Submitted by Jeffrey Snider of Atlantic Capital Management
Volatility Is The Price Of Real Progress
As we all ponder what may come at us in 2012, the ongoing volatility in almost every corner of every marketplace is certainly concerning, as it should be. This record volatility has enormous implications for any investor, but especially those in leveraged ETF’s. Volatility is the anathema to these vehicles, as has been well discussed, but that does not diminish their targeted usefulness.
As a portfolio manager I use leveraged inverse ETF’s as hedges against the dramatic downside. They have a very narrow window and only perform when the market more or less moves in a straight-line down – just as it did in early October 2008, May 2010 or July/August 2011. Other than those sustained sell-offs, they are a drag on portfolio performance, a cost of doing business in this risk-on, risk-off “marketplace”.
I willingly pay that cost because I have no concrete idea when another fit of sustained selling will actually take place, but I have more than an inkling that it will. Instead, this massive and growing volatility, even though it is costing me some short-term performance, is a good sign that there is actually progress being made. What we are witnessing is a titanic battle between the world as it really is and the one central banks need you to believe it might be (if only you would set aside your own perceptions and self-interest). The fact that volatility has risen is a clear indication that the central bank-inspired anesthesia is no longer as effective as it was in 2009, or even in the QE 2.0 inspired insanity of 2010. Reality, and the free market, is being imposed – and that means there is a place for even narrowly-useful hedging vehicles.
The current market battle is nothing more than the extreme measures of the rational expectations theory and a form of the fallacy of composition, combined with the political aspirations of a century-old theoretical notion of how the economic system should be ordered. Mainstream economic “science” has developed in a relatively straight line since the Great Depression, starting with the idea that the economy must be governed in emergencies. Executive Order 6102 and the subsequent devaluation of the dollar solidified the place for the entire field of economic management, marking perhaps the last time it would be challenged by mainstream thought.
Without the guiding hand of the educated economist, capitalist, free market economies are believed to be wrought with the danger of total collapse, unable to escape from their own emotional whimsies. At the most primal level of modern economics is a deathly fear of deflation, a fear that is best summed up by Fisher’s paradox.
In 1933, Irving Fisher published a paper in the Federal Reserve’s Econometrica circular that amounted to a point-by-point logical deduction of the string of events that led to the unusual collapse of the economic and banking systems. The scale and pace of the disaster confounded “experts” of the era (it seems experts have trouble with inflections in every era), so his deduction offered a highly plausible, well-reasoned and “logical” explanation.
For Fisher, the combination of over-indebtedness and deflation was the toxic mix from which the calamity grew. But within that mix lay a paradox that formed a trap by which no self-made recovery was possible:
“…if the over-indebtedness with which we started was great enough, the liquidations of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to less their burden increases it, because the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: the more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing.”
The lessons of this paradox are interwoven into the fabric of modern/conventional economics, that whenever deflation might be present a recovery has to be forced since it cannot start on its own. But it is extremely curious that only one half of the equation was chosen as an outcast: deflation. Over-indebtedness has, obviously, been warmly embraced in the decades since Fisher’s proposition. The development of the mainstream of economics has led to the belief that intentional inflation can always defeat deflation, and therefore debt can assume a role, even a primary role, within the schematic of economic stewardship.
Fisher’s paradox survives in many forms, but among the most important was a logical derivation, namely the idea that economic participants can do what they believe is best for themselves, but in doing so harm themselves through systemic processes. This is known as a fallacy of composition; that what is good for individuals is not necessarily best for the whole. It overturned the traditional economic notion of an economy at its most basic level, from the time of Adam Smith describing individual self-fulfillment. Sure, this idea had been around for awhile before Fisher’s paper, but the Great Depression “proved” that the fallacy was real and potentially cataclysmic. Originally it was confined to the narrow interpretation of depression economics, and so the evolution of unquestioned economic management started from there.
