Jim Puplava's interview with Richard Bookstaber

Richard Bookstaber's interview on Financial Sense (21 July - audio file) was interesting. He discussed the derivatives market (which is the subject of his book, "A demon of our own design"), in which he has been intimately involved. It's a long interview and I'll just pick out one or two points.

Derivatives are financial bets. Portfolio managers use them as a kind of insurance, which then means that they can safely (they think!) increase their exposure to equities.

But derivatives are complex, and can have unexpected effects. For example, in October 1987 there was a sizeable drop in the stockmarket, and as the prices went down, automated trading programs noted the crossing of pre-set thresholds and this triggered more selling, which took the market below other programmed thresholds, and so on.

Also, to work properly, the derivatives market needs to be "liquid and efficient". Well, when the major turmoil was happening as just described, people held off buying back in - the scale had scared them. So they weren't doing what the system expected them to do, and this change in behaviour meant that there was less support at certain price levels than the system assumed.

Another way in which the system became inefficient at greatest need, was that certain classes of asset behaved in an untypical fashion. For example, normally bonds move together, and in the opposite direction to equities; but in 1987, when it looked like major disaster, poorer-quality bonds fell as though they were equities (because of fear of their defaulting), whereas Treasury bonds (backed by the government) rose.

I have heard that in times of stress, people make unusual mistakes, such as confusing left and right, and it seems that the derivatives market has similar potential in extreme situations. You can't tell how people will react under great pressure.

Then there's "black swan" events that haven't been factored-in, but can still happen, such as Russia's decision to default on its loans, which very nearly did for Long Term Credit Management and much more besides.

On top of that, there's the question of leverage, i.e. borrowing that greatly increases the risk and returns of an investment. The current debacle re mortgages packaged as interest-yielding investments stems from the fact that not only are the packages leveraged by a factor of 10 or 20 to 1, but the hedge funds that bought them might themselves be leveraged by a factor of 5, so magnifying the basic risk of sub-prime lending by a multiple of 50 or 100. So when things go wrong, they really go wrong. As we now see.

There is also the question of inadequate information about derivatives. The method of accounting was originally developed to track rolling stock for railways, not for super-fast, computer-based trading. The data available may not be what you need to assess the situation properly, and will almost certainly be out of date in the moment-to-moment market changes. Bookstaber thinks we need to use modern technologies to get the right data out of the system fast enough to make sensible decisions.

And in assessing risk, people's memories are too short. Fund managers may be too young to remember really bad times like 1989-91, so run the risk of complacency.

Speaking of age, there's a demographic risk, too: the baby-boomers are coming to the point where they'll want money out for retirement, and maybe the market hasn't fully realised this change in the financial climate. It could be a "slow burn" crisis like the one that hit Japan, lasting maybe 15 or 20 years.

Now, many of these periods of turbulence probably don't impact on the individual investor, says Bookstaber; the private investor should buy and hold, not panic.

However, a systemic risk that could have really serious consequences is the possibility of a major failure in the mortgage and credit markets, which could then roll on to the banking sector.
Yet again, we're back to the banks, credit and the money supply. How ever did we come to think of bankers as responsible people!

Anyhow, listen to the audio file and see if I've represented it fairly. And buy the book if you think it's relevant to your line of work or investment.

Dow survey update

One more day and we'll stop - thanks for your responses. We've seen a little bit of a rally in the last 36 hours and so far (12.35 New York time) the Dow is down 2.55% from its 25 July close. Pessimism is also down a bit - less than two-thirds expect the Dow to be below 13,000 at year end.

Any more votes?

Dow value afterthought

...and if we remember the heady close of December 1999, before tech stocks burst, the Dow was then at 11,497.12. We've had 7 years and 7 months elapse since, with an average growth of just under 2% compound per year. Adjusted for inflation (or available bank deposit interest rates), we've actually fallen behind; or, from a different point of view, we're not so wildly overvalued.

Actually, what I suspect has happened is that the balloon has a tear in it, and has been kept from falling to earth by massive amounts of extra monetary hot air; but "in real terms" we're still stuck somewhere in 1999. In short, we haven't yet faced up to the problems of our economy.

To use a different analogy, we're still drinking, in order to put off the hangover. But maybe there's lots more "booze" left (i.e. the Fed's printing press, aped by the Bank of England and others) and our "livers" (the real economy of production and jobs) will hold out a while longer.

It's not a strategy I'd recommend. I wonder what you think.

What should the Dow Jones be worth?

The Dow closed yesterday at 13,358.31; ten years before, it stood at 8,254.89. That's a compound annual growth rate of 4.93% (less, when you adjust for inflation).

Or if you take it from the big, big scare of Monday 19 October 1987 (close: 1,738.74, down 508 points from the previous Friday!), it's an average 10.88% compound per year. Does that seem too hot a pace? Unsustainable? But remember that we're starting that run from a real panic. If we took it from the happy close of the Friday before, the average becomes 9.53%.

