TAKING STOCK:  THE MADNESS OF MARKETS

Jerry Harkins

“The current crisis has demonstrated that neither bank regulators, nor anyone else, can consistently and accurately forecast whether, for example, subprime mortgages will turn toxic.”

                     —Alan Greenspan, March 10, 2010

Poppycock!  Total, utter nonsense!  The truth is that it is in the nature of bubbles to burst.  The truth is that you can’t make silk purses out of pigs’ ears.  The truth is that anyone who tries to slice and dice subprime mortgages—or subprime anything else—and thereby turn them into investment grade securities needs his or her head examined.  The run-up to the crash of 2008 was an obvious bubble and the subsequent meltdown was entirely predictable.  Its ramifications were near catastrophic and are still being felt around the world.

The markets for stocks, bonds, commodities and other asset classes play several crucial rolls in all capitalist societies.  Economically, they provide the capital companies and governments need to promote innovation and efficiency.  Socially, they provide the basis for virtually all savings especially those meant to support major family expenditures such as housing, education and retirement.  They act as the principal means of encouraging sustainability in terms of resource utilization and other social goals.  By their very nature, they act as insurance that the long term interests of both the economy and the society are taken into consideration in the decision-making process.  Or they should do all these things.  But the crash of 2008 was compelling evidence that these functions were being jettisoned in favor of the extremely dangerous idea that markets are nothing more than ultra short term, high stakes casinos.

There had been early warning signs.  Amidst the euphoria characteristic of the markets around the turn of the century, there were some naysayers, among them the executives of Procter and Gamble who saw portents of stormy weather.  In early 2000, P and G had been looking forward to profit growth of 13% above 1999.  That would have been spectacular performance but on the morning of Tuesday, March 7, 2000 the company released a statement saying that earnings for fiscal year 2000 would likely be only 7% higher than 1999.  By any rational standard this would still be outstanding performance.  But, the minute the stock market opened, P and G took a 30-point or 33% hit.  Within three minutes, $36 billion of its market valuation simply evaporated.  Poof!  By week’s end, the stock shed an additional $4 billion.  It wasn’t a complete surprise.  The market had already taken the company down by 25% from its 1999 high.  Even at 13%, it was no longer a sexy “new economy” company. 

Proctor and Gamble was and is among the bluest of the blue chips.  Founded in 1837, it has always been one of the best managed entities in the world, right up there with IBM and GE.  It is as recession proof as any company can be, home to a roster of global consumer brands including Ivory Soap (1880), Crisco (1911), Tide detergent (1946), Crest toothpaste (1955), Pampers diapers (1961), Folgers coffee (acquired 1963), Bounty paper towels (1965), Clairol hair coloring (acquired 2001) and dozens of others.  By contemporary standards, it is big but not huge.  In 2013, its sales amounted to $84 billion and its net earnings were about $11 billion.  Its market valuation was $220 billion, only $10 billion less than Facebook.  In 2014, it ranked 31 on the Fortune list of the 500 largest U.S. corporations.

In a rational world (or in an efficient market), it simply could not have lost 33% of its value in a matter of minutes.  But what happened to it was not uncommon in 2000 as one company after another performed well but not well enough to satisfy the voracious expectations of growth that Wall Street had come to believe were its birthright.  Stock prices were now being governed by these expectations rather than by conventional measures of value.  James J. Cramer, a pundit for TheStreet.com, taunted traditional value investors by writing, “All of that price-to-earnings flotsam and discount-to-normalized-earnings jetsam didn’t save you today.”  Still, the idea that investors would bail out of P and G because it might grow by only 7% was a sign that something was very wrong in the stock market, something that has gotten progressively worse in the succeeding fifteen years and that threatens both the economic and the social functions of markets.

There had been other warnings.  On October 19, 1987, “Black Monday,” the Dow Jones Industrial Average [1] lost 22.6% of its value on volume that was twice the previous record.  It was the worst day in the history of the market and no one knew why.  It subsequently inspired a vast speculative literature but to this day no one really knows why it happened.  Then and now, much of the discussion centered around “program trading” which was initiated by computerized systems responding to various “trigger” events.  But there had been no obvious triggers.  There were concerns about rising interest rates and an unexpected increase in the trade deficit but there is nothing unusual about such concerns or about Wall Street being surprised by them.  Wall Street is easily surprised.  It was also in some ways a slow motion crash.  On the previous Wednesday, the Dow Jones had lost a then-record 95 points and two days later it shed another 108 points.  On Monday, intense selling pressure overwhelmed the trading systems which were reporting over an hour late thereby adding to the anxiety.  But it was not Armageddon.  The market began to recover on Tuesday suggesting that traders knew it had been oversold.  Two months later, it ended the year up slightly over 1986 and began an historic rise that lasted twenty years with only minor interruptions.  On a long term chart, the 1987 crash appears as a mere blip.  Still it was not your grandfather’s classic panic and the psychology of the market has never been the same.

