Sunday, December 26, 2010

Funny Phone Call Between Client and Broker and how Market Makers Abuse

I find this audio file rather illuminating. It is a recording of an exchange between a client of GNI Touch (Man Group) in the UK, and a broker from the firm. Have a listen, but be warned it is full of expletives and foul language

The funny thing is I tend to be on the side of the client! Whilst there is no excuse for the foul language and abuse, this exchange highlights some practices in the UK that are simply antiquated and leave the retail client subject to manipulation. If you can put aside the abuse, the client is making a sound point here and the broker is really trying to fob him off and cost him money at the same time.

Let's look at what I think happens in this call. I will fill in some details for the international reader.

  1.  The client wants to buy 25k of Taylor Woodrow (which was one of the top 350 companies in the UK at the time) in the middle if a bear market whereby investors were dumping
  2. The broker 'goes to market'. In reality, this involves him calling the market makers and telling them he has an order to fill. In my experience, what usually happens is that the broker calls the 2-3 that he normally deals with or who he thinks normally hold this stock. As part of the unwritten 'convention' the broker usually gives the market maker an indication of the size
  3. All the market makers come back and say they can't fill the order. This then gives them an opportunity to raise the 'offer' price so they can take advantage of the situation
  4. The broker goes back to the client and suggests he tries to 'work the order' by leaving it on the order book. Again, this subjects the client to having the market raise the price on him.
You hear the rest.

Market Makers Abuse?

I want to point out a few things. Markets makers tend to know each other and in the City of London, great emphasis is put on the sociable aspect of networking and getting to know one other. Market makers and brokers are constantly doing 'favors' for each other. Unfortunately, these 'favors' can sometimes expose clients to unnecessary costs.

In this case, the client is-rather inarticulately-pointing out that he wants his order filled by the market maker and doesn't want to be subject to prices being moved against him. The stock is, after all, a mid cap UK Company. The broker keeps trying to get him to accept paying the cost of not being able to do this. This is why the client keeps insisting that he speak to someone who can fill the order. In other words, he wants to talk to someone who can call the market maker and say 'do me a favor and fill this clients order'. Eventually, he gets put through. I suspect it got filled.

How Market Makers Work

The essence of the problem, and cause of the invective, is the antiquated way in which market makers work. It is out of touch with modern day practices.  I note the betting industry via exchanges such as Betfair has allowed consenting adults the freedom to trade with each other at a price that they see fit.

Why is it that the UK stock market can't do this too? Not all stocks are traded on SETS, and even many that are, don't get much liquidity from market makers. This is a serious issue. Investors are unnecessarily paying wide spreads in small cap stocks (market makers can't be bothered to make markets in small companies) and the system is open to abuse by chummy market makers and brokers.

It gets worse. I think that there is an 'AIM discount' that is being mentally applied to small cap stocks. Given some of the outrageous spreads that market makers gave investors in 2008, many will simply not trade these stocks again. I am highly reticent to buy a stock unless I can trade it directly via Level 2.  Moreover, all investors are loath to buy a stock with a 3-10% spread and then be subject to manipulation from the very people who are supposed to be providing liquidity! This causes a problem for small companies because they won't get supported. Moreover, AIM market listings will slow if companies are faced with this problem.

The Financial Services Authority (FSA) should act to ensure individuals can trade with each other in an open and fair market. After all, it is the essence of capitalism.

Saturday, December 25, 2010

Richard Dawkins The Selfish Gene: A Book Review

Book Review: The Selfish Gene by Richard Dawkins

Richard Dawkins’ ‘The Selfish Gene’ is a well written and enjoyable book. As the title suggests, it is an exploration of the role of genes in evolutionary theory. Dawkin’s asks us to accept the genes are programmed to survive and that we or any other organism are merely ‘survival machines’, within which evolution plays out the outcomes of gene mutations.

This asks us to reframe our assumptions about the world and accept it as a huge battleground for genes fighting for survival. This can be a liberating thought for a scientist because it then allows him to apply scientific method and rationalize behavior using this initial assumption. Indeed, Dawkins goes on to explain a collection of interpersonal, societal and biological relationships by applying game theory to the behavior of the ‘survival machines’ within these relationships.

The Selfish Gene

Pivotal to this idea is the notion of ‘selfishness’ in the title. In fact, to Dawkins, the genes are just trying to ensure their survival (and promulgation), in other words, they are not so much immoral as amoral. However, the term ‘selfish’ is probably used to highlight this amorality, and he spends ample time explaining how apparently altruistic behavior is, in fact, selfish behavior.

He adds succor to this conclusion by pointing out that he is not advocating the case for selfishness as an evolutionary moral code. This would make his argument weaker. On the contrary, he is arguing that this is how it actually is.

On the whole it is an interesting read and I would advise it as a thought provoking tome. However, it would have been preferable if Dawkins extended the scientific rationale to his exploration of religion. He touches-unsatisfactorily-upon religion in the book, but never manages to reach what I think is the inexorable conclusion of his this theory.

