Public Relations Part I

So it begins...

The other day while reading about how shocking it is that more Americans are not rallying against the return to the status quo that is taking place in the financial industry, an astute observer linked to a video series online called The Century of the Self.

Don't worry the first 10 seconds are a little scrambled as it looks like some one ripped this from a VCR recording. VCR? Well it was a machine that played videotapes, which were very similar to cassette tapes in that you could record on certain types videos from your television. My grandmother vividly remembers watching two or three Nintendo video games instead of Dr Zhivago, but I digress.

So I started watching and then I started note taking and below is what I have garnered from watching two of the four parts (they are each an hour long.)

In the beginning there was Freud. Freud gave his young nephew a copy of his book called "General Introduction to Psychoanalysis" This nephew was Edward Bernays and he worked on the PR effort for the US during the First Great War. One of his key messages that he created was that the US was not restoring old monarchies but bringing democracy to Europe. He attended the peace talks with Woodrow Wilson and emerged with a slogan "Making the World Safe for Democracy." After the war he wondered, and would soon make himself rich upon, whether the same type of propaganda/persuasion employed during the war and peace talks could also be equally applied in peacetime.

In a later in life interview with Mr. Bernays he casually states that the Germans had used the word propaganda and now it was tainted, thus, he coined a new term called public relations. The idea that information is power was certainly very relevant to Mr. Bernays. However, he also knew that the information could be coached in such a way as to elicit the desired response despite what logical conclusion could be drawn from it. This was a key understanding of his uncle's work.

One of his first clients was the American Tobacco Company. His task was to find a way to break the male originated taboo of public smoking for women. As Big Tobacco noted, they lost half the target market due to this social taboo. Bernays turned to AA Brill who told him and ATC that cigarettes represented the male penis and male sexual power. Brill continued, stating they would need a way to connect cigarettes as a way of challenging male power by giving women their own penises.

This is where Bernays makes his money. During the NYC Easter parade, Bernays had female models stash cigarettes on their person and at a designated time to light them up and begin smoking. Then he informed the press that Suffragettes were going to light up cigarettes in public as a protest of voting rights and that the cigarettes were "Torches of Freedom." The symbolic gesture, the phrase, the emotion and the memory all tied together as one in the American psyche. The Torches of Freedom ran in major newspapers and soon the sale of cigarettes began to rise. Women found them socially acceptable and felt that smoking made them more powerful and independent. You read that right, a product, a consumption habit (unhealthy at that), was signaling to other people status and power. Bernays had proven what Freud has insinuated that you can produce irrational behavior in people by fulfilling deeper needs and desires.

This method became Bernays masterstroke that he would employ over and over again for businesses. It was called the tie in and it would be the machine that drove the "engineering of consent." One example is of Cosmopolitan magazine (a customer) and he would place advertisements next to specific articles or interviews, which would be one of his other clients, say an actress. In the pictures of the interview she would be wearing or consuming the product. Then in the next movie she filmed she would also be using the product. These powerful images of an attractive person, leading an attractive life filled with products that everyday citizens could also enjoy marked a new era in consumerism.

In the days before the war products were sold on a basis of practical value. Industry worried that once you had sated people's needs that there would be fewer profits as you would then only be replacing obsolescence. Bernays was now showing a new way for the consumer to buy, to have their desires out shadow their needs. He was changing the focus from the clothing to how the clothing made you feel. Also implicit in this was the idea that consumerism helped the country as well. This is because products could fill the voids of everyday life by appealing to the desires and fears of the masses. By keeping these consumption machines happy, which would also keep them docile. It was now as though products were giving people "feel-good" medicine and thus initiating social control. So instead of using social institutions to control people, you could answer their desires and upon sating the desires, the elite could then go about ruling the country.

Some additional acts Bernays pioneered include: product placement in movies, selling cars as symbols of male sexual power, paying doctors to state a product was healthy or recommended (an apple a day...), having fashion shows at department stores with models.

This became especially relevant once the Bolshevik revolution in Russia. The idea that humans could make rational decisions was being crushed as Moscow and St Petersburg burned. This was not the only piece of evidence. As the Great Depression began and ran its course the new consumer Bernays created died. Then the Second Great War ended and the aftermath including the Holocaust very much convinced those in power that humans are dangerous and needed to be controlled.

