Knowledge lies at the heart of western capitalism.

By Hernando de Soto

The world economy is made up of many tiny parts that are useful only when we combine them into more complex wholes. The higher the value of these aggregations, the more economic growth.Humanity’s achievements – from the 120 ingredients of my clock to the countless financial deals and developments that produced the internet and flight navigation systems – all result from joining people and things to each other.

That’s why western capitalism has triumphed for the past 150 years: it gave us the best knowledge to explore economic combinations. Capitalism does not need to be re-thought or re-invented; it simply has to be re-discovered.

The reason credit and capital have contracted for the past five years in the US and Europe is that the knowledge required to identify and join parts profitably has been unwittingly destroyed. The connections between mortgage loans and liquid securities, between non-performing financial derivatives and the organisations that hold them; the non-standardised, scattered records that obscure who holds risks; and the off-balance-sheet accounting that obscures many companies’ health: these all make it harder to trust and hence combine. Until this knowledge system is repaired, neither US nor European capitalism will recover.

Reformers and policymakers must recognise that they are not dealing with a financial crisis but with a knowledge crisis. Capitalism lives in two worlds: there is a visible one of palm trees and Panamanian ships, but it is the other – made up of the property information cocooned in laws and records – that allows us to organise and understand fragments of reality and join them creatively.

The world of organised knowledge and joining began in earnest in the mid-19th century, when reformers in Europe and the US concluded that the segmented, undirected knowledge left by the old regimes could not cure the recessions that beset early capitalism. They faced what was known as “the knowledge problem”, the inability to select and store dispersed information about economic things. Those reformers created “property memory systems” to map – in rule-bound, certified and publicly accessible registries, titles and accounts – all the relevant knowledge available on assets, whether intangible (stocks, patents, promissory notes) or tangible (land, buildings, machines).

Knowing who owned – and owed – what and where, and fixing that information in public records, made it possible for investors to locate suppliers, infer value, take risks and combine such simple things – to borrow a famous example – as graphite from Sri Lanka and wood from Oregon into pencils.

Reformers also helped to solve “the binding problem,” finding the information needed for parts to fit together. This metaphysical concern affected all disciplines: physiologists discovered that what binds cells to form an organ performing specific, sophisticated functions is a nucleic acid now called DNA. The logic behind the property documentation is the DNA of capitalism.

Modern recording systems evolved from data warehouses certifying isolated assets, into factories of facts for facilitating the knowledge entrepreneurs need to combine assets, skills, technologies and finance into more complex and valuable products. Thus, real estate documentation no longer just says that Smith owns the house on the hill but also describes that house as the address at which mortgages can be foreclosed; debts, rates and taxes collected; deliveries made; and from which utilities services can be controlled and bills collected.

This knowledge allowed western economies to grow more since the second world war than in the previous 2,000 years without big credit contractions.

Until 2008, when we began to learn that memory systems had stopped telling the truth – through off-balance-sheet accounting; debts buried in footnotes or the ledgers of “special purpose entities”; financing raised by “bundling” mortgages into securities not recorded in traditional public registries; and nations masking debt as income by swapping it from one currency to another. No wonder institutions and investors have lost confidence in the system.

The brilliance of western capitalism lies not in providing a formula for wealth creation but in its property memory systems, which are the result of examining, selecting and validating information about who owns land, labour, credit, capital and technology, how they are connected and how they can be profitably recombined.

For the past 15 years, the records of western capitalism have been debased, leaving governments without the facts to spot what needs to be fixed and for businesses to know where their risks are. To regain its vitality, western capitalism must bring under the rule of law and public memory hundreds of trillions of dollars now swirling mindlessly out of control in the obscure world of financial innovation. That task requires major political leadership.

The writer is author of ‘The Mystery of Capital’ and ‘The Other Path’