Dawkins, Genes and God

It is entirely feasible that a gene that causes the brain to accept submission to a higher authority (an idea which characterizes all religious thought) as the ultimate creator exists. If such a gene is successful then the ‘survival machines’ (us) that it occupies might see continued promulgation. Those that do not possess it might seek immortality by treating to recreate this creation process and dying out with their failure. In this sense, religion can be seen as an entirely necessary part of evolutionary development. I happen to believe that history shows us that all men ultimately submit. Even as established religions seem to be on the decline in, say Europe, they are being replaced with no end of new age nonsense. Dawkins’ irrational belief is his faith in ‘science’ and science killed many more men than religion did in the last century.

Whilst the idea of this gene seems obscure enough, it is entirely consistent with Dawkins’ approach. Animals do not seem to trouble themselves with notions of Gods or question their ultimate reality or creation. We do. Why Dawkins seeks to isolate this one area of evolution and then subject it to the onslaught of ‘reason’ in his later works is a real mystery.


Dawkins, Richard 'The Selfish Gene' Oxford University Press, 1989

Thursday, December 23, 2010

Generating Alpha by Using Behavioral Finance Approach: Biotech and Oil

Behavioral Finance is one of the fastest growing, yet least understood of investment management fads. Unfortunately, when a new investment strategy or technique becomes fashionable it is often latched upon by practitioners looking to reword and reinterpret it in order to fit their pre-existing strategy. Especially when this pre-existing investment strategy involves earning money on commission! It’s funny how much discourse on utilizing behavioral finance techniques involves ending up in promulgating a long only investment ‘strategy’!

This article on behavioral finance has a different objective. It is intended to argue that alpha generation-in terms of isolating stock picking ability-could be produced in the biotech and oil exploration and production (E & P) sectors. Moreover, this alpha generation could be significantly enhanced by using behavioral finance techniques to produce a hedge trading strategy. ETFs would be an integral part of this strategy.

Do to this I will have to answer three questions

What is Behavioral Finance?
What Sectors or Stocks are Best Suited to Behavioral Finance?
How to Generate Alpha Using this approach?

What is Behavioral Finance?

Behavioral Finance is best encapsulated in the work of Kahneman and Tversky’s seminal volume ‘Judgment under Uncertainty’. In this work the authors develop a series of case studies which all emanate from a central starting premise or observation. This premised is the idea that when faced with decisions under uncertainty we use heuristics or ‘short cuts’ to reach a conclusion. Unfortunately, these heuristics are, quite often,  not the optimal solution to the problem.

Moreover, according to Nassim Taleb, medical research has discovered that we use the emotional parts of our brains to make decisions based on risk. Knowing this, it should come as no surprise that we often make in-optimal decisions based on greed and fear in the markets.

There is plenty of literature on the subject and I would refer to the work of Kahneman and Tversky in the first instance. However, I shall briefly mention one heuristic, namely, the availability heuristic. This relates to our tendency to over estimate the importance of near-term or ‘available’ information. For example, I believe that investors tend to irrationally discount the rest of a biotech companies pipeline, just because they have had a recent failure in the lab. I think a similar process applies to Oil E & P stocks.

Why Biotech and Oil Stocks are Suited to Behavioral Finance

The key is uncertainty. These are sectors that exhibit a high degree of individual stock volatility, but interestingly that does not necessarily mean a high degree of dispersion. This allows them to be subject to long/short strategies which I will outline in the last section. For now, I want to focus on the two sectors in more detail.

Biotech investing is fraught with uncertainty. Not only are there the usual concerns of clinical safety and efficacy, but also regulatory and pricing concerns are paramount too. There are also competitive concerns to any company pipeline. This comes not only from generics (after patents run out) but from competitors starting to trial ‘me-too’ drugs with similar modes of action to the one that is in more advanced trial stages. I will focus on the clinical and competitive issues here, because arguably the other issues will reflect across the industry as a whole. Recall that we are trying to generate pure alpha here, not call the sector higher or lower.

Probabilities of Success in FDA Clinical Trials?

Evaluating the pipeline of a biotech company inevitably involves making some assumptions over the ‘chance of success’ of a drug achieving endpoints in clinical trials and getting FDA approval. This involves uncertainty. Biotech investors can use this uncertainty to their benefit, if they understand not to overreact to a companies trial results. In addition, there are all sorts of general assumptions made over drugs probabilities of success in FDA clinical trials, which turn out to be misguided or plain wrong.

I will go into more detail on this in another article in future. For now, let me give one example. How many times have you seen an analyst research report ‘pencil in’ a 50% probability of success for a drug in Phase III? The reason they do this is because historical evidence suggests that, that is a fair estimate. However, this evidence rarely analysis the influence of the mode of action. Is the compound using a similar mode of action to a compound that has been FDA approved before? What about the trial sizes? Is this a novel class of drug? What about the time spent in clinical trials? How tricky is the target indication? There are myriad inputs and a one size ‘50%’ fits all solution will not do.