A closer look at National Socialism was enlightening. Here were normal every day citizens wielded as a weapon by the leadership. The messages were spun in a way to channel the feelings of the masses. Analysts would look at the situation noting that libidinal forces were repressed in deference to the leadership, but it created violence. This violence was then directed outside the group. Even though this behavior should be considered irrational the social norms instituted by the Nazis outweighed what an earnest human being might deem correct.

Later, during a controlled experiment in which 29 participants were actors, 30 people would have to decide which of two lines shown were longer. At first the actors would choose the correct one and of course the experimentee would as well. Then after about 10 different sets, the actors would choose the shorter line. The lone real person, would hesitate, take longer to decide, may at first fight it, but eventually succumb and choose the shorter line to achieve group consensus.

More during the next post, stay tuned.

jupiter and the infinite beyond

Nice shot from Mars of Earth & Moon and also Jupiter and some moons in the same frame.

H/T Gizmodo

AD & AS: 1st AD then AS and finally in concert

1st of a three part series. 1st we consider the AD & AS model. Then the AD curve is explored in depth. Then the AS curve is explored in depth. Finally, we use them in concert to explain the economy.

More models... this one is different from the rest. When we view this chart we can see the equilibrium between price and output. That is to say, the AS curve represents the total quantity of goods and services firms are willing to provide at each point along the price level continuum. The AD line shows how much people, businesses, the government and foreigners would wish to buy at each price point. The equilibrium clears this market. As I said this is different from a microview graph because there cannot be a substitution to another good, this is the economy on a whole. So if ice cream prices rises one cannot just substitute frozen yogurt.

The AD curve slopes downward. Consider the equation

Y = C + I + G + NX

So that each factor will affect how much output is created by an economy. We can consider C + G together because both are consumption expenditures the only difference is one is for the public and the other is the government. Say for instance that the entire economy only make ice cream. You make two dollars and the government taxes you a dollar. The cost of ice cream is a dollar. So that you and the government can each have one cone. If the price of ice cream were to fall to 25 cents you would still have your dollar but now you could purchase 4 ice cream cones. So when the price level falls you have more purchasing power, as does the government. Now in a real economy the price level dropping will entice you to consume more, in our hypothetical economy you might tire of more ice cream quickly or develop diabetes and thus an aversion to sweets. The converse is true, when the price level rises, the value of the dollar falls which will reduce your wealth, consumption and the quantity of goods and services demanded.


Here we can see the chart of price level. As the price level drops from P1 to P2 the quantity of goods and services increases from Q1 to Q2.

The price level will also affect interest rates and thus investment. The effect is because imagine you are a household from above in the ice cream economy. Maybe you desire to only purchase one cone of Ice cream a year, thus the drop in price of ice cream from a dollar to 25 cents frees up 75 cents. Since more ice cream wouldn't give you any more marginal satisfaction you instead lend out your 75 cents. You might put it in a certificate of deposit, buy a bond or place it in a savings account with the bank. These three choices are all the same you would be lending the money out or giving the money to a bank to lend out for you. This, in aggregate, will drive interest rates lower. This then has a secondary effect in which because the interest rate is lowered more firms and households will borrow to purchase assets, plants & equipment for businesses and cars & houses for households. Again price level rising would have the opposite effect of raising the interest rate (less deposits), reducing investment and spending.

Exports
Since the interest rate is lowered by the mechanisms described above this will cause investors to seek higher returns from abroad. As these investors buy foreign currency to purchase investments in yuan, euros and Australian dollars this will increase the supply of US dollars in the exchange market. The increase supply will drive down the exchange rate against this basket of currencies. Since the dollar will now purchase less foreign currency than it follows that the US dollar will buy less foreign goods as well. As a corollary this will make US goods less expensive compared to comparable goods delivered by foreign countries, so net exports will increase. This will increase the demand for US goods and services. In reverse, a higher price level increase the interest rate, the dollar increases in value and the appreciated dollar will lower net exports (increase imports and decrease exports) which decreases the demand for US goods and services.

These are three reasons why the AD curve slopes downward but it can shift too.

We can also look at the variables C, I, G and NX to show why the AD curve would shift.