Extraordinary Measures for Ordinary Times

Harold James

Greece economy

MUNICH – It has been ten years since the financial crisis went international. Until July 2007, the subprime mortgage crisis seemed like it was strictly a problem for the United States. But then Landesbank Sachsen and IKB Deutsche Industriebank, two publicly-owned regional German banks, had to be bailed out, and it suddenly became clear to policymakers just how interconnected the global financial system had become.
The legacy of 2007 is still with us. Its most devastating and destructive effect was to put a premium on unconventional monetary measures. Unfortunately, when policymakers scrambled in search of “big bazookas” ten years ago, they set the stage for the return of an old character: a strongman willing to pull the trigger.
To be sure, at the height of the financial crisis, politicians were right to conclude that they could not rely on business as usual. Central banks needed to provide liquidity on a massive scale, and governments needed to complement those monetary-policy efforts with fiscal expansion.
Accordingly, China and the US, in particular, launched large-scale stimulus programs in 2008 and 2009, respectively.
Some of the extraordinary measures implemented in response to the financial crisis proved to be ill-conceived, and were abandoned or revised. In the US, the Troubled Asset Relief Program (TARP), which former President George W. Bush signed into law in October 2008, started out as a program whereby the Department of the Treasury purchased problematic, largely mortgage-based assets directly from financial institutions. But that turned out to be more complicated than originally thought, and, within weeks, the government simply recapitalized US banks instead.
Other bad decisions were not so easily reversed. Hoping to prevent a bank run, the Irish government offered a blanket guarantee for all banking deposits. With that one unilateral decision, Ireland destabilized the rest of Europe. Suddenly, other governments had to fear that their own banks’ depositors would flee en masse to the backstopped Irish banks (never mind that the cost of the guarantee was too much for the Irish government to bear).
Still, overall, the response to the financial crisis was strikingly successful, and those who led it were right to pat themselves on the back for having prevented a repeat of the Great Depression.
But, because unconventional policies were so effective, they are now considered appropriate and necessary responses to any problem, while constitutional safeguards are increasingly dismissed as petty bureaucratic concerns.
Already in 2008, former Federal Reserve Chairman Paul Volcker warned that the Fed was at “the very edge of its lawful and implied powers.” Of course, some might ask why a policymaker should not ignore that edge for the sake of the country’s welfare. But invoking salus populi suprema lex – the maxim that laws should reflect the public interest – is an old way of justifying autocracy. Indeed, who is to say what is in the public’s best interest, let alone determine the supreme law of the land?
John Adams, America’s second president, noted the dangerous ambiguity of this concept: “The public good, the salus populi,” he wrote, “is the professed end of all government, the most despotic, as well as the most free.”
The post-crisis view holds that a powerful leader can and should fix things by himself (strongmen are rarely women). This approach was readily apparent in the Russian government’s response to collapsing aluminum prices in 2009, when job losses and unpaid wages gave rise to large-scale protests at a plant in Pikalevo, 150 miles (250 kilometers) southeast of St. Petersburg.
When then-Prime Minister Vladimir Putin toured Pikalevo, he made a show of humiliating the plant’s owner, the oligarch Oleg Deripaska, by calling him a “cockroach.” Putin didn’t announce any new policies to help Russian workers; nonetheless, his performance in Pikalevo was hailed as a bold assertion of state power in the face of capitalist excess.
Strongmen tend to present themselves as being uniquely able to tackle a specific problem. For Philippine President Rodrigo Duterte, that means a “war on drugs” that has led to thousands of extrajudicial killings. Putin and Turkish President Recep Tayyip Erdoğan justify their policies in the context of fighting terrorism. And Hungarian Prime Minister Viktor Orbán has framed his autocratic behavior as a necessary response to a domestic financial crisis. By focusing on one narrow “crisis,” these leaders create a mindset in which all other problems become crises that demand immediate, effective, and unconstrained action.
This post-crisis mentality is in keeping with the German political theorist Carl Schmitt’s doctrine of “decisionism.” Schmitt, who joined the Nazi Party in 1933, held that sovereign decision-making is the central feature of the political process. When leaders make political decisions, they are reasserting control over the concept of sovereignty itself, which has been gradually eroded and transformed through various phases of globalization.
According to Schmitt, how leaders arrive at their decisions is secondary to the fact that a decision has been made. A sovereign “needs” to act forcefully to protect particular threatened interests. Often, this entails symbolic gestures. In 1930, for example, America’s Smoot-Hawley Tariff Act singled out Swiss watches, Japanese silk products, and other nationally iconic imports.
Protectionism today is no different. Consider US President Donald Trump’s threat to impose tariffs against BMW and Mercedes-Benz: two high-visibility brands that one immediately associates with Germany.
In response to Trump’s threats, Europe has also tapped into the politics of symbolism. If Trump follows through, the European Union may retaliate by targeting bourbon whiskey, a distinctly American spirit that is heavily produced in Kentucky, US Senate Majority Leader Mitch McConnell’s home state.
Unfortunately, this approach has created a political environment in which established norms have been eroded, and no new norms have taken their place. The Soviet-born British journalist Peter Pomerantsev said it best in the title of his brilliant book about post-Soviet life: Nothing Is True and Everything Is Possible. Now that crisis has been normalized as a permanent condition, we are all post-Soviet.

China’s Industrial Dragon Burning Less Hot

China’s growth started showing signs of strain in July

By Nathaniel Taplin

  A man with a kite shaped like the symbol of China's People's Liberation Army poses in front of Shanghai’s Pudong financial district on July 27. Photo: aly song/Reuters

China is in the midst of a historic summer heat wave—temperatures in Shanghai hit their highest in 145 years on July 21. However, the country’s economic growth, which surprised on the upside in the first half of the year, is suddenly looking less hot.

China’s official factory and services sector gauges both ticked down in July—the first concerted decline since April, although both indexes remained in positive territory. More important, the purchasing managers’ indexes contained hints that two of the most bullish factors for Chinese growth in recent months—fat industrial margins and strong exports—may be waning.

The new export orders PMI subindex fell by 1.1 points to 50.9, its sharpest drop since late 2014. That’s worrying because the turnaround in export growth has been one of the main factors painting a brighter picture for China this year. As recently as March 2016, falling net exports were subtracting nearly a percentage point from the annual growth rate. However, by early 2017 the global recovery in trade was adding nearly half a percentage point instead.

If China’s July trade data confirms the latest weakening trend, downside risks in the second half will increase.

The sharp rise in factory input costs and a much weaker gain in sales prices imply that margins probably weakened in July after months of expansion, which drove industrial profits up 19% from a year ago in June.

The factory-gate price index rose 3.6 points, but the input price index rose nearly twice as fast, and hit its highest level since March. Rapidly rising steel prices may be one factor—China’s statistics bureau noted that both input and output prices rose rapidly in the iron-and-steel sector in June. Downstream companies in machinery and other industrial sectors will start to feel the pinch.

On the whole, July’s PMI shows the economy still in good health—but if margins keep eroding and exports slow further, the picture could darken in late 2017 or early 2018.

Russian Sanctions: The Kremlin’s Response

By Jacob L. Shapiro


The U.S. has issued a direct challenge to Russia with the passage of expanded sanctions. U.S. President Donald Trump begrudgingly signed a bill Aug. 2 that was passed by both the House of Representatives and the Senate with veto-proof majorities. If Russia does not respond, it will appear weak – something the Kremlin can’t tolerate. The question now is not if Russia will respond but how.

The answer is already beginning to take shape. The Russian Federation is a shadow of the Soviet Union, but the strategy it employs is still much the same: undermine the U.S. alliance structure by challenging the U.S. in peripheral areas. If it can distract the U.S. and make U.S. allies question Washington’s reliability, Russia will improve its negotiating position when it comes to other issues of vital Russian interest.