 I argue that investors can use this to their advantage. I also argue that investors tend to mentally adjust ‘probabilities of success’ based on whether the company has had success/failure recently in other trials.

Chance of Success for Oil Exploration?

Similarly, with Oil E & P, I would argue that their exploration campaigns are fraught with uncertainty. A company with recent success with the drill bit suddenly sees its existing drilling program being presented in the best possible light. However, one with a few failures gets sold off and then many investors are convince themselves that the management are idiots. Another example is how companies get bid up just because they have prospects in a region similar to that which has had success. It doesn’t seem to matter that the prospect could be in an unrelated field or be a different type of play entirely.

Generating Alpha Using Behavioral Finance

What makes Biotech and Oil E & P interesting is that the individual share price movements display a high degree of event volatility, yet they will be correlated. This means that a long/short investor can generate alpha by buying a portfolio of stocks in the sector and then shorting the relative ETF.

For example, accepting that Oil companies are priced based on a factor of their reserves, an investor could argue that the chance of success in his oil stock portfolio is 40% He and the market agree that the un-risked NPV is $1000. This gives him a risked NPV of 1000*.4=$400 In other words, he thinks his portfolio is worth $400.  However, the market is pricing his stocks at $300. The market thinks the oil reserves in his stocks are only worth $300.  There is a value discrepancy here.

 He buys the stocks at $300 then shorts $300 worth of oil. When the value discrepancy is ironed out- by his companies discovering oil- then he will make $100 because his stocks go to $400. Note that this $100 return is irrespective of whether the price of Oil has doubled or not. In other words, this is pure alpha generation using a hedged approach to risk.

It is not hard to see how this approach would work with biotech stocks too. However, biotech stocks tend to be less correlated with the economy than Oil stocks. Also, I would expect their results to be more dispersed, because their end product is not a commodity as would be the case for oil producers. Biotech is subject to more technological obsolescence by medical science developments. This makes it more feasible to be used as a non-correlated concentrated portfolio than Oil E & P.

Nonetheless, both are great sectors to generate alpha utilising a behavioral finance approach. As a proxy for shorting Oil or Biotech a relevant ETF should give good exposure.


Kahneman, Daniel and Tversky, Amos ‘Judgment under Uncertainty: Heuristics and Biases’ Cambridge University Press, 1982

Kahneman, Daniel and Tversky, Amos ‘Choices, Values and Frames’, Cambridge University Press, 2000

Taleb, Nassim Nicholas ‘Fooled by Randomness’ Random House, 2008

Tuesday, December 21, 2010

CFO Survey Indicates Good Growth Ahead

The latest Duke University Fuqua School of Business CFO Survey came out recently and it made pretty positive reading. First of all top line data in the States suggests an uptick in confidence...


However, we see a slightly different story in the Rest of the World


Essentially, what we are seeing here is confirmation of good growth in the US and in particular in retails sales. Ultimately, this has a concomitant positive effect upon those Asian countries that peg their currency to the US Dollar and are structured to export to the US. A classic example being Taiwan and how they rely on the US semiconductor industry via their manufacturing foundries.

China is not as strong and I suspect this reflects some macro economic concerns relating to the housing market and/or the Government trying to rein in inflation by increasing the banks reserve requirement ratio. Even so, Chinese business still forecast 19.1% earnings growth in the next year, as well as 11.3% increase in capital spending. Both of these numbers were above last the last quarters forecast.

In Europe, the numbers are noticeably weaker. This reflects the fears of pressure on the financial system from the European Sovereign Debt crisis. Earnings growth forecasts were reduced to 10.4% annual growth  but capital spending plans increased to 6.8% Worryingly, hiring plans were reduced to an anaemic .2% growth.

Returning to the US, we see that earnings growth is now forecast at a stonking 19.8% with capital spending plans increased to 8.9% Technology spending is predicted to increase by 4.8% and employment by 2% The employment number seems low, but it is actually the highest since March 2006!

Bullet Points on the CFO Survey

A few bullet points here
  • Perhaps there is more to run in the capital goods sector?
  • US Employment growth looks better
  • Asia ex-China looks set for growth, but can they cope with any slowdown in China?
  • Europe is reacting to Sovereign Debt fears
Conclusions on Duke CFO Survey

In conclusion, I think this survey perfectly encapsulates the dichotomy in the Global Economy. Growth in the US is getting stronger, but perhaps the differential between the US and Europe is explained by the relative sentiment of Sovereign Debt? If so, than should US Municipal Bond fears flare up than the solidity of the recovery will be called in to question. I think 2011 is delicately poised.

