Global Supply Chains

One of the effects of the recent unfortunate earthquake in Japan has been the disruption of automotive supply chains. For example, one facility, Renesas's Naka factory, has 20% of global auto production relying upon its output. As we move towards a more globalized world, should we have higher risk premiums to defend ourselves against such concentration of risk?

Highs to be taken out

Although markets swing around, lurching high and low, I feel they are still mostly efficient, in the sense that at any given moment, there are equal bull and bear cases to be made, and these offsetting opinions creates trades in securities, the trillions we see everyday. Essentially, there is ALWAYS a reason to be bullish or bearish, hence the market is always at an equilibrium of sorts. I could list a 100 reason to be bearish, or 100 reasons to be bullish. The task of a financial analyst is to sift through those multitudinous variant opinions, and isolate the essence to instruct trading decisions. I have read a lot recently, and although I wish (generally in life) to be an original thinker, in this instance I need to 'borrow' a persuasive graph from Macquarie:

If the above graph is correct, there is much more to go i.t.o. economic activity. I find this graph far more persuasive than "The Fed Model", PE bands, etc. And if the scenario as suggested by the graph plays out, the economic strength would result in markets making new highs.

We never learn.

A common mistake when looking at crises and catastrophe is to look almost everywhere and at everything in the immediate vicinity of the time that the incident occured, but losing sight of the broader historical context. This common problem, a myopia, happens again and again. An example of this myopia is now on display with the current changing of the guard at Morgan Stanley. The general sentiment on the newspapers is that Mack has done "o.k.". The reason for this tepid farewell is due to Morgan Stanley derisking in the past 12 months (unlike Goldman Sachs). The fact that Mack is not applauded, but instead pitied, for choosing to derisk during the largest period of deleveraging since the Great Depression, shows that people never, ever, ever learn.

Here is an example of the tone that currently depicts the feelings towards Mack (WSJ).

and also here (WSJ as well).

US Housing

Inventory levels are currently at around 12 months supply.

A more normal level is when this is down to 6-7 months.

Until then, more cuts in homebuilding is required.

Marshallian K

I've always been struggling to find a good relationship between money supply and asset prices.

A few days ago I came across this BCA research study (GIS 090306 - Gold), where they compare Marshallian K to asset prices.

One thing to notice is how correct Marc Faber is. That rises in money supply to lead to rises in the gold price (and it appears to be quite a tight relationship). What is also interesting is how money supply does not lead to consumer inflation, merely asset inflation. I need to look more into this dynamic, maybe they are driven by the same underlying inflationary force, but consumer prices have offsetting mitigating effects (like trade, globalization, technological advancements).

However, I see a conflicting discussion of Marshallian K in Niall Ferguson's Chimerica article.

He argues that there has not been a surge in liquidity (maybe a little in the Eurozone, but for the US, Marshallian K has actually been flat from 2003 to 2007). So has there been a surge in liquidity or not? What's actually happening here? Is Niall's data incorrect, or am I not comparing the same series (maybe there are many different Marshallian K's).

I did some more Googling on Marshallian K and surprisingly found very little. I could only find a single paper on ideas.repec.org ! I did however find this little paragraph on the topic by Stephen Roach:

"My favorite gauge of the quantity dimension of liquidity is the so-called “Marshallian K” -- the difference between growth in the money supply and nominal GDP.  In essence, this measures the surplus of money that is not absorbed by the real economy.  Joachim Fels has constructed such a measure for the “G-5-plus” group of industrial countries -- the US, Japan, the 12-country euro area, Canada, and the UK. This measure is based on “narrow money” (i.e., M-1) -- the monetary aggregate that still has the tightest linkage to central bank policy adjustments.  The trend in this version of the global Marshallian K is now ticking below the “zero threshold” for the first time since 2000 -- consistent with earlier turns in the liquidity cycle that have been associated either with recessions (1991 and 2000-01) or abrupt adjustments in financial markets (1994)." 

 

mental aspects of trading

i've read the thousands of websites and books pertaining to trading and trading psychology.

Accept your losses before a trade, don't trade more than 2% of your total capital, cut your losers and let your winners run etc.....

I know I only follow about 5% of this advice, but nevertheless I'm very familiar with it.

