Stocks Directly Contradicting Fundamentally Placed Markets

This week past the sixth anniversary of the market trough and the delineation of how we were to pull out of crash. March 9, 2009, was the lowest point in the stock market, recorded by various indices across the world. From that ashen and smoldering ruin, hope appeared distant and the world seemed permanently blighted to most. But the natural progress of natural economics actually expects the worst to give us the best. That is the beauty and distinction of creative destruction.

What we got instead were insults to natural economic order, starting well before the bottom with "too big to fail." Then came the ultimate manifestations of deep intrusions into not just the occasional price or financial indication, but the overrunning and unseating of entire markets. Because those efforts happened to coincide with the end of the disaster, at least that part of it, those efforts were championed as the "solutions" to all problems. Ben Bernanke was given official sanctification as the hero of the panic.

That narrative foundered almost as soon as it was given imprimatur by "convention." Bernanke received "Person of the Year" status in December 2009 and within months Greece was on the front pages and the Europeans were "bailing out" anything and everything. While the economic hierarchy begged continued ignorance and pleaded that such disruption was localized (again), only a few months further, just after a shocking one-day crash in the stock markets bled out by unexpected "dollar" disruption once again, Bernanke's apparatus was again engaged.

To many that was re-assuring in that this time the central bank appeared proactive and fresh from dissecting what went wrong in the first place. To the vast majority, it was an uncertain signal about what was supposed to be unquestionable. When the FOMC voted in favor of the first QE, as with ZIRP, there was no equivocating about the end result - there would be full and honest recovery. Economic and monetary theory were certain to such effect, as the basis for all that was historical context surrounding what Milton Friedman once described as the "plucking model."

The post-war history of the recession cycles was nearly identical, to the point that by the early 1990's Friedman was certain of it as a rule. The trajectory of the economy was symmetrical, meaning that the depth of any recession was met and matched by the recovery that followed. The rationale for such observation was equally obvious and intuitive, as the economic trends that dominate sustained progress through the decades and ages are only temporarily disrupted by whatever "unforeseeable" "shock" that pushes the economy into recession in the first place. The job of the central bank under such conditions is to remove the "shock" and simply allow the economy to revert to its prior trend.

Expectations in 2009 were thus set by the depths of the Great Recession, owing to symmetry. The panic in 2008, starting in 2007, was vicious and severe, but with QE, ZIRP, TARP and all the rest the financial impediments to the return trend were believed set aside in full. This was largely a replay, in modern conduits and vernacular, of the Great Depression as monetary authorities put into practice everything that was "learned" of that collapse. As it was, the great emphasis of orthodox economics upon that period was due to exactly how the US economy, and the world with it, violated so sustainably Freidman's plucking existence - there was no symmetry in the Great Depression as the recovery from the collapse may have been sharp but all-too-shallow and deficient.

Determined not to make the same mistakes, the Federal Reserve acted with huge resolve which was unbefitting the circumstances. Not to be overly melodramatic, but the events of late 2008 (and really all that transpired from early 2007) ate their lunch for them. No agency or body could have gotten more wrong at the worst possible time than the FOMC in 2008. Yet, none of that mattered by 2009, which we know with the current release of the FOMC's transcripts for that year. There was unquestioned confidence in their abilities that was unmatched by their own performance, including, as it turns out, their own ability to judge their performance.

To hear it from their own descriptions, they were victims of circumstances sidelined by any number of "unforeseen" developments that alluded their "best and brightest." Reading through their discussions, especially the surety with which QE was delivered, I cannot help but think about Bertrand Russell's famous retort, "the whole problem with the world is that fools and fanatics are always so certain of themselves, and wiser people so full of doubts."

It was Russell, among many others, who championed the idea of logic and empiricism through correlation, of all things. As he wrote in Mysticism and Logic in 1917,

"The supposed contents of the physical world are prima facie very different from these [our senses]: molecules have no colour, atoms make no noise, electrons have no taste, and corpuscles do not even smell.

"If such objects are to be verified, it must be solely through their relation to sense-data: they must have some kind of correlation with sense-data, and must be verifiable through their correlation alone."