It looks like Spain is in trouble and I expect more action will be necessary by the ECB. I would not rule out the creation of 'Euro bonds' before the end of 2011. Whether the US Municipal Bond Market falls victim to negative sentiment is anybody's guess. However, I note that, whenever I check it on CMA Datavision, the market is pricing in the probability of default in California as being similar to that in Italy.

Moreover, any slowdown in the US housing market will hurt revenues in California and Florida. There are also question marks over the probability of China engineering a soft landing for its housing market.

With regards asset allocation, I still consider market neutral to be the optimal strategy for 2011.

Sunday, December 19, 2010

The Moral Case for the Free Market in the Light of the Financial Crisis (Part II)

In a previous article I outlined the moral basis for the premise that free market economics are the optimal option for economic development. I also argued that -in the light of the financial crisis-the rationale behind these arguments has been significantly challenged. Indeed, the solution to the crisis-that of collectivising risk-not only confirms moral hazard but actively encourages it in future.

 Capitalism doesn't work unless the capitalists and the capital issuers (the banks) are both working under competitive conditions benefitting from Adam Smith's invisible hand but always managing the risk of his slap. Unfortunately one side of the capitalist equation (the banks) has not been working under this premise in recent years.

It's time to look at the scorecard in terms of the arguments outlined earlier and, see how they have fared.

The Argument from Materialism

The strongest moral defence for bailing out the banks was that it would eventually make the environment better for everyone. I think the logic is indisputable, in that as total collapse of the banking system would shave benefitted no one. However, this argument comes with significant caveats. The principle is that all would benefit and that there would not be a significant transfer of wealth and resources from one group to another via collectivisation and redistribution. Unfortunately, this has not happened.

The reality is that significant risk has been transferred to the public from the banking system. Central \banks took on toxic assets. Sovereign Debt Fears have exposed peripheral Europe to significant drags on growth that affect everyone. Furthermore, the actions of the Central Banks have, thus far, ensured that whilst the banking sector has been recapitalised and their staff are enjoying the benefits, they feel the need to hoard cash. In a sense, the banks are doing exactly what they did before the crisis. In other words, taking the benefits and rewards whilst passing on the risk to the taxpayer. They are parlaying the system in a zero sum game that is directly hurting the populace at large.

For example, the UK banks according to the CEBR, they paid their staff £7bn in bonus. Saviles (the upmarket real estate agent) estimate that £1.6bn of this will go into the London housing market. Meanwhile, the UK has loaned the Irish £7bn in order to help out their Sovereign Debt crisis, ostensibly so that it doesn't hit the UK banks.

These actions (by the banks) are the height of irresponsibility. They know full well that the Sovereign Debt on their balance sheets (remember that the risk to public debt increased by taking on banks toxic assets) threatens their capital/asset ratio, so why are they awarding themselves bonuses?

 So, in conclusion, the UK taxpayer has increased risk, higher taxes and now higher house prices to pay thanks to a redistribution of return and risk.

The Epistemic Argument for the Market
Libertarian defenders of this argument will argue that the banks should have been allowed to fail and, that this is part of the process. However, the problem with this argument is that it doesn’t devolve the free market system from the responsibility of creating the financial crisis in the first place. Moreover, allowing the banks to go bust was simply not an option.
The banks and their employees were incentivised, under guiding principles of self interest, in order to maximise profits. Unfortunately, this profit maximisation came at the expense of the taxpayer, the shareholder and the economy at large. The people garnering excessive rewards were not exposing themselves to the risk. In fact, the greater risk was in not complying, because if the employees didn’t take part in the game, then they could have lost their jobs.
The essence of the problem is that the banks were leveraged and all following the same directional strategy. The forces of competition rely upon accountability and also on the fear of failure. It relies upon large companies acting under the same conditions of competition as the smallest entrepreneur is subject to. None of these conditions applied.
Indeed, if we go back to the arguments postulated by the Austrian School over the difficulties of simulating market pricing, we get to a curious irony. Many of the banks were arguing that they didn’t need to engage in mark-to-market pricing of their CDO’s because the market was artificially pricing them lowly and, forced selling would only exacerbate the problem. Similarly, they spent large parts of 2008, trying to justify loss provisions based on their own assumptions of the housing market. In a sense, they repeated the inevitable errors of centralised pricing.
They did so, despite being guided by market competition.

