The Often Ignored Collectivism of Capitalism

Many have come to appreciate the very simple realities shared by this blog when one abandons ideology, partisanship and prejudice and logically attacks the issues of today. Partisans and one way thinkers are silly. We all appreciate that fact more when we concentrate without influence on a topic with good old fashioned common sense.

Here are a few simple realities many can't argue with nor agree upon:

1. Socialized Medicine. We already have socialized medicine. The insured pay the bills of the uninsured and under insured. Twenty-five dollar aspirin and rising deductibles, premiums and co-pays are the result of free medical procedures performed by hospitals on the indigent, under insured and uninsured. Our disagreement and inability to manage this reality causes tremendous inefficiency.

2. Mark to Market Accounting. There is no such thing as "mark to market." There is mark to transaction price accounting, but transaction prices aren't always correct. In the short run, transaction prices can run higher and lower than what a reasonable person would buy or sell for. The fallacy resides in the fact that it doesn't count those who refuse to come to the market at a said price, the silent majority. When prices are too high many buyers refuse to do business. When prices are too low many sellers avoid coming to the market. Mark to market only measures what those who are willing to do business under very specific conditions, sometimes unwillingly, are transacting at. As price points shift, often there are very different buyers and sellers who come to market. In other words, if one sale is made at x, and no other sales are made, the price would be x, even if ten thousand transactions would have occurred if the price was y. In the long run, values are functions of aggregate incomes and demands of society, not prices.

3. The back story to the stock market. There is no back story or information that is causal to stock prices. In any given day the only invariable truth is that there were more buyers than sellers or more sellers than buyers. The only reason financial news bears any relationship to stock price fluctuations is that the buyers and sellers believe that such stories are related. This results in a massive and naively trusting game of signaling. So long as, the majority of positions all "agree" to weight the news equally, short term fluctuations can be reasonably explained. That said, it's not the news - it's the agreed upon norm of how to act on such news that moves the price. In the end, its the buying and selling that moves price.

4. The market is always right. The market is nearly never right. Over long, LONG, periods of time, the averages of the market tend to support logical results. On any given day, the market is as wrong as any individual. It could be argued the market is further from truth than any free thinking individual in the tendencies of market participants to stampede in and out of positions moving equilibriums past proper price levels at neck breaking speed. If the real value is five and the market spends ten years at 2 and the subsequent 10 years at 8, than on average it was right even if it never maintained that value.

Of course we could go on and on, but it is important to land the plane on the point of this obvious exercise in logic. Regardless of which issue we speak of, the solution to inefficiency, breakdowns, inequity, fallacy, losses and failures is the point of agreement in society. All of our actions impact our fellow countrymen and women. When we agree, momentum is created, whether it be positive or negative. A point of agreement is anything from a sale to an appraisal. The willingness to stay in an upside down mortgage to ensuring all have access to affordable health care. A decision to place a put or call option on natural resources one doesn't require to thinking for oneself. We are our brothers keeper whether we believe that or not. Our failure to properly conduct ourselves in a positive manner shall manifest itself in the our reality.

Energy prices, home values, loan qualifications, joblessness, health care costs, profits and losses are our decisions collectively. They are the fruit of our actions. It is collectivism, or a positive point of agreement, that creates abundance. Our world is a manifestation of our collective perspective. Gold is not edible, usable or valuable in its own right, only by collective recognition and agreement of its value does it become an inflation hedge or an international currency. Whether collection of our individual efforts results in disruption, decay and depression or prosperity, innovation and hope is all decided by the direction of us as a mass. The apex is thus the superseding values of our population to act in self interest without detracting from the progress of society as a whole and influencing our families, neighbors, friends and coworkers to abide as well.

The Accounting Crisis: Mark to market and the Destruction of the U.S. Banking System

Did you ever see the Stephen King movie The Happening, where people throughout New York City are committing suicide in mass? You see people literally turning on themselves to end their own lives as a result of some strange spore released into the air by plants protecting their existence. Well, if you think about it this is analogous to the current destruction underway in the financial system of the United States. Banks literally are turning the knife on themselves by sheepish lending practice while the accounting rule of mark to market is silently spreading to induce the massive death and destruction.

Mark to market is a rule whereby publicly traded companies must "mark," or declare, the value of their assets to what it would be worth if it was to be sold at that very moment. This rule, while widely used in valuing liquid assets such as securities was applied to nonliquid assets, such as real estate, after the Enron scandal. The general hypothesis towards applying the rule to nonliquid and liquid assets alike is to prevent companies from misleading investors by valuing its held assets at higher price than their "real" value.

The problem in the banking world is that banks are regulated stringently by the Federal Government and must maintain a certain ratio of assets to loans to be considered legally solvent. The result is that when a bank must mark its assets down according to the accounting rule, it is legally required to cover that write-down by adding another asset, usually cash, or decrease the number of loans it has outstanding. Since their is no practical way to call loans, banks must raise additional cash when the marketability of their assets fall regardless of whether those assets are performing perfectly.