In economics, as in physics, quantum physics in particular, direct observation is impossible. Cause and effect can only be inferred from what we think we see of resulting outcomes, all of which is clouded at the very beginning by our inability to define terms and then measure them in anything better than very loose approximation. Yet, modern economics covers itself in the maths of hard science, as if there is such a thing as precision in operation as well as command.

Correlation itself has been turned into a regression variable, forming not the incomplete basis of doubts about economic knowledge but rather the means through which to balance nothing more than subjective equations. Orthodox theory, both "freshwater" and "saltwater" varieties, believes unquestionably that if any entity is induced to spend for the sake of spending the resulting increase in "aggregate demand" will induce further spending and so on. This belief persists not because anyone has physically observed the movement of physical dollar bills from origin to the chain of transactions that are presumed to have been caused, but only because of a loose affiliation of imprecise measures that seem to follow somewhat closely along those lines.

There is nothing much of recognition of all the fuzziness; the FOMC "loosens" policy and it as if B follows from A every single time. For "some" reason, however, this time it did not. The effect of QE2 was no better than QE1, even in the very math the FOMC uses to project its own competence. By various "studies", the academic side of the central bank has judged that the various QE's have taken a diminishing track upon something called "term premia." In other words, even among the math which is established to follow the "proper" and defined outlook of such things QE is viewed to have had less impact with each iteration.

Conceptually, "term premia" itself is an outgrowth of broken correlations. This relates to the last decade, the buildup toward the great correction and panic, where the same kind of expected precision failed to materialize. And it wasn't a minor miss that time, either. Alan Greenspan, after "precisely" timing his rate increases beginning in 2004, ran into the reality of long-term interest rates that did not follow despite all prior established relationships that were certain they would. He termed this a "conundrum" and all manner of academic study was unleashed to figure out why.

Before about 2005, the idea of "term premia" was entirely devoid of attention and played absolutely no role in understanding monetary transmission and interest rates. Starting with Greenspan's conundrum, however, it became a hot research topic and leading candidate to unlock the "mystery." As the BIS described it in July 2006,

"To a considerable extent, this heightened attention in recent years has been instigated by the puzzling behavior of long-term interest rates in the United States and numerous other countries following the start of a series of policy tightenings by the Federal Reserve in the summer of 2004 (see eg Kim and Wright (2005)). Rising short-term interest rates have typically been associated with a rise in longer-term yields, but in this episode yields at longer maturities have stayed surprisingly low - arguably too low to be explained purely in terms of revisions to expectations."

The "term premia" of long-term interest rates is defined as the excess yield that investors require in order to hold a longer maturity bond rather than a shorter one. In this respect, investors apparently make a calculation as to a series of short-term bonds spaced out in the future and thus follow the excess yield as if sufficient to cover the risk that their "bootstrapping" doesn't pan out. Another way of putting it is that this is how academics describe bond investing so that it can be placed within a regression context and thus "studied" and calibrated.

In the context of 2006, however, it all "made sense." There was no "conundrum" as the resurrected idea of "term premia" explained the behavior of long-term interest rates with respect to their break with past correlations. Some economists began to argue (and still do) that the outsized decline in yield curve steepness was due to lower "term premia" among bond investors because they were increasingly assured of a stable future by the ingenuity and prowess of the Federal Reserve's ability to steer, correctly, the US economy. That simply meant the Fed was perfect no matter which way it went; as if long-term rates rose as Greenspan "tightened" then it was as expected, but if long-term rates did not it was just as good because credit markets were saluting the genius.

And the equations could all balance.

Except, that was the primary problem to begin with, as long-term rates were reflecting, among other factors, an impartial solution to actual correlation. The balancing of credit market equations only took place because of a short-cut, in this case the Gaussian copula's extraction of correlation among mortgages. In order to price mostly illiquid loan pools, there had to be a way to measure correlation of mortgages where trading just never existed; and furthermore would never exist.