The Argument From Autonomy
As discussed previously, much of this argument is rendered complicated by definitive arguments over positive and negative liberty. Assuming that ‘autonomy’ means needs can be satiated; we see that the question posed here can be defined as, autonomous to do what?
If we accept that we can define satiable needs, and start out to do so, I think that it could be argued that employment, housing and raising a family are all essential aspects of the ‘good life’. It is hard to argue that this autonomy has increased over the last few years. Not only have the redistributive aspects of Government policy (as outlined above) reduced the material prospects for all, but they have also entrenched the vested self interests that actively deny young people the opportunity to do this.
The Government has allowed the banks to game the system and made the conscious decision that, the solution to the problem was ‘more of the same’. They have artificially supported the banking system and the UK housing market. There remains an undersupply of housing in London and South East. 
It need not have happened like this. The opportunity was there to generate growth by relaxing planning restrictions in London. Such action would have produced GDP growth, employment, and made housing more affordable in the areas where people actually want to live. Instead a decision was made to shore up the wealth of a select few in the UK by continuing to artificially rig the London housing market.
It should not be lost on the reader that the beneficiaries of these actions are-in many cases-the self same people that benefitted from the creation of the financial crisis. In 2008, a Savile’s strategist informed me that around 25% of overseas high end (houses £4m and above) where overseas bankers working in the UK.
None of these actions has increased the autonomous options available to most.

The Argument From an Increasing Intellectual Quotient
The desire of the banking industry to ‘intellectualise’ their activities in respect of replacing good ol’ fashioned lending from customer deposits, towards reliance on short term wholesale funding was a serious defect of the system. Similarly, the creation of ‘off-balance’ sheet accounting which enabled the banks to take on significant directional leverage helped create the ensuing crisis.
This ‘intellectualisation’ was anything but intellectually enhancing. In fact, it was a shabby and reckless attempt to maximise short term profits which ultimately ended up in a collectivisation of the losses due to it.
The aftermath of the crisis has brought about an increasing focus by regulators to discourage this kind of financial engineering with derivatives trading. Whether, they will be successful or not is another question.

Creation, Globalisation and the Poor
The last three arguments are best dealt with in one section. Firstly, it is undoubtedly true that free markets engender greater creativity. However, as we have seen, this creativity can sometimes be channelled towards destructive or exploitative purposes which curtail others creativity. The banks gamed the system to the taxpayers’ expense. This is not an act of ‘creativity’ worthy of the name.
Globalisation as actually made the situation worse. It has encouraged greater correlation of markets and therefore amplified the risks when things go wrong. I wonder out loud whether the Asian Financial Crisis (97-98) will be the last major regional crisis not to significantly affect the global economy in a synchronised and coordinated manner.
As for the poor, I fail to see how the redistribution of resources and wealthy that has, knowingly, taken place as a result of bailing out the banks, has in any way contributed to social mobility or advantage to the poor. On the contrary, unemployment is still very high in the States (the US is not a country structured with a welfare system to deal with these problems) and remains persistently high in Europe.

The narrative of this article has been consistently negative. I make no apologies for that. The behaviour of the banks is morally unacceptable. Moreover, regulators are at fault for not upholding the same standards of free market accountability on the banks as they would for anyone else. Whilst the libertarian approach is exposed as a fallacy, it does not mean that the morals and principles of the free market are not the optimal approach. However, they only acquire moral validity by their actions and their results.
The solution to the problems engendered by allowing banks to operate under ‘free markets’, seems to inevitably end up in collectivising and redistributing resources towards them. Therefore, it is better to take collective action before hand, in order to make them directly accountable for their actions. The libertarian approach fails and the moral arguments in favour of it are bankrupt. ‘Too Big To Fail’ is not an option anymore.

Tuesday, December 14, 2010

Wheat Prices Set to Go Higher?

The USDA published their monthly outlook report on wheat today and it makes for interesting analysis. You can review the source document here and it makes a slightly bearish reading

"World 2010/11 wheat supplies got an almost 5-million-ton boost this month from a combination of a 3.6-million-ton increase in production, with major increases in Australia, Pakistan, and Canada, and from a 1.3-million-ton upward revision in beginning stocks. Increased 2010/11 wheat supplies more than compensate for a 0.7-million-ton increase in consumption. World wheat ending stocks for 2010/11 are projected higher this month by 4.2 million tons to 176.7 million tons."

Furthermore, US total wheat ending stockpiles are reported to be at around 858 million bushels (23.4 million tonnes)...
One-Year Chart for Total Wheat Ending Stocks (WUSETWES:IND)

source: bloomberg

Now, this chart is slightly misleading because although stockpiles have been coming down since July, they remain significantly higher than where they were in 2008 when wheat prices hit an all time high. For example, stockpiles were at a low of 250m bushels (as compared to the 858m now) in 2008 when wheat prices were doing this...

Wheat - Monthly Price - Commodity Prices


So we can see that wheat prices are moving up as stockpiles decline from July. This makes sense as you would expect them to be correlated. However, how come the move is so dramatic because stockpiles are far higher than what they were in 2008? In fact, they are higher by a factor of 3.4x

First of all, we have had a drought in Russia this year which caused the Russians to stop exporting wheat; secondly the wet weather in Australia has called into question their crop production for 2010/11. Thirdly, if we go back to the USDA report we see that consumption...