Russia has therefore made moves in a few important areas that should be seen as a response to the sanctions. The first area is the Caucasus. On July 31, a delegation from Russia’s Defense Ministry visited Georgia’s breakaway region of South Ossetia to implement a deal that would integrate South Ossetian soldiers into the Russian army. On the same day, Abkhazia, another Georgian breakaway region, ratified an agreement to establish an information and coordination center with Russia. Meanwhile, Azerbaijan has withdrawn from NATO’s Noble 2017 exercises, and tensions seem to be rising once more on the eternal Nagorno-Karabakh problem.

In the North Caucasus, Russia’s goal is fairly straightforward: to remind Georgia just how flimsy U.S. security promises are. In the South Caucasus, Moscow can exploit the drifting apart of Azerbaijan and the United States. It is an ideal place for Russia to push back against U.S. containment and undermine U.S. legitimacy. The fact that in recent months Turkey and Russia have reached an accommodation of sorts only exacerbates this reality.

A picture taken on July 31, 2017, shows the U.S. Embassy building in Moscow. MLADEN ANTONOV/AFP/Getty Images
This type of activity has been most evident in the Caucasus, but it’s not the only place Russia can cause trouble for the United States. The U.S. remains intensely focused on the Korean Peninsula, as North Korea shows no signs of stepping back from its nuclear program. Russia may not have many avenues to shape this situation, but that’s not going to stop it from trying. Moscow has reportedly delivered certain resources, like flour and possibly crude, to Pyongyang in a potential attempt to weaken U.S. moves to isolate North Korea. Russia doesn’t necessarily have any strategic interests in North Korea, but the situation on the peninsula offers a useful distraction that could keep the U.S. from focusing on the Kremlin.

China, which has seen deteriorating relations with the U.S., is another place where Russia can create a distraction. On the same day the sanctions bill passed the U.S. House of Representatives, China and Russia held joint naval exercises in the Baltic Sea, another region sensitive to Russian assertiveness.

China and Russia don’t see eye to eye necessarily, but Beijing may also be the target of future U.S. sanctions for its unwillingness or inability to push back against Kim Jong Un. A show of solidarity with China in a region like the Baltics, where the U.S. has made security guarantees, serves Russia’s purposes nicely.

Then there’s Ukraine, in large measure the fundamental issue that lies unresolved between Russia and the United States. On July 31, The Wall Street Journal reported that a joint State Department and Department of Defense proposal to provide Ukraine with defensive arms was delivered to the U.S. president and is under review. In some ways, this move would be even more worrying for the Kremlin than sanctions are. It’s not surprising, then, that there have been signs that the situation in eastern Ukraine is worsening. Some armed units in Donetsk and Luhansk will reportedly participate in military exercises with the Russian army in August and September, and Kiev cut off electricity to Donetsk last week. This may foreshadow things to come.

This is not an exhaustive list of where Russia will seek to respond to the sanctions issue. Moldova, the Balkans, Eastern Europe and Central Asia are also compelling candidates. The goal in all these regions is not to trigger an actual conflict but to create the impression that conflict is possible, at least to the extent that the U.S. will release some of the pressure on Moscow. The secondary goal is to capitalize on and even exacerbate tensions – sometimes the result of U.S. overextension, other times a result of competing interest – between the U.S. and its allies.

And Russia may have a somewhat unexpected ally in the European Union, which did not approve of the expanded sanctions but could do little to stop them. Russia will try to exploit the gap between U.S. and EU interests on this issue. In particular, Moscow will avoid destabilizing activity that jeopardizes even a small confluence of interests with Germany.

This is not a perfect solution for Russia. It suffers from two critical problems.

First, the White House doesn’t control U.S. foreign policy. Only Congress, which has firmly supported sanctions against Russia, has the power to dissolve them. Russia therefore can’t reach an understanding with the U.S. president to make the sanctions go away. He would need congressional approval, and there’s arguably as much conflict between Congress and Trump as there is within the Trump administration itself.

Second, the fundamentals of Russian power put Moscow in a very difficult situation. The Russian economy is struggling with low oil prices, and President Vladimir Putin does not have a great deal to show for his leadership beyond a freshly contentious relationship with the United States. Putin needs to find ways to show both the Russian people and the world that Russia is powerful – even if it isn’t. Russia is holding a weak hand, and though it is fair to say Moscow has demonstrated it knows how to play a weak hand very well, the deeper point is that the sanctions are forcing it to play the hand whether it wants to or not.

Hulbert on Markets

3 Signs a Bull Market Is About to Tumble

Stocks are even more overvalued than they were 10 years ago, though other signals appear more benign.

