making process of policymakers-where the default option or the path dependency by any government, in a world of central banking, has been towards inflationism as recourse to any critical economic problem.

And Mr. Fels appears to be reading the market along our lines.

Price inflation, which Mr. Fels warns of, is starting to creep higher and becoming more manifest even in economies that have been expected to have lesser impact from inflation due to more monetary constraints, such as the Eurozone (see figure 2).

Figure 2: Danske Bank: Will Nasty Inflation Challenge the ECB?

The Danske team, led by Allan von Mehren, expects an inflation surprise[11] to challenge the European Central Bank (ECB) based on 3 factors, rising oil prices, rising food prices and depreciating Euro.

For us, these factors are merely symptoms of the political actions and not the source of inflation.

And for those plagued by the said dogmatic biases, they keep repeatedly asking the wrong question-“where is inflation?”-even when (corporate and sovereign) bonds, commodities, stocks, derivatives and most market signals have been pointing to inflation, across the world.

The fact that inflation is in positive territory for most economies, already dismisses such a highly flawed argument.

Yet, the narrowed focus or the ‘focusing effect’ or excessive tunneling on business or industrial credit take-up or unemployment rates or on rangebound sovereign yields (particularly in the US) purposely disregards the fact that inflation is a political process.

Government which resorts to the printing press as the ultimate means to resolve economic predicaments can only reduce the purchasing value of every existing currency from the introduction of new ones.

Tea Parties As Signs Of The Reemergence Of The Bond Vigilantes

In addition, such outlook neglects the fact that

-inflation has existed even during high period of unemployment rates as in the 70s,

-consumer credit isn’t the principal cause of inflation but intractable government spending and

-as argued last week, governments will opt to sustain low interest rates (even if it means manipulating them-e.g. quantitative easing) as a policy because ``governments through central banks always find low interest rates as an attractive way to finance their spending through borrowing instead of taxation, thereby favor (or would be biased for) extended period of low interest rates.[12]”

Moreover, for a population with a deepening culture of dependency on government welfare programs, the inclination is to accelerate government spending[13] in order to keep up with public demands for more welfarism. And this can only be funded by borrowing, inflation, and taxes in that pecking order.

Why taxes as the lowest priority? Because to quote Professor Gary North[14], ``Politicians fear a taxpayer revolt. Such a revolt is unlikely until investors cease buying Treasury debt. For as long as the government can run deficits at low interest rates, that is how long they will continue.”

The ballooning Tea Party in the US, for instance, which reportedly accounts for 15-25% of the population is relatively a new spontaneously organized political movement that has apparently emerged in response to the prospects of significantly higher taxes.

For the politically and economically blinded progressives to demean this as “superficial” accounts for as utter myopia. How superficial is it to resist a runaway government spending spree, which should translate to prospective higher taxes and or lower standards of living via inflation?

As author and Professor Steven Landsburg rightly argues[15], ``Once the money is spent, the bill must eventually come due—and there’s nobody around to foot that bill except the taxpayers. We are locked into higher current spending and therefore locked into higher future taxes. The president hasn’t lowered taxes; he’s raised and then deferred them. To say otherwise is—let’s be blunt—a flat-out lie.” (bold highlights mine)

Instead, the superficiality should be applied to the fabled belief that government spending and inflationism will account for society’s prosperity. Name a country over human history that has prospered from the printing press or inflationism?!

Hence, the emergence of the Tea party movement appears to sow the seeds of a taxpayer revolt, or as seen in the market, the soft resurfacing of the long absence in the bond vigilantes, who could be simply waiting at the corner to pounce on the policy mistakes based on the delusions of grandeur by charlatan governing socialists and their followers, at the opportune moment.

Until the tea partiers gain a political upperhand, the deflation story is nothing but a justification to undertake more inflationism.

The Siren Song Of Inflation

Going back to the naïve outlook for deflation, the lack of borrowing from both domestic and overseas savings doesn’t close the inflation window, in fact it enhances it. This will entirely depend on manifold forces as culture, habit (or addiction)[16], time constancy of political sentiment and political tolerance and etc...and importantly, the attendant policies in response to the political demands.

