Musing on the Markets : market fundamentalism

Where's John Maynard Keynes When You Need Him?

Vinny Catalano, CFA — Thu, 10 Jul 2008 08:19:00 GMT

This morning’s testimony before Congress affords US Treasury Secretary Paulson and Fed Chairman Bernanke yet another opportunity to allay the fears of all parties interested in the health and wellbeing of the world’s economies and markets. Unfortunately, however, what is likely to be heard is more dogmatic drivel regarding the magic of the markets as the elixir that cures all ills.

Words such as “market discipline” will almost certainly be uttered by Messrs. Paulson and Bernanke today, as they cling to an ideology, “market fundamentalism” (laissez-faire or neo liberalism, if you prefer), whose time has passed. For with their adherence to “market discipline” comes the front line, the first wave of economic chaos in the form of a rolling destruction of major chunks of the financial services industry (not wholly undeserved) and the multi-dimensional feedback loop that the resulting deleveraging and radical shrinkage of the credit creation process will produce on the US (and ultimately world) economy.

Perhaps one might wonder if those on the other side of today's testimony table might provide some philosophical leadership in this highly charged political year. Guess again.

The Republicans find themselves locked in a defensive mode attempting to preserve their market fundamentalism ideology. (Supply side voodoo economics still rules this roost.) And where they are proactive is in areas that are tied to the ole timey magic of the “invisible hand” such as oil crisis = more land for drilling. No real solutions. No real comprehensive energy policy. More of the same animal spirits, magic-of-the-markets thinking.

As for the Democrats, their agenda is fairly obvious – look busy! As they appear to “fight” for the US consumer against the dark forces of cowboy capitalism and market fundamentalism their real end game is more power via a landslide victory this fall. Until then, why take more than band-aid economic action that will result in any form of a rebounding US economy when the more advantageous political objective is to pin the McCain tail on the Bush donkey?

Investment Strategy Implications

Cowboy capitalism expressed in the financial markets is market fundamentalism. They are rooted in the same philosophical thinking that has wrecked havoc on the world’s economies and markets via fat tail economic and financial crises that mega trends such as globalization, technological innovation, and financial innovation have only exacerbated.

What is needed, and getting more desperately so with each passing month, is new thinking and a new intellectual philosophy regarding government, the economy, and the markets. A good start would be a clear recognition that the philosophical underpinnings of the past two decades, the market ideology known as market fundamentalism and its economic counterpart, cowboy capitalism (replete with trickle down economics and ever resetting stock options for corporate executives), has produced radicalized results for the interconnected world economy and markets. What is needed is fresh thinking and a willingness to transform a broken system rooted in a defunct ideology. But that is not what you and I will hear today. What you will hear is regulation and half measures. But neither is a real, sustainable solution. Therefore, the only remaining question is what will it take for transformative action that will produce less radical economic and financial results? The answer might lie in a global recession to rival the one some 70 years ago. Then we may see who emerges as this century’s John Maynard Keynes.

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It's All About the Price of Oil

Vinny Catalano, CFA — Thu, 26 Jun 2008 13:52:00 GMT

Does Oil Price Speculation = Manipulation?

The US stock market could not have sent a clearer signal these past two days as to what it is obsessing on – the price of oil. For as important as the Fed’s actions are (with the same opinion being applied to the Financials and their prospective economically destructive write-downs and write-offs), the price of oil is numero uno in the mind of Mr. Market.

And in this regard, the debate rages over just what explains the high price of oil. For example, today Libya , in contemplating cutting production, joined Saudi Arabia in declaring that the physical demand for oil is being more than met by existing supply. Yet, free market ideologues continue to rant that it’s all about the physical supply/demand equation with references to the oil output crisis du jour be it Nigeria or questions re the true reserves in Saudi Arabia or impending hurricane season in the US or failure to build and update adequate refinery capacity or….well you get the picture.

The center of the oil price storm appears to rest with the battle between the US politicians and the free market ideologues. In this regard, it seems that both the politicians and the free market ideologues have got it partly right, but wrong in key aspects

The politicians are right to focus on the speculators as they have tilted the supply/demand equation via speculative positions. Moreover, in a world where positions established cannot be determined (dark markets, OTC index and derivative related trading), it is anybody’s guess as to just how strong the demand is and to what end such demand is being established. Where the US politicians have gotten wrong, however, is their implied (and often stated) conclusion that speculation = manipulation. In this regard, it is hard to support the view that speculation = manipulation if large asset managers (e.g. pension plans) move large sums of their investment capital into what they have come to accept as an attractive asset class – commodities. Moreover, it is hard to support the speculation = manipulation thesis when true speculators (versus large asset managers) piggyback on the speculative (not physical) supply/demand imbalance pushing prices higher. That is, of course, assuming that collusion is not occurring.