The economics profession truly believes that there exists economic states where individual self-maximization no longer benefits the larger societal association of economic actions, so it “logically” follows that some process (or entity) has to step in and enforce conditions contrary to individual notions of self-maximization. In other words, there are times when people must be forced to do what they perceive is against their own best interest.
In the context of depression avoidance this seems to be rather innocuous, but in the displacement of political thinking since the 1930’s, it was a slippery slope. What Fisher’s paradox essentially required was a benevolent authority to administer and visit a kind of beneficial tyranny upon the economic population. In the constant forward roll of history, though, the slippery slope of needed benevolence has been applied to a larger and larger cohort of economic circumstances – emergencies breed human desire for such authoritarianism.
It is important to remember that the Federal Reserve was a secondary institution for much of the post-Depression period. After the monetary debacles of the Great Depression, especially the unnecessary reserve requirement hike in 1936 that initiated the depression-within-a-depression in 1937, the Fed was relegated to being simply a monetary check-writer. The Treasury Dept. was the economic powerhouse, especially during a time in which the dollar was the primary tool of economic management. The Fed was consigned to managing the money supply around treasury debt auctions to ensure the federal government’s uninterrupted ability to borrow (in some ways things never change). When that borrowing exploded in 1965, the money supply went with it and the seeds of the Great Inflation were embedded.
Paul Volcker changed this with his “heroism” in defense of the dollar, a dramatic departure from the previous era of Treasury Dept. domination. Conventional wisdom posits that it was Volcker’s Fed that vanquished the inflation dragon, in doing so he “created” another pillar of the fallacy of composition (high interest rates were not good for individuals, but seemed to be good for the larger system). The chastened Fed of 1965 that allowed inflation to begin building was dropped for the activist Fed of 1980 that could apparently do no wrong (the monetary history of the 1970’s was completely and conveniently ignored). The Fed’s reputation soared with the perceived economic success of the 1980’s, handing Alan Greenspan an amount of power unparalleled in human history.
But how much economic success in the 1980’s was earned? Again, conventional wisdom sees the Great Inflation ending in 1982, giving way to the Golden Age of Economic kingship – the Great Moderation. What I see is simply a transformation of inflation from consumer prices to asset prices. Instead of overwrought money creation circulating within the real economy in the form of wages and higher consumer prices, new credit production capabilities allowed a secondary circulation of credit money into assets, indirectly feeding into the real economy – first as interest income, second as debt – as the notorious “wealth effect”. The economy in this age would transform from one based on earned income to one based on paper movements of created money, with the irony of the “wealth effect” being its tendency to incrementally create economic activity without actually creating productive wealth. The global economy was increasingly reliant solely on money creation, a transformation that cannot be understated and a prime cause for re-evaluating the whole of the Great Moderation.
We see this quite clearly in the consumerism of the period. In 1975, household spending was still largely a function of wage income. If we adjust Disposable Personal Income by subtracting asset income (interest and dividends), we see a modest deficit in spending sources of about 3.5%. Households spent more than they brought in from wages, benefits, government transfers (net of taxes) and rental income. Consumer/household spending needed asset income to make up that small funding shortfall (and to go beyond to generate a positive savings rate). By the midpoint of the Great “Moderation” in 1990, the spending deficit was a chasm, 19.3%. Without the $898 billion (nominal dollars) in asset income there was no way that consumer spending would have grown so far so fast.
That interest/asset income was a leftover effect of the Great Inflation when monetary creation found its way into growing stockpiles of “safe” financial assets for the household sector. By 1990, US households had accumulated $5.1 trillion in deposits and credit market assets (largely US treasury bonds) against only $3.6 trillion in debt (including mortgages). But that was a huge “problem” for the growing acumen of an activist Federal Reserve. As the 1980’s progressed, interest rates were declining with consumer inflation (and providing a helping hand to asset prices running wild with credit now focused in that direction). The mainstream of economics took this as a sign of success, but it was really just a marked decrease in monetary efficiency since new money was now circulating heavily in asset prices (the junk bond bubble and the new, great bull market in equities).