Nevertheless, Morgan Stanley’s Spyros Andreopoulos enumerates why inflation is seemingly a siren song[17] for policymakers in dealing with a gargantuan and burgeoning debt problem.

From Mr. Andreopoulos (bold emphasis his, italics mine):

``Public debt overhang: The higher the outstanding amount of government debt, the greater the burden of servicing it. Hence, the temptation to inflate increases with the debt.

``Maturity of the debt: The longer the maturity of the debt, the easier it is for a government to reduce the real costs of debt service. To take an extreme example, if the maturity of the debt is zero - i.e., the entire stock of debt rolls every period - then it would be impossible to reduce the debt burden if yields respond immediately and fully to higher inflation. Hence, the longer the maturity of the debt, the greater the temptation to inflate.

``Currency denomination of the debt: Own currency debt can be inflated away easily. Foreign currency-denominated debt on the other hand cannot be inflated away. Worse, the currency depreciation that will be the likely consequence of higher inflation would make it more difficult to repay foreign currency debt: government tax revenues are in domestic currency, and the domestic currency would be worth less in foreign currency. So, the temptation to inflate increases with the share of debt denominated in domestic currency.

``Foreign versus domestic ownership of debt: The ownership of debt determines who will be affected by higher inflation. The higher the foreign ownership, the less will the fall in the real value of government debt affect domestic residents. This matters not least because only domestic residents vote in elections. Note that unlike domestic owners, foreign owners may not necessarily be interested in the real value of government debt since they consume goods in their own country. But they will nonetheless be affected by the inflation-induced depreciation. So, the temptation to inflate increases with the share of foreign ownership of the debt.

``Proportion of debt indexed to inflation: By construction, indexed debt cannot be inflated away. Hence, the higher the proportion of debt that is indexed to inflation, the lower the temptation to inflate.

``To these purely fiscal arguments we add another dimension, private sector indebtedness:

``Private sector debt overhang: An overlevered private sector may generate macroeconomic fragility and pose a threat to public balance sheets. Hence, high private debt also increases the incentive to inflate.

As per Mr. Andreopoulos perspective, there are many alluring technical reasons on why the political option is to inflate rather than adapt market based austerity or to allow market forces to clear up previous imbalances so as to move to the direction of equilibrium.

And combined with today’s prevailing economic dogma and direction of political leadership, the path dependency will most likely be in this direction.

Real Economic Progress And Deflation

None the less, real progress is characterized by increasing efficiency and technological advances that decreases costs of production and increases in output.

The result of which is a rising value of purchasing power of money or “deflation” (see figure 3) and not higher inflation which is the result of excessive government intervention.

Figure 3: AIER: Purchasing Power of the US dollar

This was mostly the case in the United States until the introduction of the US Federal Reserve in 1913, from which the US dollar has been on a steady decline or where the only thing constant today is to see the US dollar collapse in terms of purchasing power.

Going to the US government’s Bureau of Labor Statistics’ inflation calculator, $100 US dollars in 1913 is now only worth $4.55. That’s a loss of over 95%!

So aside from death and taxes, another thing certain in this world is that the value of paper money is headed to its intrinsic value-Zero[18]!

Yet it is funny how protectionists, who stubbornly argue about the “overvalued” currency of the US as the main source of her problem, have been only been asking for more of the same nostrums, instead of looking at WHY these has emerged on the first place.

Like in reading markets, belief in myths can be the greatest error that could lead to tremendous losses that investors can get entangled with.

As former US President John F. Kennedy once said, ``The great enemy of the truth is very often not the lie -- deliberate, contrived and dishonest, but the myth, persistent, persuasive, and unrealistic. Belief in myths allows the comfort of opinion without the discomfort of thought.”