"Global consumption of wheat in 2010/11 is projected up 0.7 million tons (about 0.1 percent) this month to 666.5 million,"
is expected to be higher than production...
"Global wheat production for 2010/11 is forecast up 3.6 million tons this month to 646.5 million."
This is despite production being forecast to be at the second highest level ever. Furthermore, long term wheat demand is predicted to be good.

In addition the amount of wheat planted in the US has been falling in line with pricing (millions of acres)...

                                       04/05     05/06     06/07    07/08    08/09   09/10     10/11
Area Planted                   50.0       50.1       46.8      51.0      55.7     49.9        47.6
Area Harvested               59.6       57.2       57.3      60.5      63.2     59.2        53.6
source: USDA website

Furthermore, this time around (as compared to 07/08) the price of rival crops that farmers could be planting is also very high. For example, sugar..

Sugar - Monthly Price - Commodity Prices

and cotton...

Cotton - Monthly Price - Commodity Prices

and soybeans...

Soybeans - Monthly Price - Commodity Prices

So I suspect that if you combine all these factors there is still potential for upside with wheat prices despite stockpiles being currently high.

The Moral Case for the Free Market in the Light of the Credit Crisis (Part I)

After the demise of the Berlin Wall much ink was spilt outlining the impeding triumph of liberal democracy. The subject of this inquiry is not so the democratic part of the formula but rather the liberal bit. Specifically, I think it is time that intellectual debate focused on the shock that the credit crisis has caused to liberal thinking.

This first article will outline the moral case for the market. In the second I will appraise the 'scorecard' for these arguments in the light of the developments of the last few years. How does the moral case for the market stand up in the light of Moral Hazard?

Too Big to Fail and how it Broke the Libertarian's Case

In short the demise of the capital markets and the collectivist solution that was inevitably enacted has shaken the libertarian's very philosophical foundations. Whereas previously, free market enthusiasts would rely on Adam Smith's 'invisible slap' to, or rather the fear of it, in order to generate a self regulating system that ensured that
  1. Economic agents were accountable for the risks they took
  2. Risks were graduated into the system via agents having the fear of failure
  3. The diversity of agents ensured that when failure occurred the system was maintained
Now, clearly 'Too Big To Fail' and the necessary collectivisation of the problem, dealt a fatal blow to the tacit acceptance of the idea that the libertarian ideal could ever work in practice. Some will argue that the Banks should have been allowed to fail, but I think this is a largely academic argument. However, these issues are covered very well by the likes of Nassim Taleb and also in a speech from Mervyn King, which I wrote about here, and I do not want to go into detail on them now.

Rather, I want to focus on the re-appraisal of what these events have meant for the moral case for free market economy. This matters to me, because I happen to believe in these arguments!

The Moral Foundations of the Free Market do not Depend Upon Weath Creation Alone

It would be easy to draw the conclusion that because, the free market system has demonstrably been more successful in generating material wealth, that the moral case for the free market lies on this ability. Frankly, I think that this utilitarian argument is a weak one because economic growth, in itself, does not contain an ethical dimension. Moreover, this kind of quantitative assessment has never (and can never) get to what the numbers actually mean to an individual's assessment of his life or his ultimate reality.

We can no more accurately find a 'measure' for the sum of each individuals utility in this way, than we can accurately simulate market pricing by via a command economy. Relying solely in GDP growth is not the answer. Indeed, post war Russia was a rapidly developing economy with high GDP growth. It just developed lots of things that nobody actually wanted!

The Moral Case for the Free Market

In John Gray's "The Moral Foundations of Market Institutions" a number of arguments are propagated for the primacy of the market model. Although, for Gray a libertarian position is not adequate.

"a crucial feature of the logic of the ethical defense of the market becomes apparent. This is that the argument which justifies free markets as enabling devices for autonomous choices also, and inexorably, justifies the institution of an enablng welfare state"
He goes on to outline the reasoning and principles behind his model of the social market.

In 'God and the Marketplace', Michael Novak writes a chapter in which he comments on Gray's work and also elucidates a number of moral arguments for the market. Ignoring Novak's critique of Gray, I will outline these arguments and then put them in the context of the current financial crisis.

The Argument from Material Improvement

It could be argued that capitalism is promulgated by the self interest of the individual in making his material condition better. When coached in terms of 'covetousness' this 'moral plus', not only becomes an infringement of Christian Theocracy, but also is seen as a zero sum game. In other words, he who has had his good or material coveted, is set to have it taken from him.

However, material improvement need not be seen as a zero sum game! Indeed, in the act of creation or improvement that an individual sets out to achieve, can be built the edifice of improvements to society that benefit all. These material benefits can clearly be seen. The poorest person eligible to receive medical treatment via public provision today, will receive better treatment than Queen Victoria or George Washington ever would have. Moreover, the act of creation in itself is a positive for the individual involved.