C - Consumption - consumption patterns could change. For instance, household wealth could fall because of a falling stock market and housing prices falling more in line with what a rental market could support. This would cause consumers as a whole to demand less services and goods at any price level, thus shifting the curve leftward.

I - Investment - if firms become pessimistic about future business conditions this will cause them collectively to invest less in plant and equipment. This also would shift the AD curve leftward. The government does have two tools in which to affect businesses' collective decision, it can employ fiscal or monetary stimulus. On the fiscal side it could lower taxes, of course in the current situation lowering taxes will not do as much because businesses will be employing NOLs (net operating losses) over the next few years and thus their tax burden will be less or zero anyways thus negating the positive effect this might have. The other tool is monetary policy, the Federal Reserve can increase the money supply thus lowering the rate of interest, which will encourage households and firms to invest, thus shifting the curve to the right combating the leftward shift of the gloomy outlook.

G - Government - any shift in purchasing plans of the US government will shift the curve. If the government decides to spend less this will shift the curve leftward, if it decides to spend more it will shift the curve rightward. There are two ways the government can spend, it can either lower taxes while keeping it spending the same running a deficit. Or it can keep taxes the same and spend more, both have the same effect. Unfortunately, Republicans only like the former and Democrats only the latter even though while in office both do the same, that is run deficits.

NX - Net Exports - NX is tricky because it has two variables affecting: the desire of the rest of the world to purchase US goods and also people and firms moving their wealth into and out of the US economy. On the first if China grows at 10% this year, all things else being equal, it will import more goods from the US. This will cause NX to shift outward. Because of this people and firms may sell their US dollar assets and use US dollars to purchase Yuan. This will depress the US dollar and cause NX to shift outward even further. However, should a recession occur in China the reverse would occur, the NX curve would shift inward because of less demand and the flight of capital from China to the US would strengthen the US dollar making imports less expensive and shifting the AD curve further inward.

Next we consider AS.

Economic Survey October 2009

I considered digging my Businessweek out of the trash for an easy layup of a post, but instead I wanted to look at a survey of some current economic data points.

1st I saw this at Calculated Risk earlier this week. I highly, highly recommend his blog. He does some analysis but he always has good data and charts for the periodic economic reports that various government agencies generate each month. This is the JOLTS survey.

from Calculated Risk
What's important to note here is how the graph works with the blue line and the green & red bars being the most important. The green and red make up the loss of jobs. The green is persons who have quit and the red is the layoffs. The blue is the amount of hires. Obviously when the blue line is above the green and red column the economy is adding jobs.

When I read the chart it is telling me the turnover in the economy is slowing. Both hiring and loss of labor is slowing down and there is also structural unemployment as workers switch from housing and finance related careers to healthcare and government roles. People are not leaving their jobs for new opportunities, it seems as everyone is hunkered down. This is especially bad for young people who are trying to enter the workplace with their new degree (Bachelors and Masters) in hand. As the turnover falls people are not advancing upwards creating new entry level jobs. Some anecdotal evidence is here, and here.

The yellow line represents job openings. Obviously more data points would be helpful, this survey was only begun in 2000 but job openings at its lowest level does not portend well for the economy.

Second on my economic survey is the trade data. Again Calculated Risk did the heavy lifting with the charts.

1st We look at it on an absolute level. The drop in trade is breathtaking. However, the economy has also grown in the past 15 so we should look at this data in real terms as well. I should probably do this myself but I am lazy and will just tell you that it isn't any worse than it was in 2002 in "real" terms as a percentage of GDP. Here is a chart I found after a minute of Googling.

Here is my updated chart from the BEA.


So it reaches about 5% and has now contracted back and expected to do so in the near term. However, the near term means about 5 years. Here is what happened this month.


via Calculated Risk
You should enlarge the chart to get a good feel for it. Here Calculated Risk has shown the deficit in goods/services with oil removed, oil by itself and then the total. So even though the data point is improved overall (blue line) it was because oil was cheaper in this month. We actually imported more goods/services. [The removal of oil is because of this line of thinking: oil will be whatever it has to be because it the lubricant of the economy, so we should remove it to see what the underlying consumer is actually doing.]

Maybe a few brown shoots but I still don't see the green shoots.