Still too hot? If nearly 20 years isn't enough to establish a sensible long-term trend, let's look at an even longer period: 30 years from 30 July 1977. Then till now, the Dow's capital growth averages out at 9.45% compound per year. The market's folly can outlast your wisdom.

"Two views make a market", and that's it. Mr Market is making his wares available to you - will you buy at today's prices? (I wouldn't - but obviously others will, or the market would be lower.)

You can play with the figures yourself, on this fine page from Yahoo! Finance.

And please click on the poll opposite, to give your prediction for the year's end.

Have I got my sums wrong - or right?

Bill Bonner, in The Daily Reckoning Australia yesterday, quotes Paul van Eeden as saying that gold has kept pace almost perfectly with inflation since the 1920s.

My post of 29 July did some figures with US gold stocks, the price of gold and the money supply, and came to an arresting conclusion. A kilo of gold costs x dollars, yet at that price, all US gold could be bought for 1/66th of all US dollars. There'd be a huge pile of spare paper money left over, completely unrelated to gold.

From one point of view, the current gold price is not surprising, if gold is merely one tiny part of the overall economy governed by the dollar system. Yet the ratio in the previous paragraph - 1:66, which is the same as 1.5 cents to 1 dollar - is almost exactly what The Mogambo Guru (Richard Daughty) said is the difference in purchasing power between one modern dollar and one 1913 dollar. According to him, the modern dollar is worth two 1913 cents.

Perhaps Doug Casey is right: if trust in the dollar collapses, gold could be "going to the moon".

We need bad times

iTulip has just issued its latest email newsletter - I do suggest you subscribe, especially since it's free.

Their thesis this time is that the Dow will NOT continue to rise much, because the private investor isn't going to come in and be fleeced again. It's not just "once bitten, twice shy" but the fact that money's getting tighter (energy and food costs rising, etc) and the value of assets (especially houses) is in question. On the other hand, iTulip are not doomsters, either.

My view, for what it's worth, is that we have to wait for something unexpected to trigger a real correction, but the sooner it comes, the better. While our governments put off the evil day with borrowing and monetary inflation, our productive capacity is being exported. One firm I know is having an (atypical for here) bumper year; but whereas once their business used to be moving other people's machinery from one site to another, now they're shipping it abroad. How do you make a living if you sell your tools? Even administrators in bankruptcy can't force you to do that. But the economic folly of our rulers can.

In the British Midlands where I live, I've heard engineers complain (like Lewis Carroll's Oysters) about industrial decline ever since I attended a British Association for the Advancement of Science conference in 1977, but our leaders have plodded on, chatting comfortably to each other like the Walrus and the Carpenter, while the Oysters' numbers dwindled. I drive past new man-about-town city centre flats where only 17 years ago I was talking to a self-employed woman turning metal parts. The mighty Longbridge car plant is a broken shell, and the surrounding area is turning over to drugs, alcohol, crime, teenage gangs, domestic abuse and all the rest.

The system continues apparently unaffected, but I think it's a fool's paradise. Only last night, I watched a TV programme about India. The city of Bangalore (home to tech giant Infosys) is modernising and booming; its university aims to attract the world's best. When industry and learning have gone East, what exactly will the West have that anyone could want? We'd better start making it again now, and at a price that our trading partners are willing to pay. Or at least, make sure we have what we need to produce what we consume, as locally as possible.

Yes, currency devaluation means inflation and recession, but better that than a full-on, generation-long depression. We've got to take the nasty-tasting medicine while it can still make a difference. But who will force us to do it?

The US Presidential elections are still a year away, and the new President won't take over until January 2009. In the UK, we have a Prime Minister we didn't elect, who could choose to defer the next General Election right up to 2010. If we're going to get the right people to deal with the heavily-disguised crisis we're in today, the economic issues will have to break out into the open within the next 12 months.

In the meantime, investors must prepare for turbulence.

Gold and M3 (US)

According to GoldPrice, gold today is going for $21,242.64 per kilo. The World Gold Council says that as of June 2007, the USA holds 8,133.5 tonnes of gold. So that means America's gold stock should be worth $172.777 billion.

This site says "as of early 2007, M3 is about $11.5 trillion", which is 66.56 times the value of US gold reserves. So if everybody insisted on having their money out in gold, which they can't do any more, they'd get about 1.5 cents-worth back for every dollar they were owed.

I suppose that's what inflation means.

UPDATE

Wikipedia says, "As of 2006 the required reserve ratio in the United States was 10% on transaction deposits (component of money supply "M1"), and zero on time deposits and all other deposits."

If reserves and loans were all the money we had, then using a ratio of 1:10 for all of it (and it's worse than that!), the nominal value of bank reserves would be something like 6-7 times what they could buy in gold at current rates. Surely I've got this wrong?