Papers increasingly attempt to model financial uncertainty

There used to be time when a belief in the eternally optimal market outcomes was the article of truth. Paper after economic paper was littered with stylized models depicting these desirable outcomes, jingoisitically referred to as “Pareto efficient” or “Pareto-optimal equilibria”.

Few lone voices, like Hyman Minsky, argued that no such “equilibria” existed and that markets are, after a bout with exuberance, prone to self crashing.

Minsky gained in notoriety after the great 2008 crash, but behind his financial instability hypothesis was left a “modeling” void – an absence of a stylized set of circumstances onto which economists can apply equations, do some calculus on them, and “show” that, indeed, markets are crazy.

“Although individuals in our model are rational; markets are not,” says the latest paper by Roger E.A. Farmer, Carine Nourry, Alain Venditti.

This triplet of economists says that markets are not rational because had it been rational no trader would be able to profit. The fact that some, in the financial world, make money by trading on the account of informational discrepancy, is indicator enough that there is no such thing as rational markets.

As a result, financial markets do no produce “Pareto efficient outcomes, except by chance,” say the authors.

They are critical of the existing literature which starts from the premise that all is logical in the financial markets and the screw-ups are caused by various types of “frictions” – sort of road blocks that srew up the intrinsic bliss of the free-flow of financial information and trading skills.

“We do not rely on frictions, market incompleteness or transactions costs of any kind. Instead, we modify a simple stochastic representative agent model by allowing for birth and death and by allowing for heterogeneity in agents’ discount factors,” say the author cryptically.

The “birth and death” problem assumes that a financial contract made in the past is incongruent with the financial realities that predominate right now. As a result, some traders are  “unable to participate in markets that open before they are born” therefore they have inadequate means to hedge against that.

“The first welfare theorem fails because participation in financial markets is necessarily incomplete as a consequence of the fact that agents cannot trade risk in financial markets that open before they are born. For this reason, financial markets do not work well in the real world,” conclude authors.

We see such outcomes in the wage and wealth numbers of cohorts.

“When agents have realistic death probabilities and discount factors ranging from 2% to 10%, we find that the human wealth of new-born agents can differ by a factor of 25% depending on whether they are born into a boom or into a recession,” note the authors.

With full intricacies of their stylized model and pages of equations dabble, the paper is available here.

Funds load up bullish bets on copper

Even though most commodity hedge funds lost money in 2012, fresh cash from the hedgies is said to be lining up to make new bullish bet in 2013 under belief that economic growth in China will accelerate.

“Next year, if the global economy improves and somehow we get a fiscal cliff deal and Europe also solves itself, then commodities could be off to the races. But that’s a big if,” said Tyler Stevens, of the U.S.-based Commonfund.


Money managers say that they expect “further build up in Chinese economic recovery” and that would be beneficial to copper.

Last week, new bullish bets were loaded up in the futures markets, the data shows. After a brief flirtation with bearish bets, copper longs outnumber shorts by 2,408 contracts.

Meanwhile, gold is increasingly seen as a bear-bet.

“For more and more managers, gold is probably no longer a ‘no brainer’ trade, so some of them are starting to wonder if they could start implementing some short trades,” said Gabriel Garcin, a portfolio manager at Europanel Research & Alternative Asset Management in Paris.

Koen Straetmans at ING Investment Management says that gold is “vulnerable to all kinds of changes in sentiment”. He is neutral on gold.

Last week, speculators have cut their long positions on gold even more, data shows.


Chicago Fed National Activity Index up sharply

From today’s report:

Led by improvements in production-related indicators, the Chicago Fed National Activity Index (CFNAI) increased to +0.10 in November from –0.64 in October. Two of the four broad categories of indicators that make up the index increased from October, but only the production and income category made a positive contribution to the index in November.


Available here.

Increasingly more question the gold rally

Increasingly, folks are questioning the sustainability of the gold’s rally.

From Jan Harvey, Reuters:

A rise in real interest rates is perhaps the biggest threat to stronger gold prices as they increase the opportunity cost of holding the metal rather than higher yielding instruments. In a note this month, Goldman Sachs said a stronger U.S. growth picture may prompt just such a rate rise, and  consequently a turn in the gold market cycle, next year.

“Our… modeling suggests that the improving U.S. growth outlook will outweigh any Fed balance sheet expansion, and that the cycle in gold prices is near an inflection point,” it said.

The latest report by the World Gold Council (WGC) shows data that the speculative money has been rallying gold via ETFs and that an actual, physical demand for the metal is negligible, if that. The most often cited reason for such speculation has been a belief that Fed’s QE is somehow bullish for the metal.

“The environment for gold is good, but it isn’t improving further by the day, so some slowdown in the uptrend in gold should be expected. The days of very easy gains, when you could just buy gold, hold it, and see it rise 10, 11, 12 percent each year are over,” says Credit Suisse analyst Tobias Merath.

Meanwhile, many have forecasted some sort of a blow-off rally in gold, similar to the one in oil in 2008, as a culmination of the gold bubble. It may turn out, regrettably, that no such repetition could clearly mark the end of the rally.

Instead, the slowly creeping rise in interest rates – as is foreshadowed by the move in the bank stocks and the turn in their long-term moving average curve -  could grind out the gold bugs into slow losses and continuing whining.