Extreme crashes are blessedly infrequent but since 1987 global markets have witnessed a spectacular increase in average volatility. [3] For example, in the first quarter of 2015, the DJIA posted an increase of 0.008%, a virtually flat performance.  But on March 30, it had a gain of 263 points, more than 1%.  The following day, the last session of the quarter, yielded a loss of 200 points.  This was not unusual.  Since 1987, the indices have often gone down 1% or more one day and up 1% or more the next day and such volatility can continue for weeks on end.  Why?  It has absolutely nothing to do with the underlying value of the economy or even for its prospects.  Most recently, oil futures prices and interest rate fears have taken much of the blame.  When oil is down, though, the market may rise or fall.  When the Federal Reserve is thought to be signaling the end of low interest rates, it is taken as cataclysmic news.  We seem to be living through a period when tea leaves set off earthquakes.  The market has become a gambling den for professional players who constantly strive to game the system by shedding risk and passing it off to others.  They are true believers in the adage that there’s a sucker born every minute.

Again this is nothing new.  As St. Paul points out, “…the love of money is a root of all kinds of evil.”  He might have added that the love of money can readily transform itself into the love of more money which we call greed.  And greed seems to be an inherent concomitant of free markets and a constant challenge to regulators.  It is essential that all market participants have incentives but it is human nature that incentives tend to become addictive and require more and more to satisfy the hunger.  Like all addictions, the process is insidious corrupting some players in ways they may not even notice. Some very smart people wind up doing stupid things in the belief that they won’t be caught. 

Shortly before he went to jail for insider trading, Ivan Boesky famously told students at the University of California, “I think greed is healthy. You can be greedy and still feel good about yourself.”  This line became famous when paraphrased by Gordon Gekko in “Wall Street” (1987) and by Larry the Liquidator in “Other People’s Money” (1991).  But it is not true.  Once natural self-interest metastasizes into avarice it becomes both sociopathic and self-destructive.  The trick is to recognize and excise the cancer before it reaches that point.  This is easier said than done as is evident from the headline scandals of the last generation.  Among them were Archer Daniels Midland (price fixing, 1995), Enron (accounting fraud, 2001), Tyco (racketeering, 2002), WorldCom (accounting fraud, 2002), Health South (Bribery, 2003) and, of course, Madoff Securities (Ponzi scheme, 2008).

What is captivating about this list is the diversity of the alleged crimes from simple theft to the most exotic financial skullduggery.  The Tyco executives were accused of stealing $600 million from the company by giving themselves unauthorized loans and issuing stock fraudulently.  It was little more than a mugging with the money going to high living including a $2 million birthday party for the Chariman's wife and a $6,000 shower curtain for his bathroom.  It actually hurt almost no one including the shareholders who have seen their stock rise nicely.  The Enron case was quite the opposite:  a grab bag of elaborate almost incomprehensible financial schemes meant to present to the world the picture of a huge, successful energy company.  The outside world knew it as Number 6 on Fortune Magazine’s list of the largest 500 global corporations.  In fact, it was nothing of the sort.  It had already been sucked dry by gross mismanagement and Wonderland accounting designed to conceal the losses and bleed California electric ratepayers.  The key players were paying themselves enormous salaries and bonuses but, like Tyco, those had little long term effect on the company.  Mostly it seemed these geniuses were covering up for their own operating mistakes.  In any event, the important point is that very few people could ever claim to understand their financial machinations.  In this regard, Bernie Madoff was a throwback to a simpler era.  So simple that he was able to fool regulators and clients for twenty years or more depending on whom you believe.  Ultimately the law caught up with him.  His penalty did nothing to deter the next dozen or so Ponzi schemes.

As bad as these scandals were, they did little to affect the market as a whole.  Enron, for example, hurt a lot of people, mostly shareholders to the tune of $74 billion (including employees’ pension savings) and creditors totaling about $67 billion.  However, substantial recoveries were realized and the total actual loss (not counting overpayments by Californians for their utilities) was probably just under $11 billion.  The scandal also contributed to the market downturn of 2000-2003 but its impact was dwarfed by the events of 9/11.  The Madoff scandal may have exacerbated the 2008 meltdown but, again, its was overshadowed by the subprime mortgage fiasco which represents a whole new level of financial deviltry.