Currently my trading model has longs in equities emerging and domestic, real estate US and ROW, bonds both emerging and domestic, gold. Shorts are in commodities and managed futures. However, I expect that this stance will not last very far into the new year.

BusinessWeek, just put my subscription on hold

Cooper's article again lacked any whiff of rational thought and underlying facts to support his thesis but an even more egregious article was penned by Ben Levishon and Mark Scott. (Editor's note: don't click the link to the article unless you want some cheesy advertisement to queue up and start playing. WTF is that?) I imagine the penning of this article took place after a long three martini afternoon at the Delmonico.

I won't bore you with the details of the article but here is the handy dandy chart (which I had to re-create because they don't include it in their online article version. Seriously, WTF?)

Notice damage, pay extra, fewer choices, cost rising.

Notice now: may affect, may ..., could rise

So based on something they overheard while watching a monkey wrestling match at Delmonico even then they could not bring themselves to state that these reforms will actually affect any pricing. "I don't know what we are yelling about... Loud Noises!!"

Derivatives
They did find a partner whose firm represents JP Morgan Chase, ABN Amoro, Barclay's and BNP Paribas to state "it won't make it any easier for companies and investors to dig out of the recession." So they quickly put that in their sub-head on their collateral damage chart, except the editor made them add the caveat "may."

The authors then pen this gem "Credit Default Swaps - blew up, prompting huge loses at insurer American International Group and other companies. The reforms are meant to prevent another disaster." The thing is though, they did not blow up, in fact CDS's were the only market actively trading during the entire crisis. What did happen was that AIG posted no collateral for the CDS trades they initiated. They "wrote" these contracts meaning they would take in premium periodically over the life of the contract and if the underlying security defaulted then they would have to pay out.

Well some of their contracts triggered and then they need to pay those claims out. Then their counterparties demanded that they start posting collateral for CDS they underwrote. This created a $180 billion dollar hole in AIG's balance sheet almost over night. It was not the instrument!! It was that unlike contracts that trade at the CME, the Merc, NYMEX where you have to post collateral when contracts go against you, there was no action you could take against AIG until it was too late, thus the run on the company.

The authors continue "Exchange-based derivatives cut into cash reserves. Under current requirements, companies have to fork over 3% of a contract's value as collateral up front in case the transaction goes south." Well, we already talked about that above. Their argued flaw is actually the enhancement that will prevent AIG-type companies from blowing up!!! Avoiding collateral charges because of their AAA ratings is not reasonable. This idea ensures that counterparty exposures can be nipped in the bud when companies bet wrongly in the derivative markets.

So there goes one of the boys arguments.

"The changes could also make derivatives a less effective tool for controlling expenses. Derivatives sold over the counter are tailored to a company's individual needs, while exchange-traded contracts are standardized."

The regulators are treading lightly. They want safety for the financial system, but also not to deter consenting adults from making contracts. The hope is to move CDS contracts to the exchanges where there are more safeguards. Thus far, regulators only want to move standardized contracts to the exchanges. Tailored CDS solutions will still be allowed if that is what a client needs. However, it will be out in the open and very transparent that companies will take on a huge counterparty risk if it chooses a non-exchange traded contract.

Another one bites the dust and now for the nail in the coffin.

Here is the real reason the shills are heading their masters' calls. From Satyajit Das "Derivatives by their inherent nature are also have a Mr.Hyde side. The ability to use derivatives to speculate, create off-balance sheet positions, increase leverage, arbitrage regulatory and tax rules and manufacture exotic risk cocktails will continue to be a major factor in derivative activity. The reality is that hedging and risk management is secondary to the other uses. For companies, the ability to use derivative trading to supplement traditional earnings, which are under increased pressure, is irresistible."

Commodities
From the article, "In light of the changes, financial firms are pulling back on some commodity offerings for small investors...Barclays Wealth recently told high-net-worth clients to ditch exchange-traded funds that focus on commodities in favor of hedge funds and other alternatives that invest in this area."

This is probably a sane idea as well from Barclays. There is a must read article from David Merkel about investors in Commodity ETFs are being snookered.