By Mark Hulbert                

Getty Images/iStockphoto
It would be easy to hang our heads in shame as we approach the 10th anniversary of the 2007 bull market top.
Most of us failed to recognize that the top had even occurred until well after the fact, missing the early warning signs that, in retrospect, seem so obvious. From the Oct. 9, 2007, market top to the March 9, 2009, bottom, the Standard & Poor’s 500 index went on to lose 57%.
Consider what was happening 10 years ago this summer: On July 11, 2007, the Federal Reserve placed 612 mortgage-backed securities on its credit watch. On Aug. 6 of that year, American Home Mortgage—then the 10th-largest mortgage lender in the U.S.—filed for Chapter 11 bankruptcy protection. Small-cap stocks, as measured by the Russell 2000 index, hit their bull market high on July 13—and over the next five weeks dropped more than 12%.
How could we have missed these signs?
No doubt we won’t miss those particular ones if they were to occur again. But, needless to say, they won’t. Whenever the current bull market comes to an end, it inevitably will have been preceded by an entirely different set of warning signs.
And since bull market tops are characterized by widespread optimism, most of us will ignore them.
There is at least a ray of hope, however, if you’re willing to resist the widespread euphoria that accompanies tops. According to a number of market analysts I interviewed for this column, most major market tops do share certain telltale characteristics, even if their presence doesn’t guarantee that a bear market is imminent.
By focusing on them, it’s possible to avoid being taken completely by surprise by the next bear market.
Here are three such characteristics:
Overvaluation. Valuation indicators such as price/earnings, price-to-book, price-to-sales, or price-to-dividends ratios are notoriously poor at identifying market tops. Overvalued markets can remain that way for quite some time, if not become even more overvalued, before the laws of gravity set in. But we ignore valuation indicators at our peril, since it’s also true that almost all bull market tops in history have begun when they signal that the market has become overvalued.
In the summer of 2007, the stock market—as measured by these traditional valuation indicators—was more overvalued than it had been at almost all previous peaks since 1900. In fact, regardless of the valuation indicator chosen, there had been only one previous market top when the stock market had been more overvalued: the dot-com bubble in 2000.
A struggling financial sector. One of the S&P 500’s 10 sectors that typically suffers when a bull market is approaching its end is financial stocks. During the last three months of all post-1970 bull market tops prior to 2007, the sector lagged the S&P 500 two-thirds of the time, according to Ned Davis Research. And it did so again in 2007, lagging the S&P 500 by 3.1% over the three months prior to the Oct. 9 bull market top.
An even stronger early warning signal came from smaller regional banks, according to Hayes Martin, president of Market Extremes, an investment consulting firm that focuses on major market turning points.
Martin’s research has shown him that such banks are even better “canaries” than the financial sector generally. He says that regional banks peaked in December 2006, and by July 2007 they were already significantly behind the broad market—providing “early warnings of trouble ahead.”
These warning signs from the financial sector became progressively worse over the next few months, and by October they were screaming “sell.”
Wide divergences. Another indication of an unhealthy market is one in which fewer and fewer stocks are participating in the uptrend—divergences, in market-timing parlance.
Many market-timing systems focus on divergences in their attempts to pinpoint market tops. The Dow Theory—the oldest market-timing system that remains in widespread use today—uses divergences between the Dow industrials and Dow transports as the precondition of a sell signal. The Advance/Decline Line, a market-timing system that measures the number of rising stocks net of declining ones, points to imminent trouble if it shows the majority of stocks to be declining even as the broad averages continue rising.
David Aronson has been researching increasingly sensitive ways of measuring the market’s internal divergences. Aronson, an adjunct finance professor at Baruch College and the author (with Timothy Masters) of Statistically Sound Machine Learning for Algorithmic Trading of Financial Instruments, proposes a particularly systematic measure of divergence that focuses on each stock’s recent percentage change. It’s a sign of an unhealthy market, he says, when those changes fall within a wide distribution.
This was very much the case in July 2007, Aronson told Barron’s. Prior to that month, the stock market had exhibited more-extreme divergences less than 3% of the time. By October 2007 his measure of divergence reached even higher levels, registering readings that had been exceeded only a couple of times previously.
The bottom line: Though there will never be a foolproof system for pinpointing major market tops, it would be incorrect to say that those tops occur randomly and that therefore we should simply give up. The 2007 bull market top did share certain crucial characteristics with prior bull market tops.
So where does the current stock market stand relative to 10 years ago? Fortunately, just one of the three telltale characteristics of a top appears to be present today: overvaluation. Stocks, on average, appear to be even more overvalued today than they were at the 2007 top, according to any of the standard valuation ratios.
The financial sector is not struggling currently. In fact, it’s the third-strongest performer among the 10 S&P 500 sectors over the past three months, beating the S&P 500 by a margin of 4.9% to 3.8%. And though Aronson’s divergence measure did rise to alarming levels earlier this summer, he says it has backed off recently. Martin adds that the market today is “in far better shape than it was 10 years ago.”

The demise of Libor is not a done deal for markets
Moving more than $350tn of derivatives pegged to benchmark will take longer than five years

by: Alexandra Scaggs

       © FT montage

Reports of the death of Libor may be exaggerated, particularly in US markets.

The UK markets regulator, the Financial Conduct Authority, has set a rough timeline for banks to prepare for a transition away from the floating interest rate benchmark that is crucial to world markets. By the end of 2021, it will no longer require banks to contribute to its calculation for rates in sterling, it said.

Yet that may not signal the passing of a number that over the last 30 years emerged as one of the pillars of global finance and, more recently, a symbol of its decay.

Libor’s administrator, the US’s Intercontinental Exchange, will still be able to publish the dollar rate after that point, and analysts and trading executives say it may still be necessary.

Five years is not long enough for banks to overhaul the $350tn of outstanding derivatives, loans and mortgages tied to the key reference rate, they say.

Banks, companies, insurers, pension funds and consumers are among a multitude of participants that have swaps and debt that is regularly affected by changes in short-term interest rates in the money market. Libor for a term of one month and, more often, three months maturity are the cornerstones of the floating interest rate market for the broader economy and users of derivatives.

The question now is, how many banks will be willing to contribute to the benchmark after 2021, and for how long?

“It’s certainly possible that they’ll continue to publish the rate,” says Mark Cabana, a strategist with Bank of America Merrill Lynch. “But it’d be something banks do because they recognise how pivotal Libor is in the financial system, and not because of anything related to their bottom line.”

Libor has already created headaches for market participants. Banks and interdealer brokers racked up $9bn in penalties because their employees tried to manipulate the rate, and authorities demanded a wholesale review of Libor, passing administration from the industry to ICE, a regulated Exchange.