A look at the breakout in housing stocks

Yesterday, housing stocks broke into new, higher price territory and this morning Commerce Department reported that building permits for November were at 899,000, up 3.6% from October and 26.8% from November 2011. Economists polled by Reuters expected this numbe rto be at 873,000.

A better than expected number will fuel the debate with the vocal skeptics who believe that housing stocks are overpriced and, with yesterday’s break out in some names, would argue that these are even more so.


Based on any one of the metrics in the above table a case for (or against) one stock or another could be made convincingly.

All of those metrics, however, are backward looking and do not reflect the individual dynamic of the sector nor of each individual name.

For example, Lennar is vested in places where home price appreciation is the greatest. It has a slew of developments in California, Texas and New Jersey so it is clocking a nice 34% revenue growth.

housing-starts Faced with price appreciation and rising sales, how realistic is it to assume  that the pricey forward PE will stay there if some of these housing names are clocking revenue growth above 30% and a double digit profit margin?

More from Zacks:

Moreover, the median sales price of new houses sold in October 2012 was $237,700; the average sales price was $278,900 up 8.0% year over year.

The data also shows that there are currently 4.8 months of supply of new houses (thanks to strong sales) on the market at the current sales rate and 5.4 months of supply of existing homes. For reference, a healthy market would be between 5 and 6 months of supply.

Inventory levels for October 2012 were also low. Five-year data also suggests that inventory for new homes as well as existing homes has been declining.

Anyway, the price action in Lennar suggests that it is in the breakout mode, that the next likely stop is $43 which is around the bottom of the right shoulder set in April of 2007. The right shoulder from 2007 has a top around mid-50s so depending on risk-reward having these ranges in mind is helpful.


Trend in equities points higher

Stocks are in a significant territory which can move the rally up another 200 or so points higher on the Dow.


The 60-minute chart is suggesting that equities could move on to capture 12,588, the level from the October. The concerning thing is that the momentum trend line is diverging from the price movement on this chart, suggesting that eventually there will an end to this strong move higher and a sell-off-phase could begin.

With banks and housing names clocking strong gains the break-out towards 13,588 looks very probable by the end of the week. BAC, C and LEN look the best in this group.

EBAY and Visa (V) look most attractive on any pullback.

Commodities look like a crowded trade

Bets in commodity ETFs increased 92% this year with hedge funds holding 51% more cash on bets that a commodity rally is yet to occur, data from EPFR Global, a firm that tracks these flows, shows.

“It comes back to the uncertainty about the economy, and the government policies that are going to be enacted or potentially changing over the next year. That’s why you’re seeing that disparity in the outlooks of many of these forecasting firms,” says Peter Jankovskis of Oakbrook Investments.

“It won’t be a straight line higher, but there’s a pretty good undertow for commodities. Commodities in general will trend higher the next few years, but there’s room for selectivity,” says James Paulsen of Wells Capital Management.

With SEC giving approving the JPMorgan copper ETF, hedge funds just got themselves another instrument to speculate on.

But will these instruments be appealing in a rising interest rate environment?

So far, parking cash in non-income earning things like the metals was profitable because, with a 0% yield, such instruments yield better than the negative real yield on, say, bonds.

However, if and when the bond yields turn higher, the cash holding paper commodities will seek a quick exit out of the crowded door.

In fact, if we are to gage the forward bond-yield trajectory by the long-term moving average on some major banks we could well conclude that the bottom in yields is well behind us.

Of course, time will tell.

Empire State Manufacturing Survey


From this morning’s report:

The December Empire State Manufacturing Survey indicates that conditions for New York manufacturers continued to decline at a modest pace.

The general business conditions index was negative for a fifth consecutive month, falling three points to -8.1.

The new orders index dropped to -3.7, while the shipments index declined six points to 8.8.

At 16.1, the prices paid index indicated that input prices continued to rise at a moderate pace, while the prices received index fell five points to 1.1, suggesting that selling prices were flat.

Employment indexes pointed to weaker labor market conditions, with the indexes for both number of employees and the average workweek registering values below zero for a second consecutive month.

Indexes for the six-month outlook were generally higher than last month, although the level of optimism remained at a level well below that seen earlier this year.

Full report here.

Global wage cut could slam profits, GDP

The race to the bottom in the global worker wages could eventually lead into an economic depression because it could drive the consumer demand way too low which would not be able to be offset by loose credit says the UN’s International Labour Organization (ILO).

“There is also a problem of collective action: while each individual country may in principle increase aggregate demand for its goods and services by exporting more, not all countries can do so at the same time. The world economy as a whole is a closed economy. If competitive wage cuts or wage moderation policies are pursued simultaneously in a large number of countries, competitive gains will cancel out and the regressive effect of global wage cuts on consumption could lead to a worldwide depression of aggregate demand,” says the report.


Wages now account 43% of the GDP, a 10% drop since 1970, while corporate profits doubled to 12% of GDP since 2005.

While wage drop trend looks sustainable on the downward course that could be further stumulated by more stringent “right-to-work” laws,  it is less likely, however, that corporate profits could register another 100% gain in next 7 years, and this can have an impact on the stocks.


Austerity is but one example of the longer road of deliberate policy to accrue an ever larger share of productivity gains onto corporate profits ledger thus delinking wages from productivity gains.

“Since 1980 hourly labour productivity in the non-farm business sector increased by around 85 per cent, while real hourly compensation increased by about 35 per cent,” notes ILO.

Full report here.