Traditionally, residential mortgages were safe investments.  For one thing, people who were not creditworthy generally could not get them.  For another, mortgagees tend to prioritize their mortgage payments each month.  Beginning in the 1980’s, however, banks began to market adjustable rate loans to borrowers with less than excellent credit.  This virtually guaranteed that the default rate would increase.  About the same time, Michael Milken was discovering that high yield or “junk” bonds issued by financially stressed corporations could be packaged together.  Each such package would have a known risk of default which would be fully reflected by their high yields.  In essence, this meant that they could be marketed as though they were high quality investment grade securities.  Milken’s theory might work in an environment of  stable markets but it was soon being applied to packages of subprime mortgages and other instruments that were unstable by definition.

“Securitization” itself can be a useful financial tool and it is important to separate the theory from the insider trading and other abuses that came to be associated with its practice.  Unfortunately, the “rocket scientists” of Wall Street could not leave well enough alone.  They began to create more and more exotic investments by separating out every conceivable aspect of the underlying loans and focusing exclusively on their short term performance prospects.  Given a basic package consisting of, say, 100,000 subprime mortgages, an investor, usually a bank or an insurance company, could buy an instrument that exposed it to only the principal repayment stream or only the interest stream or to some combination of both based on the average yield and/or the average maturity.  The possibilities got even more abstract when investors were able to buy and sell puts and calls on options or future contracts or engage in custom tailored “swaps” of any combination thereof.  In the monkey-see-monkey-do world of high finance, it soon became possible to make exotic bets on interest rates, weather conditions and space on oil tankers.  And this was only the beginning of a process that has rendered investments increasingly abstract and increasingly divorced from the real world and its long term interests.  In many cases, Wall Street sold instruments that had no palpable connection to any underlying value.  In the most notorious cases the bankers who engineered these instruments did so specifically in order to bet against them and thus against the customers who bought them.  It was roulette.  For the customers, Russian roulette.

We have already noted that the increasing volatility of the stock market is not caused by anything in the real world.  A good example of Wonderland markets is the price of oil.  By now we are accustomed to sudden spikes in the price of gas at the pump and we have learned to pay attention to the price of crude oil.  Supply and demand play a small role in this phenomenon but the real culprit is the little understood futures market.  A futures contract is an agreement to buy or sell some commodity—in this case 1000 barrels of crude oil—at a given price on a given date in the future, often 90 days from the date the contract was originally made.  These contracts can be traded at any time during their life and are usually traded many times before they expire.  A few players actually want to buy or sell the oil but the vast majority have no interest in or ability to cope with the real stuff.  They are gamblers, pure and simple, who will eventually settle their positions in cash.  They will be the first to claim they provide important liquidity to the market which is true except that the market needs only a tiny fraction of that liquidity.  Meanwhile, their speculation overwhelms the market for real oil and sets the price for vital commodities like gasoline at the pump and home heating oil.  It is as though the value of the dollar were determined by the Las Vegas blackjack tables.  The same insanity applies to the markets for wheat, soybeans, bacon and, if you remember the movie “Trading Places,” frozen orange juice concentrate.

Future contracts were invented 5,000 years ago in Mesopotamia and have been essential enablers ever since in agriculture and large scale extractive industries.  They provide a level of financial stability to actual producers and users of a wide range of commodities.  Future contracts on interest rates and other financial benchmarks are important risk management tools for banks.  But as a form of gambling, they become more complex over time.  Complexity increases the probability of what mathematicians call “cascading failures” of their component parts which lead to catastrophic failures.  As this is written, the major disaster scenarios are related to “algorithmic trading” most notably to the form known as high frequency trading (HFT), a strategy that redefines the notion of short term from minutes to microseconds.

In today’s market, 2% of the traders employ HFT and related strategies which allow them to buy and sell huge positions instantaneously.  The most popular of these strategies account for between 50% and 75% of daily trading all of which is transacted by computers programmed with highly sophisticated algorithms, statistical models that track a wide variety of trigger events.  The SEC has said that such a system caused the “Flash Crash” of May 6, 2010.  It began with the sale of 75,000 “E-Mini” futures contracts worth $4.1 billion at 3:32 PM.  (E-Minis are bets on the Standard and Poor 500 Index.  Each contract has a nominal value of 50 times the value of the Index at any given moment.)  The May 6 sale triggered other black box systems with the result that E-Minis came to define the real value of the real securities in the Index.  Within 3 minutes, the it dropped 3%.  Between 2:41 PM and 3:00 PM, the Dow dropped 998 points or 9.2% of its value and then turned around and regained most of the loss closing the day down 384 points or 3.2%.  For a half hour, the market experienced a total disconnect from anything resembling the real world. [4]