Global regulators envisaged the rate would be based on transactions, rather than the survey structure that left it vulnerable to price fixing. But the underlying market — unsecured short-term lending between banks — is not exactly vibrant.

In the second quarter of 2017, less than half of all currencies’ Libor submissions for terms of a week or longer were based on actual transactions, according to data from ICE. That introduces some legal risk, since flawed submissions could be subject to regulator scrutiny.

Substitutes for libor are planned. In June, the Alternative Reference Rates Committee (ARRC), a dealer-led industry group backed by regulators, announced a US replacement called the Broad Treasury Financing Rate (BTFR). It is expected to be running in the first half of next year. Last week CME Group, ICE’s derivatives exchange rival, said it would develop futures and options on the new benchmark.

But the rate is not published yet and, crucially, the BTFR measures the cost of overnight repurchase agreements (repo) secured by Treasuries, whereas Libor reflects unsecured money market-based borrowing between banks.

Another issue is building out longer-term reference rates, particularly for one or three months, from the overnight rate in the event of a permanent Libor demise. Dollar Libor is quoted across a range of monthly maturities out to 12 months.

The dollar-denominated swaps market has about 65 per cent of its more than $100tn in notional outstanding value tied to Libor, according to the ARRC. A swap contract involves the exchange of fixed and floating rate cash flows over a term that can run to 30 years or longer. Such contracts generally rely on three-month dollar Libor as the benchmark floating rate.

“US dollar Libor has to live longer, because the replacement is going to take a while to roll out,” says Jason Williams, a strategist with Citi Research.

ICE’s policy is to publish Libor as long as it receives five or more submissions for a particular currency. But if enough banks decide to stop contributing to the Libor panel, others may follow. And broadly, a five-bank panel is likely not enough to sustain a rate over the long term.

The market is exploring options if ICE were to stop publishing Libor before all the relevant contracts are updated. Regulators, banks and investors could agree on a fixed spread over their region’s chosen short-term reference rate, and work out a term structure.

But as Mr Cabana notes, the option “obviously would raise some concerns around what spread to be chosen, the term structure of the fixed spread . . . but these, in our view, would be easier challenges to address than renegotiating and re-hedging existing contracts”.

ISDA, the derivatives industry’s main trade association, is also working on details of potential fallback provisions to be used if Libor is no longer published. Commercial rivals are also interested. Meanwhile, the CME eyes it as a chance to exploit futures contracts that would be tied to new reference rates.

“We are working very closely with ISDA on potential fallback,” Sean Tully, global head of financial and OTC products at CME, told investors on Tuesday.

But executives and analysts acknowledge none of these new benchmarks have as wide of a reach as Libor.

“In the end, we see the most likely scenario as involving a fractured derivatives market with multiple underlying benchmarks across different countries developing,” says Mr Cabana.

The Volatility Of Everything

by: Eric Parnell, CFA

- What if capital markets were absolutely perfect? Lately, they seem that way.

- What if capital markets are not perfect after all?

- An examination of volatility across asset classes provides us with insight on what we may reasonably expect from various categories in the future.
“I want us to be together for as long as we have got. If that is not very long, well, then that is just how it is.”  
- Jane Wilde, The Theory Of Everything, 2014

How wonderful would it be if capital markets were absolutely perfect? Imagine a world where risk assets like stocks only rose and never fell regardless of valuations (OK, you don’t really need to imagine it, because that’s what’s been happening since late last year). Envision if bond yields and borrowing costs remained perpetually low at the same time that inflationary pressures were benign (OK, once again, sounds like today). And imagine having all of this in an environment where the daily uncertainty associated with the prices of these assets was minimal (OK, we’ve got that today too). What a world it would be? And maybe, just maybe this is the world that we have officially entered into during the post-crisis period. Perhaps policy makers through their actions have finally discovered the master theory that fully explains and links together all fundamental aspects of capital markets. But in case they have not, it is worthwhile to consider what might take place when capital markets move on to something other than the seemingly perfect conditions that we are experiencing today.


General Volatility
Investing in capital markets has truly seemed perfect for some time now. Unfortunately, with a perpetual sense of perfection eventually comes an inevitable sense of complacency if not outright invincibility. And for us mere mortals that participate in investment markets that have limited time horizons and abilities to replace hard earned capital that can be subsequently lost knowing that past performance is no indication of future results, a sense of dauntlessness can prove to be a dangerous thing over time.

In the current market environment, this sense of investor complacency is expressed through volatility, or the lack thereof. The most commonly referenced metric in this regard is the CBOE Volatility Index, or VIX. Also known as the “fear gauge”, the VIX measures the implied volatility of index options specifically for the S&P 500 Index (NYSEARCA:SPY). This is a first important point worth highlighting, which is that the VIX measures the “fear” levels associated specifically with U.S. large cap stocks as measured specifically by the S&P 500 Index (NYSEARCA:IVV). And today, investors are feeling as confident as they ever have in history.

Highlighting the current air of invincibility, on July 21, the VIX notched its lowest close in history at 9.36. And just last week on July 26, the VIX dropped below 9 for the first time ever in hitting an all-time low intraday reading of 8.84. It doesn’t get any more perfect than this, unless of course conditions become even more perfect in the coming days, weeks, months, or years for stock investors via even lower volatility, which is a possibility that simply cannot be ruled out.
But what of this seeming fearlessness among U.S. stock investors. What can we reasonably expect to follow afterwards?
Of course, the most readily available and commonly cited example to reference is what took place just over a decade ago. For it was in early 2007 when the S&P 500 Index last fell to similarly impenetrable levels of implied confidence. And we all know what happened over the subsequent two years, which was the near implosion of the global financial system.
But a sample of one is clearly insufficient to draw any sorts of conclusions about what might lie ahead between now and the end of 2019. And the 2007 example for the S&P 500 Index can be refuted by the 1994 to 1996 comparison where volatility dropped to comparably low levels and what followed was the five most explosive upside years in stock market history to close out the millennium. Of course, this second example also ended violently by the year 2000, but it still came roughly five years later.