Concurrently, economic management had evolved in the 1980’s with the innovation of the “rational expectations” theory. It was hailed as a huge advancement in monetary thinking coming out of the Great Inflation. In many ways it was an adjunct to the fallacy of composition. The rational expectations theory holds that the economic children of modern society can be fooled into undertaking activity that might be against their own best interest if some benevolent authority simply makes it look like everything will be better in the not-too-distant future. If the Fed screws with the price and cost of money (for debt accumulation), manipulates the price of gold (for inflation expectations), or “nudges” stock or real estate prices in the “right” direction (the notorious wealth effect), the population will act today on those conjured expectations of good times tomorrow.
By the end of the 1980’s, the S&L crisis (a stark warning that economic management might not have been all that it was advertised to be, a warning that has largely been ignored) threatened to plunge the world back into depression. The Fed and Alan Greenspan feared the consequences of a banking crisis and any attendant deflation. The Fed funds rate was pushed from around 8.25% in April 1990 to a ridiculous 3.25% by July 1992 – staying at that low level well into 1994. Alan Greenspan was trying to save the entire banking system from the S&L crisis by reducing the cost of funds so dramatically (hoping to see an increase in bank profits, leading to higher retained earnings and therefore equity capital upon which to pyramid more debt). The pressure on household spending because of the collapse in interest rates necessitated a marginal change in spending, but not back toward earned income. Instead we got the wealth effect and the myth of Greenspan’s genius.
Despite a persistently weak recovery (just ask George HW Bush) from a relatively mild recession, the Fed’s management of the economy into a “soft landing” was hailed as a new form of a New World Order. The business cycle could be smoothed (or even eliminated) by the marginal attraction to debt and the wealth effect. If expectations were properly managed, the public would suppress their base emotional instincts and dance to the tune set by the monetary kingship.
It was hubris of the highest order, of course. By the time the tech bubble finally burst (another warning of the dangers of an artificial economy) the Fed doubled down to save itself and its primacy. The results have been disastrous as the marginal economy progressed further and further away from the fundamental foundation of wages and earned income. The savings rate fell to zero by 2005. Worse than that, US households added $10 TRILLION (+269%) in debt between 1990 and 2007, with $7 TRILLION coming after 2002 alone. The household funding deficit reached a high of 24%! Even worse than that, households had shifted preferences out of “safe” credit market assets or bank deposits and into much riskier price assets simply because the systemic cost of risk was intentionally held artificially low.
The economic foundation of the Great Moderation was an illusion, nothing more than asset prices and debt; wealth effect and rational expectations. None of this describes a free market, capitalist economy.
Central banks and economists love to talk about economic potential, spending so much time trying to calculate it with their complex modeling capabilities and elegant mathematical equations. But the hard truth of economic overlordship is rather simple. The Federal Reserve, in cooperation with global central banks, Wall Street and the interbank wholesale money marketplace, simply substituted credit for earned income. And the reason is also very simple, because debt accumulation is far more easily manipulated. As long as households remained attached to earned income and “safe” savings assets, economic management was nearly impossible. The rational expectations theory needs a system more attuned by asset prices and malleable debt levels. And so marginal consumer spending shifted away from the solid foundation of jobs and wages right into the hands of the fallacy of composition and the rational expectations theory.
It is more than a little ironic that the Fed so willingly embraced indebtedness in light of their history with Fisher’s paradox. But mathematical advances in modeling along with a growing commitment to steady inflation allowed the Fed to really believe it could stave off deflation. So they made a deal with the debt devil to obtain the keys to the marginal economic castle and its grand artificial economy, and in the process dangerously surrendered to the over-indebted part of the Fisher’s paradox equation. Thus the housing bubble to mediate the tech bubble since the tech bubble had some potentially deflationary consequences. Even today, everything the Fed has done since 2007 can be seen in these terms: the fallacy of composition, rational expectations and the preservation of the benevolent stewardship of the economic, academic masters.