---

[1] Wikipedia.org, List of cognitive biases

[2] Wikipedia.org, Occam Razor

[3] Taleb, Nassim Nicolas; Fooled By Randomness, p. 195, Random House

[4] Wikipedia.org, Belief Bias

[5] The emphasis on seven is meant to highlight the degree of overextension or overheating

[6] See US Stock Markets: Rising Tide Lifts Most Boats And Is Overbought

[7] For my earlier treatise on the US dollar carry bubble see What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?, and Why The Greece Episode Means More Inflationism for my discourse on the Greece crisis.

[8] Oxford Analytica; Dollar Carry Trade No Longer a Sure Bet, Researchrecap.com

[9] Businessweek, Greek Bailout in ‘Matter of Days” to Boost Euro, UBS Says, Bloomberg

[10] Fels, Joachim, Euro Wreckage Reloaded April 16, 2010, Morgan Stanley Global Economic Forum

[11] Mehren, Allan von; Euroland: Nasty inflation surprise will challenge ECB, Danske Bank

[12] See How Moralism Impacts The Markets

[13] See Where Is Deflation?

[14] North, Gary The Economics Of The Free Ride

[15] Landsburg, Steven; Tax Relief, Obama Style, thebigquestions.com

[16] See Influences Of The Yield Curve On The Equity And Commodity Markets

[17] Andreopoulos, Spyros; Debtflation Temptation

[18] See Paper Money On Path To Return To Intrinsic Value - ZERO

Media Indicators And Market Reversals

It is said that media coverages could somehow portend the flows and ebbs of the financial markets. The reason for this is that media tends to highlight on the most dominant trend, or the extremes of public sentiment.

For instance, in the past, major market inflection points have been 'captured' by the so-called "magazine cover indicator".

As wikipedia.org defines,

``The Magazine cover indicator is a somewhat irreverent economic indicator, though sometimes taken seriously by technical analysts, which says that the cover story on the major business magazines, particularly BusinessWeek, Forbes and Fortune in the United States is often a contrary indicator.

``A famous example is a 1979 cover of BusinessWeek titled "The Death of Equities". The '70s had been a generally bad decade for the stock market and at the time the article was written the Dow Jones Industrial Average was at 800. However, 1979 roughly marked a turning point, and stocks went on to enjoy a bull market for the better part of two decades. Even after the financial crisis of 2007–2010, stocks remain far above their 1979 levels. Using the Magazine Cover Indicator, Business Week's projection that equities were dead should have been a buy signal. By the time an idea has had time to make its way to the business press, particularly a trading idea, then the idea has likely run its course. Similarly, good news on a cover can be taken as an ill omen. As Paul Krugman has joked "Whom the Gods would destroy, they first put on the cover of Business Week.""

Has the recent upbeatness of markets as revealed by this magazine cover forebode an upcoming reversal?

picture courtesy of The Economist

I am not sure about the consistency or infallibility of this indicator though.

What has been framed has been the coincidences which has exhibited "the right timing" between magazine covers and market inflection points in the past.

What has not been shown has been the success ratio or the statistical 'batting averages' between the general incidences of sentiment revealing magazine covers and market inflection points.

Picking a point or two can be "selective perception" to enforce a bias, rather than applying objective analysis.

Although based on the behavioral framework, there could be some support for this; as mentioned above, the dominant sentiment could mean "overconfidence" or recklessness or deeply entrenched view from the prevailing trend, which is common during bubble tops.

Next, I find another spook story from Business Insider.

It's about the attempt to connect market performance with the upcoming sequel of the 1987 movie-Wall Street II.

This from the Business Insider,

``Some have wondered whether the forthcoming release of Wall Street II movie by Oliver Stone portends a market crash, considering that the last Wall Street was released right before the crash of 1987.

``Actually, this line of reasoning understates the case.

``There was actually another movie called Wall Street that came out in 1929. Of course, the market collapsed that year, too."

Again, correlation doesn't imply causation. It doesn't mean that "Wall Street" type movies would automatically result to another market crash from which the authors tries to imply. It's more representative of the their bias than of a logical argued conclusion.

Nevertheless, given the market's overbought conditions, a retrenchment is likely in the cards.