Fortunately, the VIX is not the only volatility reading that we can examine to try and get a better sense of what we might reasonably expect from any asset in capital markets today once record complacency is replaced by something less than perfect.
First, let’s stay with the stock market and consider the volatility index for emerging markets (NYSEARCA:EEM). While the historical data for this metric is fairly short at just over six years, it is still notable that the VXEEM reached its all-time low in July 2014 at a reading of 13.71 that was nearly one half of its short historical average. Not long after, emerging markets fell into a difficult 18-month stretch that included a short-term -18% correction followed by a solid rally followed by another -34% correction. In short, record high complacency was followed by particularly acute turbulence.

Where do we stand today with emerging market volatility? We are back near the previous lows from the summer of 2014. But once again, the historical time series for the VXEEM is short, and the risk as measured by standard deviation for emerging market stocks (NYSE:VMO) is roughly 1.67 times that of the S&P 500 Index (NYSEARCA:VOO). Moreover, it is very possible that EM volatility could continue dropping into the single-digits as EM stock prices surge to new all-time highs. As a result, it is worthwhile to continue searching.
Next, let’s consider a major reason why “fear” returned with a vengeance for emerging markets in the summer of 2014. Of course, it was at almost the same exact time that oil prices (NYSEARCA:USO) reached their final peak at $106.86 per barrel on West Texas Intermediate Crude. Now this final top in oil was certainly nothing that could even be remotely considered a blow off top, as oil crossed over $100 per barrel in the post-crisis period in 2011 and remained well below the pre-crisis peak over $140 per barrel. Instead, oil prices effectively moved sideways for roughly three years from 2011 to 2014 before suddenly breaking to the downside.
But one key factor that defined this three-year sideways move was the fact that oil price volatility was consistently falling. By the summer of 2014, it was at less than its historical average in moving below a reading of 15.
What followed over the next few months was dramatic. And it was absolutely crushing for those companies and investors that were coasting on the complacency of steadily high oil prices. In short order, the price of oil was cut by more than half. And roughly 18 months later, it was lower by nearly -75%.
Here again we have a circumstance where price volatility for an asset class had fallen to historic lows. And what followed was a violent and sustained outbreak in downside price volatility. The move was anything but gradual, and for those that were overly exposed to the asset class, it was very difficult to emerge without sustaining at least a measurable about of pain.
But the challenge once again is the following. Sure, oil price volatility steadily dropped from at or above its relatively short historical average to new lows at 15, but what made 15 the magic number where the correction was ultimately sparked? What would have kept the OVX from falling below 10?
After all, the fundamental supply/demand imbalance had existed for some time come 2014, yet oil prices remained stubbornly high. Of course, it was Saudi Arabia’s actions at the time in attempting to impose discipline on the global oil market that finally broke the sense of invincibility in the oil market. In short, it was a catalyst that sparked the end to complacency in oil, and these effects spilled over to rattle the cage of emerging market investors not long after.
And in both cases, dramatic downside price moves followed historically low volatility levels.
Let’s continue by moving on to currency markets. Like oil, the euro (NYSEARCA:FXE) currency was also once caught in a daze of increasing diminishing volatility from mid-2012 to mid-2014. Although the exchange rate was nowhere near its historical highs relative to the U.S. dollar, it found itself gradually strengthening at a time when its underlying volatility fell from its typical 8 to 12 range to a low of 4.69. But even before it reached these historical lows in mid-2014, the euro currency had already begun rolling over relative to the U.S. dollar. And in less than a year, the euro plunged from an exchange rate of 1.39 to 1.05 versus the U.S. dollar, which amounts to a -25% loss in relative value for the euro currency in a very short time period.
Here again we have an instance in a category where volatility had moved well outside of its typical range in falling to historical lows only to be followed by a major price move to the downside.
Now in the case of the euro and oil, both are currently trading with volatility that is slightly below average but well within the bounds of what has been normal over their relatively short histories. Of course, the same cannot be said of U.S. stocks whether they be large caps or small caps, as volatility on the U.S. small cap Russell 2000 (NYSEARCA:IWM) is also at historic lows. Nor can it be said for emerging market stocks with volatility also back at all-time lows.
But what other asset classes are currently trading with historically low volatility? This is where things get particularly interesting.
Consider gold (NYSEARCA:GLD), which after years of higher volatility has seen its volatility gauge drop to new historical lows that recently touched just above 10. Putting this historically low volatility in context, it is less than the 15 reading that came just before the 2011 gold price (NYSEARCA:PHYS) peak. And it is less than the even lower 12 reading that came right before the lights went out on the yellow metal in early 2013. Put simply, the stock market is not the only place where complacency reigns at the present time.
Now consider U.S. Treasuries (NYSEARCA:TLT), which also has a volatility reading that recently revisited its lowest readings in its history and remains at the bottom end of its long-term range. But what is notable in the case of Treasuries and volatility that differentiates it from every other category mentioned here is the following. Reaching historically low volatility readings and experiencing a subsequent spike in volatility is not necessarily correlated with a subsequent measurable price decline in U.S. Treasuries (NYSEARCA:IEF). For example, after reaching a historically low volatility reading in 2007, U.S. Treasury volatility spiked dramatically higher. But so too did U.S. Treasury prices at the same time. And while some spikes in Treasury volatility were associated with a noticeable drop in bond prices, in other instances, it saw Treasuries accelerating its move to the upside. So while bond investors are just as complacent as their stock and gold counterparts, this does not necessarily mean that investors should be anything more than risk aware, as movements in Treasury volatility are more uncorrelated with changes in Treasury prices.
The Theory Of Everything Volatility
Putting this all together, we have the following backdrop for investors today.
Volatility readings across a number of major categories including U.S. large cap stocks, U.S. small cap stocks, emerging market stocks and gold are all at historical lows, albeit a relatively short history.
And past instances of trading at historically low volatility for these categories as well as others such as the euro and oil have typically been followed by sharp and extended periods of sharp downside price movement.
Does this mean that investors should sell any of their assets in any of these categories today?
Absolutely not, for the timing of exactly when markets might react to such complacency remains elusive. To this point, a historical low volatility reading for any given category could just as easily be followed by a new historical low reading in the next day, month, or years that follows. Often, some sort of catalyst is often needed to present itself to spark the reversal higher in price volatility, whether it is the onset of a banking crisis, the elevation of a far-left government into power in the eurozone, the signal that sustained higher inflation is not going to present itself in the post-crisis period, or the decision by the country with the world’s largest oil reserves to impose market discipline. Until any such catalyst presents itself, these low volatility categories can continue to grind higher with increasingly lower volatility.
But what this recent historical data also suggests is that when the sense of invincibility is finally broken, that the subsequent pain felt by investors can prove fairly sharp and severe. And in some cases, prices may not be quick to bounce back to previous highs the way that others may have in the past or present.