Somewhere in all this transition from Fisher’s paradox to Greenspan’s genius to debt-slavery, the system ceased to function as a free-market, capitalist system. The free market values the bottom-up dispersal and divergence of billions and billions of free opinions, freely associating together as unfettered price discovery. A central bank devoted to the fallacy of composition and rational expectations is a top-down system committed to manipulating price discovery to achieve ends that seem to be, and very often are, contrary to the perceptions of the vast majority of doltish economic participants. The monetarist system is forced upon the population, no matter how much they resist.
Indeed, the idea of an economic fallacy of composition is itself a logical fallacy. I have no quarrel with the idea of a fallacy of composition or any logical fallacy for that matter, but logic holds no special place in social interactions. There are no logical deductions from economics no matter how much math is applied. It is, and will remain, a subjective interpretation of events. Even the vaunted Fed and its accumulation of Ivy League PhD’s performs no leaps of logic. Like anyone else with an opinion, whatever fallacy of composition it thinks it sees is still just subjective interpretation.
And that is the real danger. Cloaked in the apparent objectivity of math, the economic elite have gained unlimited economic power. When you stop and think about it, you can create a fallacy of composition pretty much anywhere (and write and enforce rules based on it) – from the steep tax on savers with five-plus years of zero interest rates to mandating everyone has to purchase health insurance even if they don’t have the need for it.
The volatility of today is nothing more than a fight between the active perceptions of participants trying to maximize self-interest within the classical, traditional concept of a free economy, and the opposing forces of overlordship of the landed economic elite, trying to get the uninitiated to simply follow orders. The elite really believes that if everyone would gladly pile on even more debt and spend with reckless abandon, the Great Moderation would once again be within reach. Consumers should only stop thinking for and of themselves since common sense is dangerous to the controlled economic system. To get more debt “flowing” requires active price manipulation to make the world seem like it will be better in the near future so that people will start acting like it.
Economic potential to the Fed is the level of economic activity of 2006. To them, this is a cyclical recovery from a cyclical interruption in their normal smoothing of the business cycle. Sure it veered way off into panic, but that was just more confirmation that human emotion needs to be managed. But if we view the economy from the historical perspective, the lack of a cyclical recovery is not at all surprising. The Fed spent decades building up so much monetary inefficiency, so many artificial monetary channels for indirectly “stimulating” economic activity, that it will simply take an enormous amount of new money to get it all moving in the “right” direction again (Ben Bernanke and Paul Krugman at least have that part right).
The fact that resistance is growing, that investors are not drinking the economic Kool-Aid as much as 2009 or late 2010 is a sign of growing discord. The efforts in the realm of rational expectations are simply not working. That is the ultimate danger because the entire central bank gameplan is based on only that. Without willing adherents (useful idiots?) to the central authority of economic management, everything falls back to the true potential – earned income and boring cash flow of un-manipulated dollars or euros. With such a massive chasm between marginal economic activity and earned income sources of spending, it is not likely to be a shallow or short transition (this explains most of the inability of the economy to create jobs – so many jobs in the central planning era were based on money creation and financial “innovation”).
That is both the opportunity and danger of a system reaching its logical end. Put another way, there is a growing realization that while free markets are messy and somewhat unstable, central planning is not really a cure for those symptoms. In fact, it has created more harm ($13 trillion in debt is only US households) than good, more illusion than solid results. Volatility means that the free market is at least attempting to impose itself at the expense of central planning’s soft financial repression and control. By no means is such a beneficial outcome assured; rather the other half of all this volatility (the risk-on days) is the status quo desperately trying to hang on through any and all means (even those less than legal, like bailing out Europe through cheapened dollar swaps).
So the cost of using leveraged ETF’s as insurance against the failure of soft central planning necessarily rises, but that just may mean their ultimate usefulness is closer to being realized. Unless you know exactly when this transition might reach its conclusion, it is, in my opinion, a cost worth bearing.