The Epistemic Argument

This argument is forcibly articulated in Gray's work cited earlier. In his book, he summarizes the insights garnered by the Austrian School and their observations over the logical impossibility of being able to rationally replicate the information (pricing etc) produced by market systems. For Ludwig Von Mises, socialist economies are impossible because of the lack of market pricing. Friedrich Hayek argues that the market contains knowledge that is dispersed through the economy and which cannot be known by central planners. However, the market is a device for transmitting this information.

Michael Polanyi argues against central planning in economy as well as scientific planning. He thinks that science (as well as in economy) there is tacit knowledge which cannot be put together by centralised planning. The market is seen as being as the mechanism whereby this information is transcribed and articulated.

Free Markets Create Autonomy

Free Markets are seen as granting greater autonomy to an individual, in order that he can make a wider range of autonomous choices in his life. This is a contentious issue as much debate will centre on the possibility of needs to being satiated. If like Gray, you think they can, then the process can then begin whereby one would set out a pathway to achieving this. However, if you think they can not be, than you might be attracted to adopting the classical liberal position of favouring the aim of negative liberty. Isiaah Berlin is excellent further reading on the subject. However, for the purposes of this enquiry let us assume there is an intrinsic value in the greater creation of autonomy.

The Argument from Increasing Intellectual Quotient

Increasingly, goods are being produced that have a greater portion of their value in intellectual property. This results in a greater amount of human input and less on the material. As the market economy shifts us towards these types of goods the opportunity for human enrichment.

The Argument from Personal Creation

This argument was touched on earlier, but it deserves its own definition. It is, the argument that capitalism encourages personal subjectivity and creation. The individual grows spiritually as he engages in creative acts which force him to make existentialist decisions over his future. Furthermore, economies are growing increasingly reliant on intellectual capital -as expressed in the paragraph above- and this will allow greater spiritual interaction between individuals.

Globalisation is Creating Shared Interests

Given an expanding global market it is likely that interests will become increasingly enmeshed which should produce greater understanding of cultures. Markets can be seen as instruments of integration and discourse within communities and in doing so create a shared community of interests.

Free Markets Create Greater Opportunity for the Poor

It is argued that free markets create greater opportunity for the poor. Social mobility is greater in free market economies and the opportunity for skill and chance to play their role are greater. Moreover, poorer people tend to receive more opportunity given that there is more emphasis upon personal intelligence and creation in these types of economies, than there is in a centralised command economy.


Having articulated the moral case for the market, it is now time to turn to consider how they have fared over the last few years. I believe that the collectivisation of capital markets following the credit crunch is a significant event that raises significant challenges to our understanding of the society we live in.

The second article can be found here


Berlin, Isiaah "Liberty" Oxford University Press, 2002

Gray, John "The Moral Foundations of Market Institutions" Institute of Economic Affairs Health and Welfare Unit, 1992

Davies, John (Editor) Michael Novak and others "God and the Marketplace" Institute of Economic Affairs Health and Welfare Unit, 1993

Friday, December 10, 2010

The Expediency of Cutting Public Spending

One of the interesting aspects of the current problems with Sovereign Debt is that-for the first time ever-it is now politically expedient to talk about reducing Government expenditure as a share of GDP. I am aware that Margaret Thatcher achieved this, but I would question if her popularity stemmed from this or whether it was as a consequence of the economic growth plus populist policies on housing. Perhaps the reality is that Thatcher could not have achieved this without the growth in the private sector and/or selling off state industries. The latter produces a one time benefit to revenues.

No matter. The point here is that there does appear to be a wind of change on the issue. Such sentiment shifts are hard to achieve. If humans were rational, we could all sit down and see the benefit in curtailing excessive Government expenditure. However, abstract arguments are hard for people realise in practice. In reality, ideas have no resonance unless they are accompanied by emotional involvement.

It was the emotional involvement of Germans with hyper-inflation during the inter-War period that has largely shaped their consensual awareness of its dangers today. Similarly, there is no doubt that the UK (an invaded during the Second World War) views the political project of the EU with less stringency. For war bedevilled continental Europe (almost continually at war for at least 200 years) the EU project is about ensuring solidarity and harmony. Another example, can be seen in the reticence of Asian countries to depeg their currencies from the US Dollar. They remember, all too well, the aftermath of the Asian Financial Crisis in the late 90's.

Returning to the subject of this post, it is worth recalling how problematic it has proved to intellectuals to get across the idea that Government Spending should be curtailed. James Buchanan gave the greatest insight with his applications of game theory to public choice decision making. Milton Friedman talked of constitutional adjustments to enforce balanced budgets. Friedrich Hayek warned us over taking the 'Road to Serfdom'. Alan Greenspan endlessly promulgated the necessity to rein in Federal Spending. Nothing worked.

Prosperity begets power and no power exerts itself more forcibly or effectively than that of the control of the welfare state by the middle classes. The transmission mechanism of this power is, inevitably, the willingness, nay necessity, for politicians to have a beauty parade based on who can spend the most money. It takes a shock, similar to current events, for people to finally realise that the public spending that they demand is actually paid for by them. We can only hope that in the UK ,for example, the public realises the wastefulness and inefficiency of the previous regime, and in fact, of many of them before them.