They also all stress the need for a system. I dont' really have a system, my method is not something that can be written down. In short, it's a complete mess. I have a belief that I will do better by having an "anti-system". For example, I have a statiscal prior belief that any system works well until it doesn't, and this process is Poisson. I.e. the more you use the system, the higher the chance that it will blow up against you. So my philosophy is to randomise the systems, in the belief that when the system is undergoing a period of severe underperformance, due to my randomisation I will luckily not be employing that system at that time.

I have no proof for this philosophy, and it is probably fallacious. But I like it, because I believe all systems work (momentum trading, swing trading, scalping, fundamental etc), it just depends on the time period the system is being employed.

I also believe that it is very important to take a loss. At least one 2% loss in a one month period. It's sobering, slows you down, and sharpens your mind. 

For me, if there was one key to trading, it's when you've reached the level when when you make money, you feel like you've made less than you've actually made, and when you lose money, you feel like you've lost more than you've actually lost. It's when you're in this mental state that one tends to be most profitable.

I'm saying this because I used to be the opposite. I was gleeful when I made 10k on a 50k margin (1:5 gain:loss ratio) and I didn't feel so bad when I lost money. I'm trying to say that you should 'game' your psychology, to percieves your trading reality and experience as worse than they truly are. You're better off if after winning 10k you've felt that you've won only 6k instead of feeling like you've won the actual 10k.

So this ad-hoc haphazard approach serves me well until I hit a few speed bumps. A speed bump is not a loss (I expect those and am well aware that my execution is relatively mediocre). No, a speed bump is when you're philosophy gets roughed around a bit.

For example, everyone knows that correlations work until they don't work anymore. We saw during the early periods of the subprime crisis (late 2007) that USDJPY and USDCHF were strongly correlated. But then this broke down, and USDCHF tracked the USDEUR, and USDJPY became the inverse of the S&P500. So breakdowns of correlations are not new to me.

What really throws me off is when the market is internally inconsistent. For example, I lost money last week when I was hoping for the yen to rally against the dollar as risk aversion rose. It didn't, the correlation failed, and I'm ok with that. What bothers me was when there was noise about the state of the US financial system, and both US Treasuries, the Dollar and Gold all rallied. This made no sense, and was evidence of internal inconsistencies. Gold was not rallying on inflation fears (we are surrounded by evidence of deflation) so it could only be rallying on fears on the quality of the Fiat US dollar. But if this was true, why was the USD and US treasuries rising? It's the complete opposite behaviour! 

This instances really throw me off. Are there underlying stories? Is it a short term anomaly, and will reality restore itself and either gold or US dollar assets fall? 

I guess why these instances throw me off is because I derive almost all my information from prices across markets. So when this happens, these internal inconsistencies, I am not getting much information from the market.

When I see such things, I develop my own fanciful theories (which are probably almost entirely wrong). For example, to explain the gold/USD anomolay, I put it down to inter-temporal mismatches in pricing. The dollar is stong for short term reasons, and  gold is strong for medium- to long-term reasons. People want to buy dollars now to get in line for repatriation of dollar portfolio flows. So it's a short term technical reason for buying USD. If you were in the spot USD cash market, would you care about what might happen a year or two from now, or get in line and play along with the real flows that are occurring right now.

Gold however, is not a real asset (no one buys it for anything. It is pure sentiment). There is no 'flow' element to gold (and hence why there is no real 'market' for gold. Supply and demand are meaningless concepts when it comes to gold). So anyone who is in the gold market and fears the current expansion in the Federal Reserve BS leading to eventual inflation could buy gold essentially as a call option on eventual currency debasement. With lease rates so low, this is a call option that is relatively cheap, and has almost infinite maturity.

Interest on Reserves

I was just randomly wondering what the point and implications of this was today. Here are some links:

“Why is the Fed Paying Interest on Excess Reserves?”

SSRN - Interest on Reserves and Monetary Policy

Should the Fed Pay Interest on Reserves?

FRBNY - FAQs

Federal Reserve May Seek Authority to Pay Interest on Reserves

The Fed Moves Again — And Here’s What It Means

Federal Reserve wants to Pay Interest Now

Fed Announcement

(off topic, but i also remember reading somewhere about forcing privately owned banks to hold government bonds. I forgot the reasons why. I also wonder what this does for money supply (if CB buys the bonds the money supply increases. If a private investor does, it contracts (or is neutral if the government spends what is borrowed). So what's the story when a privately owned bank buys the bonds?