The solution to that problem, or really the backdoor answer to volume growth, was David Xi's copula. In a manner not unlike inferring volatility of options, the stochastic process of mining inferred correlation from observable market inputs in the more liquid segments of MBS trading would suffice. And it did, as tranching and securitization took off in a manner of credit production never before seen in our history. The marriage of wholesale finance, especially eurodollars (or "dollars" as I refer to them since they have little to do with what most people conceive of the currency of the US; in form as well as function), with the ability to actively price previously illiquid mortgage pools meant that the system itself was poorly understood by its own terms - since everything was governed by stochastic models of past history and the history of all this was next to nothing even bad calibration was mostly impossible. It only worked as long as the assumptions of copula were never truly violated, and there was never any test as to tolerance of what that might mean.

Part of the increase in credit volume was not just the static task of defining pricing methodology, of course. Modern banking, globally, is defined by its ability to shape and trade "risk." In that context, that means hedging and trading, essentially, balance sheet capacity back and forth. Where eurodollar trading in direct funding is itself nothing more than a chain of exchanged liabilities, this often derivatives-based system is also really in its most basic case just a more esoteric form of the same thing - traded liabilities.

However, there are restraints even upon a system that no longer conforms to the traditional idea of banking, or even currency, as the terms of all these traded liabilities are still defined. In most cases, these transactions required collateral, which meant in the last decade that any sustained increase in volume of MBS and structured finance meant also a sustained increase in the draw of collateral - not just of MBS securities themselves, but more often than not US treasury bonds, notes and bills. That would, on its own, solve the Greenspan riddle of long-term rates as volume growth in mortgage financing put a sustained bid upon UST securities of all types regardless of what the Fed was monkeying with its federal funds target.

You could even argue that the greater the federal funds target was pressed upward intended upon "tightening", the greater the demand for repo as a cheaper alternative to get around the Fed in the first place. I'm not saying this is the only means by which longer term rates thwarted Greenspan's intentions, but it offers all its own enough of an explanation as to how modern finance did not follow even the smallest expected conventions. Correlations derived from past function did not survive the evolution and transition.

As it turned out, that was what led to the eventual collapse into March 9, 2009, and ultimately what really stopped it. The problem of inferring correlation in the manner it was became apparent when balance sheet derisking grew problematic pushing the narrow boundaries of "acceptable" margins. The primary calculations, apart from correlation, in terms of pricing and capacity center upon volatility. The greater the expectation for volatility the more modern balance sheet mechanics demand hedging. However, the demand and supply of such "risk" trading were not separate and distinct, as they were combined incestuously and concentrated in only a few participants.

In short, as perceptions about volatility rose in 2007 for various reasons, chiefly underestimating the debasement of lending standards and assumptions, that had the self-reinforcing effect of raising the demand for additional hedging while at the same time reducing the willingness of the same participants to offer and underwrite it. The result, as of the very basic understanding of supply and demand, was rising prices for "risk." However, as bad as that would have been, the Gaussian copula inferred correlation from that same outcome - which served to reduce structured finance pricing further, escalating the demand for "risk" trading at the same time the supply nearly stopped.

By the time Bear Stearns had failed correlation trading was so skewed as to make little or no logical sense - there were even rumors that some correlations (tranche prices were most often quoted in terms of correlation, not dollars) were above 100%. Even where correlations weren't obviously nonsensical, a quoted correlation of, say, 60% is likewise nonsense and noise - that would mean if one person defaulted that the security owner should expect 60% of the mortgage pool to do also. Even the worst of the subprime vintages never saw such actual default ratios, but pricing was demanding regardless of logic.

That terrifying basis was the primary reason that the Fed could never respond in any sufficient manner. The epicenter was London and eurodollars in the first place, outside the traditional purview of legal currency measures in the FOMC's "toolkit", and there was no solving the pricing irregularity that defined not just growing illiquidity but also the very related collateral shortage and decimation. In other words, there was never a problem of "money supply" or nominal interest rates as the Fed attempted almost exclusively, but rather the determinants of circulation were fatally disrupted by essentially imbalanced equations from the very start; determinants that we still don't fully comprehend at this very moment.