Tuesday, December 7, 2010

European Sovereign Debt Spreads Before and After ECB Action

After a few days of the markets backing off of fighting the ECB, I thought it would be interesting to review some European Sovereign Debt metrics. Whilst equity markets and are enjoying a relief rally and a return to the bias towards risk assets (propelled by Quantitative Easing 2) it is far from clear whether the underlying fundamentals have been dealt with. This could take time.

Firstly, looking at Spain/German Yield 10 Year spreads...

One-Year Chart for SPAIN 10 YEAR - GERMAN 10 YEAR (.SPAGER10:IND)

reveals that they are still elevated. Similarly, Spain 5 Year Senior USD CDS

One-Year Chart for SPAIN CDS USD SR 5Y (CSPA1U5:IND)

Portuguese 5 Year Senior USD CDS

One-Year Chart for PORTUG CDS USD SR 5Y (CPGB1U5:IND)

However, it appears that the Federal Reserve at the ECB were entirely right to act quickly to avert 'Ireland' turning into 'Greece'. It is my opinion, that there were liquidity problems with some European Banks in Q2 and, some stress metrics for the banking system reflect this. Here is the 'Ted' Spread. In other words, the difference between short term interbank loans (LIBOR) and US Government debt (3 month T-Bills)

One-Year Chart for Ted Spread (.TEDSP:IND)

So it appears that QE2 was entirely justified!

I think there is a risk that this sort of game could continue in 2011. Spain's recent PMI numbers were signalling contraction recently and their housing market is far from being out of the woods.

I run a hedged portfolio with a bit of a discretionary element by which I play with delta. Right now I have the portfolio positioned with a cautious stance.

Friday, December 3, 2010

Buffet's Favourite Indicator Showing Signs of Moderation

One of my favourite economic indicators is the weekly report on rail traffic produced by the Association of American Railroads (AAR). It is published weekly and gives a timely update on industrial activity. Indeed, Warren Buffet reportedly uses this as his favourite indicator.

I've dissected the numbers and broken them down into the following table, in order to get a fix on how the US economy is performing.
2010 vs. 2009 Period to Period Percentage increase in rail road car load volumes
TotalChemicals        Grain Coal
Nov 4.5%5.0%-2.6%2.9%

source: association of american railroads, markets and culture

In fact, the last weekly number (Nov27) is rather weak because in the comparative week in 2009 the Thanksgiving holiday was included in the numbers. It is also to note, how much stronger growth was in H1 of 2010 and the pick up in growth that occurred from mid-July onwards. The car number here is the 'total' number in the first column.

I've included chemicals because it tends to be a cyclical sector. I suspect the dramatic increase in grain in Sep/Oct was due to the Russians halting wheat exports coupled with an exceptional US wheat harvest for 2010.

The stock market wobble from May until mid summer correlates nicely with the drop of in activity. My reading of the situation is that this was due to fears over European Sovereign Debt issues and that this lead to an effect on sentiment in the global economy. Naturally, if the current problems have legs then the corollary is that we could be headed for more problems.

The data certainly suggests a slight moderation in growth, but it is far from clear whether this is the start of a trend or not. I believe it to be contingent upon a successful resolution of the European debt crisis and a quick resumption to foreclosure sales in the US. Unfortunately, the Global Economy is so heavily correlated that a dramatic move in one asset class has severe effects on all the others.

I'll post on this in a few weeks when we get more data, because I think it is a key indicator.

Nov 201056.6May 201059.7
Oct 201056.9Apr 201060.4
Sep 201054.4Mar 201059.6
Aug 201056.3Feb 201056.5
Jul 201055.5Jan 201058.4
Jun 201056.2Dec 200954.9
Average for 12 months – 57.1
High – 60.4
Low – 54.4

Nov 201056.6May 201059.7
Oct 201056.9Apr 201060.4
Sep 201054.4Mar 201059.6
Aug 201056.3Feb 201056.5
Jul 201055.5Jan 201058.4
Jun 201056.2Dec 200954.9
Average for 12 months – 57.1
High – 60.4
Low – 54.4

Nov 201056.6May 201059.7
Oct 201056.9Apr 201060.4
Sep 201054.4Mar 201059.6
Aug 201056.3Feb 201056.5
Jul 201055.5Jan 201058.4
Jun 201056.2Dec 200954.9
Average for 12 months – 57.1
High – 60.4
Low – 54.4

Nov 201056.6May 201059.7
Oct 201056.9Apr 201060.4
Sep 201054.4Mar 201059.6
Aug 201056.3Feb 201056.5
Jul 201055.5Jan 201058.4
Jun 201056.2Dec 200954.9
Average for 12 months – 57.1
High – 60.4
Low – 54.4