Approximately 2.5-6% of home mortgages are in foreclosure. A staggering number, but not insurmountable. Now add that under 50% of Americans have a mortgage on their home. What do you come up with? Yes, you're right! The banking crisis has less to do with the foreclosures and more to do with arbitrary accounting rules. As infuriating as the truth is, the mark-to market accounting rule is forcing banks to value the homes that they hold mortgages on down to the values being received in foreclosure sales representing somewhere between 1.25%-3% of total homes!  Even if one intends to pay every last payment of one's mortgage with the paycheck from one's stable Federal government job, and that mortgage payment is less than 25% of one's take home pay, the bank has to value that home as if foreclosing on it today.  

The mark to market rule literally created the same bubble it is bursting.  When the market was trending to the moon in 2002-2005, banks were allowed to mark the assets up to the market price.  This increased the assets on their balance sheets and created more room for lending, thus pushing prices higher as more credit was made available.  This sinful consequence flew in the face of sound accounting where gains on illiquid assets are not to be realized until sold.  Subsequently, as prices began to fall, banks "marked" their assets lower limiting their ability to lend, which limited credit and prices fell further.  Once prices fell further, the banks had curtail lending more and guess what?-Prices fell further.  The sad reality is that the houses being sold determining this market value were not sold by choice, but rather as a result of foreclosure and therefore no true market existed.  Further, with buyers unable to access credit because of banks having to hoard cash to make up for falling values on assets (95-97% of which were performing) fewer transactions occurred to stabilize prices.

Here is the rub, foreclosures had very little to do with the financial crisis, accounting and fear were the culprits, and I can prove it.  If Bank A foreclosed on house 1 previously valued at $250,000, Bank A would not have to mark that asset down so long as they issued a new loan to the next Buyer at $250,000.  Even if the next buyer couldn't afford the house and would subsequently go bad on the loan in one year, the asset value by rule would be $250,000.  As a result, it was lenders unwillingness to lend that literally caused their inability to lend.

Clearly I understand that the moral hazard associated with the securitization of mortgages, relaxed standards by Freddie and Fannie and outright fraud caused much of the bubble of the housing market,  but the illogical extension of marking illiquid assets to the market amplified the problem from a rising market to a bubble and then from  a declining market to a catastrophe. 

 A great example of how the market rule amplifies itself occurred when Wamu was deemed insolvent by the FDIC and Chase Financial was given Federal assistance to take over the massive mortgage lender.  In taking over Wamu, Chase marked all of the acquired mortgages down to what Chase and regulators deemed a palatable level.  Regardless of whether or not the mortgages were performing, Chase marked them down as if they were to be sold that very day according to the accounting rule.  Almost immediately following this transaction Wachovia was on the brink of insolvency as a result of how Chase had discounted the assets.  All the experts agreed that there was no market for new homes and that the most difficult issue facing Wall St. and banks was how to put a value on them.  Wachovia was profitable.  Their loans were performing. Mark to market killed Wachovia because of how Chase valued the assets of Wamu in the forced sale.

Solution:  An illiquid asset is worth whatever it is originated at and at its sale, disposition, trade or disposal a gain or loss is to be recorded.  No matter what the system for valuing assets it will never be perfect, but surely it can be without unintended exaggeration.  After all accounting is supposed to illustrate reality, not create it. 

The stock market: Is it a trailing or leading indicator

Does the stock market predict things to come, or does it reflect things passed? Believe it or not, the answer is quite intuitive and simple. Stranger than that is that many financial planners, economists business leaders and stock analysts have it wrong. The answer is unavoidably that the stock market trails movement in the real economy.

How can this be? Everyday on the financial news it is taken as a given that the stock market is a predictor of the future of the economy and quite efficient in doing it. Such sources also tell us that the stock market is an efficient mechanism that reflects the true price of an asset or company based on the compilation of large sampling of peoples' opinions. Books such as The Wisdom of Crowds, by James Suroweiki, further state that large sample sizes of random guesses tend to better predict an unknown (such as an asset value or stock price) than an individual. Further, this school of thought has run a number of controlled tests that proved that a large sample size of random guesses is better at predicting an unknown than a small number of better equipped individuals (smarter or more experienced) who are collaborating to formulate a guess.

The fundamental premise is that information provided must be equal to all guessing.

It is a very small jump from this conclusion to state that markets best reflect the true value of an asset or company so long as information is freely available. People from this school of thought are most commonly referred to as Efficient Market Theorists (EMTs). Business programs predominately teach this method of market valuation to MBA students and the majority of players on the scene believe this to be true. So, if assuming EMT is correct, how can the market be a trailing indicator? Wouldn't it be a good predictor of the future?

