Over the course of my thirty five year investing life I have noticed that markets often trade on hooks. A hook is when most participants develop a preconceived notion about “how things work.” Then trading follows a pattern, drawing more in. In the past, hooks were relatively harmless and when they came undone, they had little lasting overall economic impact. However, in today’s brave new world, undone hooks will severely and I think critically damage the system. At present the hook is a doozy. It is that central banks have given speculators a put that will somehow not only save both the system and their bets, but make them profitable, even in the face of too big to save insolvencies. I hold that this hook is at peak absurdity.
In developing a further understanding of how hooks work today, I would highly recommend a reading of “Boomerang,” by Michael Lewis. Lewis describes the crazy wild-man betting that goes hand in hand with so called, and dubious, central bank puts, leverage, and financialization. ZIRP all but guarantees this. This goes far beyond infecting and wrecking capital markets. This infects whole countries, and in his opening chapter Lewis gives the recent financial history of Iceland as an example. Iceland was sold the bill of goods that being a hedge fund was much more satisfying than actually producing useful goods and services. Like all crazy-ass betting parlors, the Iceland story ended in disaster. Iceland was a microcosm of a much larger “sistema” (Portuguese) in place today. It also shouldn’t be ignored that, just like in 2007-2009, some large hedge funds are also making “big short” bets against the current hook.
A thinking person (I would imagine many of my readers) going through the revealing Lewis book would easily come to the conclusion that in bubble financial systems, gamblers learn no lessons, and given the opportunity will return to the tables for more crazy bets. The aspect that should be apparent is that the players take no heed of clear and present danger. As such, they distort markets severely and wreck the price signals of markets. This is not capitalism, not in the slightest. Even terms like “moral hazard” don’t do this justice. It doesn’t help matters that central banks have joined in on the wild-ass betting. "Providing liquidity” is Ministry of Truth (MoT) spin language for paying stupid prices for fictitious capital or lending against shakier and shadier collateral. This is the mother of all wild-ass hook betting. When Greece re-defaults in June, we will get a revealing test, as the final bill will be sent to the official sector.
In 2007-2008 the markets entered a period when certain investment gambling houses took on the silly season stupid positions of the day in the markets. It is the marginal buyer who determines prices. That is especially true today, because markets are thinned out. My suspicion is that the new AIGs, Bear Stearnses and Lehmans of 2012 are even larger, too big to save institutions and are making stupider bets than ever, mostly around mother-of-all- hook trades. And they are backstopped by too big to save countries who serve as foils. And that is the rub.
Trading in markets dominated by the Icelands and AIGs of 2012 can be very challenging. This is the reason that reactions to nasty events seem so odd. The Icelands of 2012 don’t care one iota because they are bound to drive off cliffs, Wile E Coyote style. Michael Lewis describes the incentives well: no claw-backs, and no criminal prosecution, just gamble and collect when there are winnings, and walk away when it blows up. I have mentioned numerous trigger points that will blow the sistema up, but a too big to save failure of a financial institution (or several) combined with a too big to save sovereign defacto default (or several) has as good a chance as any of being the mother of all game changers.
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