As a result, while volatility readings across asset classes are at historical lows in many cases, this does mean that individual investors should replicate this complacency. To the contrary, it is at times when volatility is at or near all-time lows when investors should be particularly attentive and aware of the potential risks that could unfold around them at any given point in time.
All of this is why a broadly diversified asset allocation strategy is so important in the current market environment. Yes, stocks continue to set all-time highs. And yes, bonds continue to hover near all-time lows. And yes, it appears that the gold price may have established a major bottom 18 months ago and is heading steadily in the right direction. All of these categories are achieving these marks with record low volatility, and they may continue to do so for the next several days, months, and years.
But there’s also no telling when any of these categories will experience a jarring wake-up call in the same way that both oil and the euro currency did a few years back. By owning all categories as part of a disciplined asset allocation strategy that includes an allocation to cash when needed, an investor can enable themselves to continue to participate in the upside that today’s market has to offer while at the same time providing themselves with protection once something arises that tests the sense of invincibility in any of these categories at any point in the future.
The Bottom Line
“There should be no boundaries to human endeavor. We are all different. However bad life may seem, there is always something you can do, and succeed at. While there's life, there is hope.”
 - Stephen Hawking, The Theory Of Everything, 2014
We are all different when it comes to investing in capital markets. Some of us are resoundingly optimistic and are fully feasting at the bounty of steadily rising risk asset prices. Others are more cautious and are seeking ways to participate in the upside that risk assets have to offer while also working to protect against the potential unknowns. But regardless of our different perspectives, our goal for investing in capital markets is largely the same, which is to maximize the growth the value of our capital over time for the associated amount of risk being taken to do so.

In recent years, the returns for taking on risk have proven tremendously rewarding. The same was also true back in the late 1990s, as I encountered many investors at the time that were willing to take on much greater levels of risk than normal given their risk tolerances in pursuit of the alluring and seemingly boundless returns the stock market had to offer at that time. But we have also seen extended periods throughout history where the reward for taking on risk has not been rewarded for extended periods of time. And if we were to somehow find ourselves in such an environment in the future, it is always important to remember that no matter how less than perfect any particular asset class or all of capital markets may become in the future, that there are always opportunities for investors to pursue and succeed in continuing to grow their wealth. The key in the end is to know what to do when your most favored asset class takes a turn that may be vastly different from what you know today.

Getting Technical

More Reasons to Worry Amid the Euphoria

As the Dow reaches another milestone, other indexes whittle away at some of the market’s bullish underpinnings.

By Michael Kahn

Getty Images/iStockphoto
It seems strange to worry about the stock market on a day when the Dow finally reached the 22,000 mark.

Even the fact that the move was largely on the shoulders of Apple’s jump higher after it released great earnings news shouldn’t make much of a difference. The trend is the trend, and it is still to the upside.

The real problem is that a few of the positive developments I’ve presented here in recent weeks have started to peel away. That does not mean this bull market is over, but it does put us on notice for the sometimes critical month of August.

Why is August critical? Not for the fireworks of, say, October. It is often a slower month in terms of turnover as summer vacations take hold. And as we approach Labor Day, volume can get quite low, creating a market where even the slightest change in mood can move the price needle quite a bit. Heavy volume provides buffers. Lower volume allows one side—either bull or bear—to dominate.

For example, the so-called flash crash of 2015, when the Dow Jones Industrial Average dropped roughly 1,100 points in the first five minutes of trading, and exchange-traded funds nearly collapsed due to panic selling. That happened on Aug. 24.

Of course, that’s an oversimplification, and there were many other reasons why prices moved so much. I contend that if the markets had been their usual robust selves, the whole incident would have been more modest.

That sets up this month for a surprise, although I cannot say definitively it will be a negative one. Yet given the recent negative action in some of the sectors and indexes whose technical breakouts I cheered on, it does seem that more caution is warranted.

Monday, I wrote here that the Dow Jones Transportation Average fell off a small cliff. The short-term condition still looked vulnerable, but the long-term trendline from the start of this leg of the rally remained intact.

I warned that the trucking subsector was already sitting on its own trendline, and in Tuesday’s session it fell below it.

It’s not the death knell for the broader market, just something to keep in mind. But now, the small-cap Russell 2000 index has fallen back into its prior trading range, and that is yet more evidence for the bears (see Chart).


