Weekly Musings 47 12-4-11
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For those who are new to the Musings: they are basically a glimpse into my notebook, the unfiltered swamp where I organize future themes, sort through the dozens of stories and links submitted by readers, refine my own research and start connecting dots which appear later in the blog or in my books. As always, I hope the Musings spark new appraisals and insights, and thank you for supporting the site.
If Risk Is Separated From Gain, Then The System Is Doomed
Risk is an ever-present characteristic of life; it cannot be eliminated, it can only be masked or hedged. We know this intuitively, yet we blithely accept official assurances that risk can be eliminated by the Federal Reserve, or the central Bank of China or the European Central Bank.
To confuse masking risk with no risk is the acme of hubris and the perfect setup for disaster. In my view, the global "official" response has all been directed at masking risk and presenting this as the "solution" that has sent risk back to its lair, defeated.
Cloaking risk does not eliminate it, it merely buries it where it accumulates unseen, or it diverts it into another system where it builds up. Once the built-up risk reaches criticality, then it explodes in "unforeseen" volatility, a "surprise" that is often triggered by a seemingly trivial event.
One way that risk is systemically and deliberately hidden is by separating it from the return gained from taking the risk. This is also called "moral hazard," and the example everyone now knows is private banks that "privatized profits and socialized losses."
From the point of view of risk analysis, the risk of losses from malinvestment, fraud and wild speculation was separated from the gains. The banks kept the gains but diverted the losses (risk) to the taxpayers via the $14 trillion TARP bailout and $7 trillion in "secret" subsidies and give-aways only revealed by a FOIA release of 30,000 pages obtained by Bloomberg.
We can understand this disconnect as the cutting off of feedback between risk to gain. If the gambler has no feedback from his losses because the casino will always reimburse his losses, then he will continue gambling wildly and losing spectacularly. After all, why not?
This explains why Bernanke & Co., and Obama, Geithner & Co., are failing so spectacularly: not only are they individually distant from risk/losses incurred by their policies, those entities they are protecting (the banking/lending sector) are also protected from risk.
Without feedback from risk (we might also call it "pain" or "threat" or "loss"), then the player and the system are both intrinsically doomed to failure. There is no other end-state possible if you start from this initial condition.
Continuing to Fight a Hopeless Battle
Thanks to reader Toby B., who sent me the book and several other fascinating histories, I have been completely absorbed in the epic history of the pivotal battle of Midway, June 1942, Shattered Sword.
The book is unique among war histories in that it explores the culture and internal conflicts of the Japanese Imperial Navy which contributed (as initial conditions) to the unexpected Japanese defeat at Midway by the numerically inferior forces of the American Navy.
Having studied Japanese history, language, geography and literature in university, the culture of the Imperial Navy was not entirely new ground. But the internal conflicts over differing strategies in the Japanese central command and Imperial Navy were new and of great interest, for they reflected not just Japanese culture but (not unexpectedly) human nature.
Japan's remarkably decisive successes in the first 6 months of the Pacific war left the high command with the unusual problem of "what do we do next?" Having achieved all their tactical goals, debates raged over what to attempt next.
Admiral Yamamoto, the chief architect (though by no means uncontested) of Japan's strategy, opted to draw out America's aircraft carriers into a "decisive battle"--the heart of Japanese Naval doctrine. He devised the Midway campaign to do exactly this.
After such an amazing string of victories over the American, Dutch and British navies in the 6 months following Pearl Harbor, the idea of decisive defeat did not enter the computations or the debates, or did the idea that all the various strategies proposed were equally doomed.
The denial and disorientation caused by the catastrophic loss of Japan's four finest aircraft carriers in a single day did not deter the Japanese commanders from pressing on to Midway; their mindset did not allow for defeat, and so they had no choice but to press on to victory.
Eventually Admiral Yamamoto conceded the campaign had ended in defeat, and that pressing on would only endanger the remainder of the fleet.
All of this struck me as absolutely telling in regards to Bernanke and his campaign to restart the U.S. economy by lowering interest rates to zero and flooding the system with free, cheap money (liquidity). His strategy is simple: drive the cost of borrowing money so low that people will once again buy homes with 3% down payments and huge mortgages, and plow their money into the stock market, as that (not counting gold, which Bernanke studiously avoids mentioning) is the only "conventional" asset class with any hope of appreciation.