As for the free market ideologues, they are right to argue that markets tend to function best when regulation is minimized. Moreover, free market activities by speculators provide desirable liquidity, which reduces the cost of investing via smaller price spreads.

Where free market ideologues get wrong, however, is to argue that free markets are efficient markets. If anything behavioral finance has proven wrong is the unfettered markets = efficient markets thesis. In this regard, it is advisable to remember that not all speculators are price efficiency arbitrage operators. Many are momentum players joining the parade for the ride and tending to exacerbate an existing trend. Therefore, unfettered free markets influenced by large shifts of capital from major asset managers enhanced by momentum speculators allowed to establish undisclosed positions is rife for price exploitation.

Investment Strategy Implications When it comes to today's stock market, it’s all about the price of oil. The economic havoc due to soaring energy costs has many parallels to the destruction of the credit creation process and broken business models of financial services firms and their effect on economic growth. If the US politicians and various experts are correct, the price of oil will decline once both regulatory (CFTC) and legislative action (closing the Enron and London Loopholes) take effect.

On the other hand, if the free market ideologues are correct, then demand destruction is the sole path to end of the current oil price crisis. However, that path will produce broad economic pain (how does a global recession sound?) and, therefore, significant and more onerous regulatory and legislative action, made more likely in a US election year.

On this last point: Investors operating under the assumption that the Democrats in charge of the US Congress will operate in manner similar to the way the Republicans have acted for a dozen years are sorely mistaken. Should the free market ideologues prove correct, investors will learn the real meaning of the slogan “change”.

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The Death of Market Fundamentalism

Vinny Catalano, CFA — Tue, 24 Jun 2008 09:53:00 GMT

commentary from this week’s “Sectors and Styles Strategy Report”*:

The US Congress was never been known for getting things done speedily. And for many years, under Republican rule, neither was it known for aggressive supervisory action. However, a decidedly more activist tone and tempo have emerged from the Democrats in charge. And the ramifications are likely to be quite significant.

The opening battleground centers on the speed and aggressiveness of the congressional Democrats (Senate and House) versus Wall Street, the futures industry, and the energy industry. Activist Democrats are on the move calling before congressional committees a steady stream of experts to testify on oil price speculation. Pressure has been brought to bear on regulatory bodies such as the CFTC. And laws are being submitted to pressure groups such as the energy companies to start drilling on the nearly 4,900 leases already granted of which less than 1,900 are in production (“Use It or Lose It”).

And it isn’t just the volume of action taken, but also the speed and a certain sense of media savvy that seems to be a part of the activist Democrats agenda. With Internet distribution of their message via organizations such as Move On and People for the American Way as well as mainstream media channels such as the “Countdown” program on MSNBC, mobilization of public opinion is moving with greater speed and power than ever before. And in the process the agenda for discussion is being set.

Republicans, in the meantime, reduced to a limited number of talk radio advocates operate in reactionary mode. The consequences of a decade of squandered opportunity.

Investment Strategy Implications

The investment implications of political matters fall into two categories: regulatory and legislative change, and public opinion. Both are being impacted by the activist Democrats. As noted above, the initial battleground centers on the price of oil. If the price of oil declines, the activist Democrats will feel emboldened as their first foray into a new era of power (speed, knowledge, informed spokespersons, and media savvy) will likely emerge. One near certain outcome will be a more aggressive regulatory regime. For free market fundamentalists, this will produce a fate worse than death.

The multi-decade era of market fundamentalism** is on the verge of ending. A more activist government appears almost certain to emerge. Bye bye laissez-faire, hello Mr. Regulator. After many years of detached government management, the pendulum appears to have swung. However, this may not be all that bad, as the detached government management style of the Bush Administration has produced poor administrative execution (e.g. Katrina) and more extreme developments in the markets (e.g. subprime). Of course, such a regulatory shift may be taken to an extreme. But that is not likely to occur for several years as political corruption takes time.

That said, it does seem probable that the death of market fundamentalism has arrived.

*subscription required

**A belief that markets are best suited to handle the trading and value of assets with as little regulatory intervention as possible.

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