If all this were merely a case of the inmates running the asylum it would be a tightly circumscribed problem of little concern to most people.  But the stock market is too important to ignore even at a time when fewer than half of Americans are exposed to it.  The various commodity markets are crucial to those directly involved in producing and using the commodities.  Real estate is central to almost everyone.  In short, the financial system is the foundation of the economic, social and cultural architecture of the entire community and it is in desperate need of reform which will not be easy.  Even if the solutions were obvious there is at present no political appetite for reform.  Throughout the developed world there is an epidemic of self interest and economic disarray that bodes ill for the kind of concerted and determined action that was achieved at Breton Woods in 1944.

We tend to forget that money is an artificial construct and that it and the systems involved in storing and circulating it are highly abstract, fragile and reactive.  Neither dollars nor diamonds have any intrinsic value but are “worth” only what someone is willing to pay for them. [5] The systems used to regulate markets tend, on the other hand, to be clumsy compromises based on political ideology and are therefore slow to recognize changing conditions.  Moreover, any changes that are made in the governance of the financial markets must be coordinated with equally profound changes that need to be made in the broader economy.  We face a daunting challenge.  But as timeframes collapse and the global economy becomes ever more interconnected market contradictions become less tenable and more threatening.  Time is short and the river is rising.

Subsequent Events

In the first quarter of 2020, volatility went through the roof of every stock market in the world, supposedly because of the pandemic caused by the coronavirus.  Actually, the down days seemed like nothing but a typical panic in the face of uncertainty.  It was as though the computers thought markets were normally certain and therefore risk-free.  The up days, on the other hand, looked like computers grasping at straws.  It was not edifying.

Earlier, Navinder Sarao who had singlehandedly caused the Flash Crash (see Note 4 below) was convicted in a Chicago courtroom and sentenced to a year of home confinement at his parents' house  in London.  He apologized for his prank, attributing it to Asperger's Syndrome, and claimed to have "found God."  The leniency was supported by the prosecution which thanked him for educating them about exotic stock market fraud.

Notes

1. The Dow Jones Industrial Average (DJIA) of 30 large U.S. companies is a reasonable and widely understood simulacrum for the U.S. equities market.  There are several more accurate measures notably the Standard and Poor’s 500 or the Russell 3000 but all are fairly well correlated and the Dow Jones has the advantage of a much longer history.  The Dow of course is no longer restricted to industrial companies but includes such as American Express, Disney, Goldman Sachs and Wal-Mart.

2.  Not everyone.  In 2013, Pew Research Center reported that investors were primarily white, middle aged college graduates with annual incomes over $75,000.  Currently, slightly less than half of Americans are exposed to the stock market either directly or indirectly, the lowest participation rate in many years.  The recent high was 65% in 2007, the year before the real estate bubble burst and the economy crashed.  Most Americans are not good savers (in part because wages have not kept up with inflation).  The average net worth of American adults is about $301,000 but the median is only $45,000, another reflection of economic disparity.  Most of that net worth is in real estate.

3.  The academic literature is full of analyses of every conceivable kind of volatility almost all of which is useless in the real market.  I use the term here to discuss the fluctuation of price over a given period of time.  Obviously the greater the change and the shorter the period the higher the volatility.

4.  On April 21, 2015, British authorities arrested one Navinder Sarao on a 22-count complaint of market manipulation issued by the U.S. Department of Justice.  Mr. Sarao is a London day trader accused of causing the Flash Crash by “spoofing,” a technique of entering thousands of large but fake buy and/or sell orders simultaneously in an attempt to influence HFT algorithims.  Conservative publications rushed to his defense and legal pundits emphasized that the government would have a hard time proving its case.  The charges against him carried a prison term of 380 years which may have been what encouraged him to cop a plea to one count.  He was sentenced in late 2017.  Anyone seriously interested in the mechanics of high frequency trading and their sociopathic implications should read Flash Boys:  A Wall Street Revolt by Michael Lewis (Norton, 2014).

5.  Intrinsic value is another one of those slippery terms you struggled with in Economics 101 and this is not the place to attempt to resolve it.  Once upon a time, gold was defined as being worth $32 an ounce.  Why?  Because some economists and diplomats said so.  It was arbitrary but useful in a simpler age.  The price (and therefore the value) of gold is now set by the gold market which, like the stock market, is made up mostly of gamblers.  A painting by Pablo Picasso recently sold at auction for close to $180 million.  Please note that no combination of canvas and paint has an intrinsic value of $180 million.