Here is the money quote for those short on time. "One of the problems that some commodity open-end funds and ETFs run into is that their investment strategy is too simple. “Buy the front month futures contract, and roll to the second month contract before the front month expires.” Nice, it should replicate holding the commodity itself, until a large amount of money starts to do it, and other investors recognize what a slave the funds are to their strategy. So, what do the other investors do? They take the opposite side of the trade early, in order to make it more expensive to do the roll. Buy the second month contract, and short the first. As the first gets close to maturity, cover the first, sell and then short the second, and go long the third month contract. What a recipe to extract value out of the poor shlubs who buy into a commodity fund in order to get performance equivalent to the spot market."

Too bad, so sad. No real problem there accept small investors may be better protected from ETFs that do not work as advertised.

Oh no the dread of all publishers who publish an honest-to-god hold-in-your-hand periodical, there is only two paragraphs left!!!!

High-Frequency Trading

"The technique [high-frequency trading] has been controversial of late as big trading firms have booked billions in profits while their clients' portfolios have dwindled."

The Daily Show With Jon Stewart	Mon - Thurs 11p / 10c
Cash Cow - High-Frequency Trading
www.thedailyshow.com
Daily Show Full Episodes Political Humor Ron Paul Interview

Well that was fun but seriously HFT is not a bad thing. It's much worse.

Commissions have gone down for trading. The spread may have lessened as Professor Lo points out. However, someone is paying for the spread and it is the retail investors. Now, back in the old days there was a market maker and he took the spread. He has now been pushed aside by the HFT supercomputers since they both perform the same function. However, investors and traders were willing to pay the spread to the market maker for liquidity. So when you bought the market maker sold; if you sold he bought. With the HFT there is no guarantee or onus of guaranteeing liquidity. If the bots do not want to play no one can make them. Thus, liquidity can be withdrawn from the system overnight and liquid positions may not be based on the, relatively [may be this is a mixed metaphor], solid pillar the trader believes them to be. There is a lot of information at this website.

So all in all not bad for BW, they missed on all three accounts.

Analysis, analysis everywhere but not a drop of think

So I stopped by my favorite, well one of my favorite, spots on the Internet. The S&P500 estimates website and was pleasantly surprised that it now had a spot on revenues. As an aside I am also working on a retail sales spreadsheet but the slog is slow, this is to show how pricing power is declining. So let me put up what S&P has on revenues.


Click to enlarge.
Below their data set I just wanted to see the data expressed in a level with the beginning of September 2008 as 1. Thus, Revenues at this point are 39.02% below where they were at this time last year.

Then I took a stab at valuing the index based upon expected earnings both operating (excludes write-offs and write-downs) and reported earnings. I used the Baa Corp Bond Yield as the discount rate. For the exit year I used both a P/E of 15 and also a straight line growth of 5% with inflation running at 3%. Here is what I found.



So what is going on in the market looks rational. Based on my crude estimates the index could be overvalued by over 25% or it could be dead on. Bulls versus bears and all that jazz. But this where I draw back to my first chart with revenues. That is, cost cutting can only do so much to hold on to earnings. Are there any other risks to earnings besides the micro factors affecting the companies that collectively make up the index? Then I remembered this chart from Credit Suisse

I first saw this from John Mauldin years ago. Now astute viewers may argue that this is not a big problem. They will reason that it says Option Adjustable Rate and since rates have fallen since these mortgages were underwritten that this will actually be a boon to homeowners. Well, yes and no. It is true that mortgage rates have lowered and when they "reset" it will be to lower rates. However, a portion of these are "recasting." Recast means that the person who took the mortgage took a interest only option, or a "pick-a-pay, " which means that even if the rate is resetting lower because the person will now be responsible for principal as well interest will see their payment jump, sometimes double or triple what they have been paying. This is because the principal has never been actually touched by the monthly mortgage payment or in some cases it has actually grown because of negative amortization. So the proportion of these loans will be key.

Click to enlarge

Basically it states that "Of the $189 billion securitized Option ARM loans outstanding, 88% have yet to experience a recast event ... Of these loans that have not yet recast, 94% have utilized the minimum monthly payment to allow their loans to negatively amortize." I'll outsource to my favorite chihuahua "Ren: ...he's DEAD! DEAD YOU EEDIOT! YOU KNOW WHAT DEAD IS? JUST LIKE WE'LL BE IF WE DON'T GET OUT OF 'ERE!"

Now let's have a look at that chart again.