Unfortunately not. The precipitous decline in the stock market in the fall of 2008 was clearly a reflection of the steady decline in the American economy beginning in the middle of 2007. The economy was sputtering in 2007, and financial analysts told the public nothing was wrong, and that if one separated the durables, autos, homes and mortgage business from the remainder of the economy everything was just fine. That was an incredible statement, and a terrible misrepresentation. It is common knowledge that durables, autos, and homes are the first indicator of a recession and as soon as they show declines, the entire economy shall follow. In fact, Alan Greenspan's company, prior to him becoming Federal Reserve Chairman, used to predict business cycles by simply tracking durables and automobile sales. That said, financial analysts, newscasters and government officials insisted that this was a "new" economy and such variables were no longer dispositive. Wrong. Funny how Greenspan, in his eighties nonetheless, predicted the recession within weeks.

The stock market continued on its upward trend throughout 2007 despite all prudent economists understanding a full blown recession would hit before the end of the year. Why was the market not reacting? The answer: denial and data.

1. Data

The first reason why the stock market is unable to predict future movements in the economy is that the prices are set by the purchase and sale of equities by analysts who base their decisions on data now known. The imperative here is that the prices are dependant on the reporting by companies of events that have already happened. Earnings, estimates and strategies released by companies are always released well after they have occurred. In other words, analysts, financial reporters, and traders receive data that has been processed by Board of Directors and executives for days, weeks and months. Therefore, it is an incontrovertible fact that stock prices trail real economic events. This reality is multiplied tenfold when the economy is recessing as companies will use deferrals and reserved profits from past expansions to buffer evidence of a slowdown in their business. The result, analysts and buyers are even further behind the curve of a bear market.

It is important to note that it isn't only business data that is slow to market, government data is painfully slow to market. One great example is jobless claims. First, one must admit that reducing capacity is one of the last cuts a business is to make. In most cases, businesses will begin cutting all areas that don't directly affect their ability to produce. As a result, necessary job cuts often come well too late in the business cycle as businesses must be sure demand won't rebound before diminishing capacity in the work force. The point is that the real economy has shifted and the financial news channels, traders, analysts and economists cannot see the shift. In other words, the government reports, which traders rely on to trade and invariably derive some picture of the future are more analogous to the wake than the boat.

In addition to equity reports and government reports lagging economic realities, commodity reports must be the least reliable of the bunch. A great example is OPEC. Cheating, overproducing and general market manipulation have created an environment where analysts and traders no longer trust forward announcements of OPEC. Analysts don't believe OPEC when they declare they will produce more oil to keep prices tolerable and they don't believe OPEC can restrain from producing at lower prices despite promises to do so to increase prices.

The net result is analysts, financial networks, and traders basing future decisions on inventory reports from the past. Worse yet, these reports are incapable of determining whether reserved supplies increased or decreased due to demand or supply. Regardless, players in this game determine how to bet based changes in the past.

In all fairness, I must state that many efficient market theorists would argue that traders, analysts and economists don't believe they are guessing at a future valuation of a company, but rather using the data to generate a prediction as to the present value of the company in real time. If that is the case, then the stock market is neither a trailing indicator or a leading indicator of the economy, but rather a barometer of the economy in that exact moment. That said, the general tendency of the market to wait for trends to emerge and the complimentary tendency to hesitate before declaring a change of trend leads to a conclusion that the stock market isn't even an efficient indicator of the current market.

2. Denial

The second reason why the stock market and asset prices always lag reality is because of momentum, or as I like to call it denial. Humans are creatures of habit. When things have been trending downward, people cannot imagine what it was like when things were growing. Vice-versa, when things are growing people cannot imagine a reversal as the common tendency is to believe "things are fundamentally different this time(commodity bubble, tech bubble, housing bubble, and soon to be the end of health care bubble)." As a result, analysts, brokers, traders and economists wait for a trend to emerge before declaring it safe to change direction.

That's right! Not only are these market participants basing decisions off of old data, once they see data signaling a change, such data is earmarked as an "aberration" until it duplicates itself. In the clearest sense people literally wait to buy once the real economics have turned more favorable and usually do so six to eight months after the company has realized the change in business.

The funniest part is that once the decision to purchase or sell is made, the real run of expansion or recession is well underway indicating that the reversal of that trend is closer than the market participants realize. As the price moves because of these transactions, it attracts more transactions in the same direction which most closely can be analogized to a stampede. This stampede always overshoots its target as the participants are watching old data and waiting in denial for trends. This creates the wild inefficiencies of markets in the short run, and also illuminates why 95% of the investing public ends up wrong all the time.

While I'm certain it is human nature to buy high and sell low because its the popular thing to do, its comical how we fear to act when the opportunity costs are low (prices are low because the majority are predicting further wealth destruction) and are so brave to act when the opposite is true. When the trend of past data is upward, indicative of a bull market, we as investors love to run directly off a cliff. Reminiscent of the old roadrunner cartoon, standing on nothing but air and filled with a false confidence by the reported data we believe to be a reliable prophecy of the future, there is no where to go but down.