When the Dow transports and the Russell separately broke out from their trading ranges, I saw the rally broadening out—a bullish signal. The failure of the transports’ breakout removes part of that argument. Now I’m watching the short-term support in the Russell within the major trading range in the 1400 area. (The Russell traded near 1413 Wednesday afternoon.)

Should the index drop below that short-term support, I would have to concede that the important upside breakout failed—and down goes another bullish argument.

Finally, recent weakness in big technology stocks has also scared the bulls. On July 27, many of the big names scored bearish reversal patterns by jumping higher early in the day and closing with significant losses.’s (ticker: AMZN) earnings miss played a large role, but the Dow industrials still managed to close at a fresh record high. New highs are not bearish.

Even Amazon is not truly bearish, as it remains above the major trendline drawn from the start of this rally leg in February 2016. Further, the NYSE advance-decline line, which measures full market breadth on the New York Stock Exchange, reached another all-time high of its own on Tuesday.

Because market breadth remains strong, even as a few sector indexes weaken, it is very hard to think the market is about to break. Three of my four key sectors—financials, home building, and tech—remain very close to multiyear highs. Only retail is floundering.

The caveat is that as August activity starts to thin, even small bits of bad news can cause a stampede to the exit doors. Of course, a little more good news could cause a stampede to higher prices, so the conclusion is to hold a bullish point of view but not mortgage the house to do it.
Michael Kahn, a longtime columnist for, comments on technical analysis at A former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, Kahn has written three books about technical analysis.

Explaining Global Recovery Amid Political Recession

Michael Spence
 London traffic 

MILAN – In the summer, as life slows down, there is space to reflect on fundamental issues. One of the key puzzles occupying my mind of late is the disconnect between widespread political dysfunction and relatively strong economic and financial-market performance.
Today, the world’s major economies are experiencing a steady recovery, despite the occasional setback. To be sure, economic performance is far from reaching its full potential: depending on where one looks, one can find output gaps, excess leverage, fragile balance sheets, under-investment, and unfunded longer-term non-debt liabilities. Still, financial markets show no signs of convulsion, even as monetary stimulus is gradually withdrawn.
Yet, at the same time, political conditions seem to be deteriorating. Polarization has intensified, owing partly to growing resistance to globalization and the unbalanced growth patterns that have resulted from it. In the United States, for example, the Pew Research Center reports that people not only disagree vehemently with their compatriots on the other side of the aisle; they also don’t like or respect them.
The political gridlock long fueled by America’s right-left divide has now become entrenched within the Republican Party, which controls both houses of Congress and the White House.
So far, President Donald Trump’s administration has only exacerbated this internal turmoil, while offering none of the hoped-for economic-policy shifts that might elevate investment and growth and boost quality employment. While it is hard to detect the Trump administration’s priorities at this point, it would be hard to argue that they include a concerted and narrow focus on policies designed to make growth patterns more equitable and sustainable.
In the United Kingdom, last summer’s vote to leave the European Union surprised many, and concerns across the EU were heightened when Prime Minister Theresa May took over and committed to securing a “hard” Brexit. Now that British voters have stripped May of her parliamentary majority in June’s snap general election, the outcome of the coming withdrawal negotiations – and the fate of the post-Brexit UK – has become even more uncertain.
Leaders in Europe, as well as in a number of emerging economies, have now concluded that both the UK and the US are unpredictable and unreliable allies and trading partners. Asia, with China in the lead, has decided to go its own way.

International cooperation on economic and security matters – never easy – seems to be unraveling.
In this context, the global economy’s resilience – at least so far – is all the more remarkable (though it is of course impossible to know how the economy would be performing in a more stable political environment). There are several possible (and non-mutually exclusive) explanations for this counterintuitive state of affairs.
For starters, institutions built over time now limit the capacity of political leaders and legislators to affect the economy. While these institutions can impede the implementation of positive policies, they also serve to minimize economic and investment risk.
Particularly on the international front, politicians cannot easily bring about a dramatic and immediate reversal of the patterns of globalization that have been established in recent decades. Any attempt to do so – undoubtedly fueled by intensifying populist and nationalist pressures – would cause serious economic damage, ultimately depleting the political capital of those who spearheaded it.
Another, more worrying possibility is that risks are rising faster than perception of them. If this seems implausible, consider the 2008 global financial crisis, in which lax regulation and informational asymmetries led to a pattern of rapidly rising risk and deepening imbalances that were, for the most part, obscured from view.
In the current context, the cumulative effect of rising geopolitical tensions, loss of trust, and disrespect for key institutions could produce either a large shock or just deteriorating conditions for investment. But it is harder to construct concrete scenarios than it is to ignore the potential risks we face.
Having said that, there is a more hopeful explanation, to which I subscribe, at the risk of being labeled an irrational optimist. The inequality of opportunity and outcomes that have fueled popular discontent and political polarization are very real, and, after years of neglect, they are finally getting the attention they deserve.
More concerted attention to social cohesion will not bring quick results. But, over time, it can help to reduce partisan intensity, refocus citizens’ attention on their common values, and restore their leaders’ capacity to deliberate responsibly and implement policy. As always, there will be disagreements – sometimes sharp disagreements – about how to achieve shared goals. The key is to address them in a context of relative mutual respect.
This scenario is far from guaranteed, but it is by no means impossible. After all, Emmanuel Macron’s election as France’s president, May’s setback on hard Brexit, and a near-universal rejection of the Trump administration’s stance on climate change and a rules-based global economic order, both within and outside the US, suggest that the center may be holding.
In the meantime, national and international institutional frameworks must continue to guard against destructive actions by political leaders. In the final analysis, confidence in these institutions’ resilience – and in an eventual end to the current political dysfunction – is what markets seem to be banking on.