The coming crisis will be about as a big as the subprime crisis. However, because the economy will be a lot weaker than it was when subprime hit this could portend a double dip recession where we take out the March lows before we finally have cleansed the system. I am not suggesting guns and bottled water but gold... it may finally be the time where gold as a store of value takes center stage in your investment portfolio.

Debt-Market Paralysis Deepens Credit Drought

Good to see MSM media covering a topic I covered over a month ago.

So I'll do a reprint plus add in my nifty chart of the financial system.


This is similar to Paul Krugman's chart found here.

Here is the re-post in italics. Below I will add some notes from the NY Times post.



I was on the Federal Reserve website checking out the major holders of debt in the United States historically. Both charts that I created show basically the same data. The first though shows the difference in the amount of debt over time, though it is nominal terms not real terms. The second just illustrates more lucidly the amount allocated to each type of provider. There were no data from earlier, but we can generalize that the banking system in the Great Depression looked a lot more like the 1943 data than the 2003's data points.

So it is obvious that the financial system has evolved, not in the Victorian sense that evolution necessarily means for the better, just that it has mutated. Securitized pools which do not exist in the data until the end of the 1980's come to make up over 30% of debt extended in its halycon days of 2003. A securitized pool is a pool of debt instruments for instance mortgages, or credit card debt, or automobile debt, or just general loans. These are sold to investors, usually pension funds, mutual funds, etc. The idea is that these instruments should be safe but yield more than comparable government bonds or AAA corporate bonds. These pools also allow the end borrower to borrow more cheaply than had investors not bid up the price they would pay for these structures.

The reason to make the distinction between the two eras or even to look back at how the debt market has evolved is that the response of the players should be different as well. When a bank in the 1920s and 1930s funded itself via deposits and then constructed a loan portfolio of assets it was subject to a risk of concentration. The first part of the concentration risk was that since there was no FDIC the deposits were not insured, so if all the people of the town came asking for their money at the same time there would not be enough cash in the vault to meet their claims. The second risk that stems from the first, was that if the financial system was in dire enough shape for people to be asking for their cash deposits back it meant that the economic system was in arrears as well with unemployment sure to follow. Thus, the loan portfolio (mortgages, small business loans) concentrated in the area in which the bank was would probably not pay back all the cash flows it was expected to generate. These are the reasons that the social safety net was constructed with unemployment insurance and deposit insurance.

So, what can be expected of the banks to do now? Well, banks will keep on doing what they have been doing. Making loans where it is profitable to do so and winding down bad loans. It is instead the securitized pools that worry me. Some of those pools were brought back onto the originating banks balance sheets, which then ties up their regulatory capital, thus decreasing their lending. Now a securitized deal cannot even be done without a guarantee from the Federal Government backing it. If we lop off the 25% of debt structure of the United States it will be hard to recover back to normal and "normal earnings and revenues." It's what PIMCO has been saying for awhile now that a new normal may be in store.

I echo thoughts from Mr Krugman. When you have a business model that relies upon investors who then rely upon rating agencies there has to be a lot of trust. When a bank makes a loan either student, credit card, mortgage, it knows its customer, or at least tries to understand it. When the loan is extended through securitization the role of the bank know falls upon the investors. Since there are multitudes of underlying mortgages or loans that make up the pool the investors rely upon the originator to have made honest assessments and to diversify the holdings. Secondly, the investor relied upon the rating agencies to act as a safeguard in reviewing these same pools to ensure they were well diversified and that they were actual assets to back up the loans. During the boom neither of these ideas were true for the banks or the rating agencies. Of course, this market is now dead.

Now as I see it there is a two fold crisis. On the one hand there is no trust, so no one wishes to lend. [The decrease in securities lending and also bank lending] On the second hand no one wishes to borrow either. People do not want to borrow to purchase a home that may continue to lose value. They do not want to borrow to obtain a MBA that will have no job offer at the end of their two year commitment. There has to be an outside stimulus of aggregate demand to shift resources from the defunct housing market to the now unemployment dole to the next engine of growth.

In my state of mind, the weakening dollar is a good thing. It will stimulate export growth and also retard imports. It will make the creation of renewable energy devices, fresh water desalinization created here rather than China. It will be our next bubble to invest in!!!