What arrested the slide in liquidity and thus stocks and everything else was not QE or TARP, but FAS 157. The ability of banks to move otherwise denoted "trading assets" to their "bank book" allowed them to shield them from mark-to-market restrictions and all the continued haywire pricing. Relieved of the requirement to post losses due to market prices, there was thus no need for further hedging under the worst conditions, and so the self-reinforcing circle was broken. I make no value judgment about undertaking such a measure, as there is clearly a downside to doing so, only offering my opinion that this was the key ending the illiquidity.

There had been rumors of mark-to-market alterations as far back as November 2008, but on March 9, 2009, it was "announced" that the House Financial Services Committee would be questioning FASB chief Robert Herz about that specific topic. FAS 157 was altered on April 2, applied retroactively to March 15 bank decisions on specific securities.

The idea of quantitative easing, then, doesn't much fit the circumstance of either failure or recovery (in the financial system). The Fed's operative approach to QE is strictly the quantity of "reserves", a "money supply" tool added to a system where "money" itself is entirely fungible and decidedly nonstandard. The only primary effect would have to be psychological because filling up the dealer network, and the dealer network alone, with idle "reserves" achieves nothing but misleading anyone not familiar with wholesale banking; a decent explanation for QE's diminishing effects.

But QE's other defects are more important and more immediate to 2015. Nothing was ever done about the collateral problem, as FAS 157 only removed the pricing and hedging pressure and did nothing to address temporarily or permanently collateral shortages that have been a constant part of the wholesale landscape. Indeed, QE in all its forms has made the problem worse by extracting usable quantities and locking them away as useless as the "reserves" that are created as a byproduct from all this monetary busywork. The FOMC knows this well, but has judged it to be a workable cost in the effort to influence "market" psychology.

All of that brings us back to the violation of the "plucking expectations" in the first place. The entire intention of monetary authorities here as well as elsewhere was to recreate the economy of 2005, even if it meant revisiting Greenspan's conundrum. That simply wasn't possible, even if it were desirable, because the banking system was never going to return to such "free reign" as it had established in the earlier 2000's. Not only was collateral never replenished, the capacity of banks to achieve a similar parity of risk trading and liability sharing and absorption has been withered to the point of serious atrophy.

Without the ability to direct monetary and credit creation and volume into the mortgage channel once again, there was no way monetary policy could fulfill its mandate, and thus the correlations of prior periods no longer applied to the current circumstances. To gain a return to the plucking model view and symmetry necessarily meant another huge burst of credit attainment; which in light of the failure to do so only raises the question about whether the prior economic trend the Fed so ceaselessly pursues was actually our "economic potential" to begin with; or instead perhaps just artificial potential based on that credit channel alone.

That observation would violate any number of basic tenets of orthodox economics. Monetary neutrality, let alone rational expectations, is certain that monetarism can have no long-term impact upon the real economy (central banks supposedly only act and influence in nominal changes, not real changes). But if this observed "equality" of the "recovery" as it is pictures the true state of the economy, then bubbles do exist and further they have the effect of skewing economic potential even over the long run. That may not allow for elegant equalities among econometric regression, but it certainly makes common sense and conforms to intuition about such things.

We don't need a lot of highly complex mathematics to judge the lack of recovery by its true roots, namely financial imbalances that were nurtured by intentional policy of just such a direction. The inefficiency of using mostly financial means to influence "aggregate demand" violates every sense of actual economics as spending for the sake of spending is only going to remit waste and devalued function. You don't need to observe the actual "dollars" in action to verify it, only the new correlations of the post-crisis era which defy all predictions and unearned surety of those still making them. There is a growing sense that just such failure is also not neutral, as almost everything from the price of oil to the US treasury curve indicates quite heightened pessimism and defiance of all the proclaimed objectives.

That includes, of course, the "price" of the "dollar" itself, the most directly observable correlation not of a shortage of dollars but of a far worse shortage of willingness to transmit "risk" and all the necessary components of modern eurodollar finance. Not only is the psychology petering out, the economy is starting to reckon, once more, with just how much economic potential was downgraded by all of this - which is to say, what are stocks pricing all this time, especially now in direct contradiction with so many other more fundamentally placed markets?