This is his strategy: drive "risk assets" like stocks up, until some magical point is reached and households feel wealthy and confident again, and once again start borrowing and spending like drunken sailors. Put another way: he wants to forcibly re-price risk to near-zero. Thatis the equivalent of putting the genie bback in the bottle.
The idea that this strategy is flawed does not occur to him; his mindset is so narrow and atrophied that he has no alternative but to "press on to victory," even as the ship is sinking beneath him. The same can be said of President Obama, who is equally unable to grasp that his policies have been catastrophically wrong.
I suspect 2012 will be the year--after four long years of the same losing battle plan--that the total and complete failure of this strategy will be revealed to all. I have already predicted Bernanke will resign "to pursue other opportunities" in 2012, and though some of my friends believe Obama is well-situated to win a second term, I see him as the captain steaming his sinking ship toward the distant guns on the horizon, confident of victory even as the cold seawater swirls around his feet.
Technical Analysis: No Crystal Ball, Just Possibilities
A very able technical analyst who prefers to go by the moniker "Chartist Friend from Pittsburgh" recently sent me a number of charts, two of which I shared on the blog. Like any sound analyst, he recently reviewed the "other side of the trade," in this case, the bullish argument, and found compelling chartist evidence that a massive, sustained rally could lie ahead.
I reprint his first chart here, showing the case for a 90% decline in stocks (the Dow Jones 30), and his more recent chart of the S&P 500, which states the case for a 12-fold rise in the 30 years ahead.
Nobody knows what will happen tomorrow, much less 5 or 10 years hence, and so my point here is to share with you the nature of technical analysis: it is not a crystal ball, predicting the future; it is rather a "pattern-matching" system which seeks patterns which played out in the past. Like a chess game, there are always many pathways the future can take, but we do note similarities as the game progresses.
Here is my own chart of the SPX marked up with some notes. A bullish flag and positive divergences suggested a strong rally in October, would unfolded quite nicely. Now price has traced out a massive wedge/pennant. Some will see this as a "continuation pattern," meaning it will resolve in a huge upside break continuing the Bull trend since March 2009.
There are flies in the ointment in this rosy view, however, for example the negative divergences in OBV (on balance volume) and MACD and the lower highs of each manic rally.
Lastly, bull markets do not advance with manic, crazed swings up and down by 2%-4% or more per day (15 by my count in a mere 3 months); that volatility characterizes markets that are about to crash. Since the Fed has "outlawed" declines, then a crash isn't "possible," just as a Japanese defeat wasn't possible in June 1942.
Most of the TA types I follow are bullish. Am I just being contrarian? Am I pressing on though the battle has already been lost? The beauty of TA is that it is open to interpretation; you can see what you want to see, or you can see what others can't discern or refuse to see for their own reasons. Reality resolves the conflict; only one side can be right. Either we rally strongly from here and the Bulls are correct, or we decline and the far fewer in number Bears are correct.
Caution is advised. The casino is rigged, but in which way? Nobody knows until it's too late to win.
From Left Field
(via "Ishabaka," M.D., who commented: "I think people assume that as a once great nation falls apart it's young people will rebel, protest, and become increasingly violent. To me, the opposite seems to be happening in Japan - it's like the whole younger generation are depressed. One of the classic symptoms of depression is lack of interest in having a love and sex life, and general social isolation. The more I find out about Japan the more I wonder if that is what is happening. The younger adults seem to be becoming more and more isolated, and their only happiness seems to be buying expensive trinkets, like Louis Vuitton handbags."
TRANSITION MOVEMENT in the UK (Via GFB) Rather than wait for a sclerotic Central State to "make things right," the way forward is to just get on with it ourselves.
Mitch Hedberg - A Comic Genius (you may disagree, but he's interesting--and sadly, gone from this world)
"True genius resides in the capacity for evaluation of uncertain, hazardous, and conflicting information." -Winston Churchill (via Kathy K.)
Thanks for reading--
charles
