Shocked and Persuaded

Three large newsaper conglomerates are experiencing a renaissance of sorts, which I hope portends brighter days ahead for the most important component of the Fourth Estate. The New York Times, Gannett Inc., and Lee Enterprises are moving up and as a huge fan of The Times and the physical satisfaction one gets from having a newspaper in one’s hands I am siked. Gannett for those who don’t care is the owner of USA Today, The Detroit Free Press (On life support), The Cincinnati Inquirer, and The Arizona Republic, while Lee Enterprises primary publication is The St. Louis Post Dispatch along with a variety of medium- and small-market newspapers that form the foundation of local journalism and are necessary to sustain a vigilant pulse on City Councils and townhalls throughout the land. We need the Too Big To Fail AND The Too Small To Care newspapers alike, because unlike the latter when applied to banking TBTF newspapers are our 1st through 6th Senses in DC, while the TSTC serve myriad custom-made and stewarded purposes.

There is alot of talk right now about Tea Party Revolution and Socialism via the Obama administration. However, the thing that these people that are not seeing is that most of what is happening is being inflicted on them via both parties in concert with the banks, health care industry, and the Military Industrial Complex (MIC). I used to be very skeptical of the socialist ideologues and remain skeptical of those that invest all their emotional and intellectual capital in one school of thought or religion for that matter. Such philosophies remove the individual’s personal responsibility. They also allow themselves to be easily manipulated through advertising. The fact is that when you look at two long-term sets of data – income disparity and the MIC – you see the true problem AND to those that blame Obama as a fascist or whatever I say a trend does not 9 months or 1 adminstration make. This guy is clearly overwhelmed but based on the data I will present he is facing an inertia whose depth and scope is quite daunting.

As you can see from the figure to the right when plotting the returns on 10 of the largest military industrial contractors it is clear that they are rapidly overtaking this country’s production sector.

What we are seeing is that those firms with a long-term presence on the Dow Jones Industrial Average (DJIA) have done quite well for themselves from the 94,171% increase in share price of General Dynamics since it’s initial offering in January of 1977. The MIC giants Boeing and United Technologies have since their share prices increase by 21,788 and 18,633%, respectively. Interestingly two new players in the MIC industry KBR a spin-off of Dick Cheney’s Halliburton and DynCorp a leading competitor of Blackwater (now called Xe Services LLC) have declined by 105 and 119% since their arrival on the DJIA in 2006. In summary the MIB has on averaged gained 15,448% relative to the 823% increase on the DJIA.

So, while the economy suffers and jobs are lost at the rate of 250-750,000 per month in the last 2.5 years the MIB is operating at a profit ratio of 15:1 relative to the DJIA. This type of ratio would usually raise red flags, but since these companies are True Patriots their profligacy is viewed as an inevitable result of the War on Terror and the Spread of Democracy. I wonder if these companies are also Too Big To Fail?

The other contention is that Obama is a looking to redistribute wealth at the expense of most Americans. Hand in hand with this argument is the idea that all citizens have access to the American Dream. Well if you look at data from the Census Bureau you will see that redistribution is absolutely happening but it is occurring in the opposite direction. Two correlated trends are quite evident from the data:

1. Every year the Upper 5% of this country increases it’s average income by $2,049, while the income of the lower 2 Quartiles increases by $93-164. This seems unfair yet the common concern amongst those that are benefiting the least is accruing enough wealth to realign themselves with those that benefit the most form the Efficient Capitalist Market. However, those that benefit the most are doing their darndest to insure that they and only they benefit from this increasing disparity.

They are doing this by promoting war in the hopes of keeping this country divided and invoking patriotism as a means to encourage those with nothing to fight for those with everything.

2. The data also demonstrates that the share of this country’s income allocated to the Top 5 Percent has risen from 43% in 1965 to 50% in 2008. If this trend continues this sector of society will account for 60% of this country’s wealth by 2050.

The Dow Jones Industrial Average (DJIA) a group of 30 companies that are supposedly an adequate proxy of Capitalism’s Temperature is under a great deal of flux. Recently we saw the removal of Citi and GM replaced by Travelers Corp. and Cisco Systems. GM had been on the Big Board for 83yrs, with only General Electric (November 1907) having a longer tenure. General Motors was one of “…the original 12-company Dow index created by Charles H. Dow in 1896. (GE has been in and out of the index three times.)” All the more reason to be disturbed given that Citi only joined the club in 1997 only to merge with Travelers, which was later spun off in 2002 (http://blogs.wsj.com/marketbeat/2009/06/08/gm-citi-officially-get-boot-from-dow-industrials-at-bell/). This comes on the heals of AIG’s removal from the DJIA in September (http://www.nytimes.com/2009/06/02/business/02dow.html?ref=business). Oh yeah and the other shoe has yet to drop given that Bank of America, which only joined the DJIA in February of 2008.

It used to be that the S & P 500 a more holistic index was well correlated with the DJIA and was approximately 12% of the DJIA.

As both have expanded in volume we see the ability of the DJIA to account for the S & P’s variability remains at 99% when plotting the annual relationship from 1950 to 2009.

However, if we hone in on 1997 to the present, the point at which futures – universally acknowledged as precursors to the toxic instruments we all now know and love (ie CDOs and CDSs) – began to be publicly traded (See “The day the signal died!”, May 18,2009) we see that while the S & P remains 12% of the DJIA the latter now only accounts for 82% of the former, which means the signal:noise ratio has essentially declined by 17% in 12 years. This roughly translates to an increase of 1.38% year over year.

While on the surface this value appears trivial it gains import when compared to annual Global GDP in the last ten years, which has hovered around 3.04-3.97% per year or more locally here in the US 5.02% per year between 1999-2008. In other words US and Global macro- and micro-economic markets are embedded with variance factors equal to 27.5 and  39.3% of US and Global GDP, respectively.

So, if the developed world continues to grow at a rate of 2.46% per year and the Dow Jones/S & P 500 decoupling continues to propagate we will see noise accounting for 52-56% of actual statistics, which even for the non-statistician has to be unsettling. What we are seeing is a decoupling of High & Low Finance, To Big To Fail & To Small To Matter, and a shift from an onus on Goods to Services here in America and the developed world. We are also seeing that once robust predictors of corporate growth are being usurped by associated noise. As we see goods being replaced with services and bank assets climbing as a % of GDP, which presumably will result in higher fractions of the DJIA being allocated to financial services, it can safely be assumed the days of a 99% DJIA Vs S & P relationship are safely in the rear view mirror. Consider for a minute the fact that US commerical bank assets stand at 70% of GDP a whopping $9.69 trillion, which doesn’t speak at all to the proliferation of hedge funds ($1.6 trillion, 12% of GDP),  investment banks OR for that matter the graying of the line(s) between commerical and investment entities following Senator Phil Gramm (R-TX) and Representatives Jim Leach (R-IA) and Thomas J. Bliley’s (R-VA) gift to the folks on Wall Street in 1999 (http://www.nytimes.com/1999/11/05/business/congress-passes-wide-ranging-bill-easing-bank-laws.html?scp=4&sq=Gramm-Leach-Bliley%20Act%20November%201999&st=cse; http://topics.nytimes.com/top/news/business/series/the_reckoning/index.html).

This basically means that in the past if investment banks sneezed commercial banks would be there with chicken soup and offer to drive them to the emergency room. Now however if those same investment bankers sneeze commercial banks (i.e. US) will most assuredly catch a cold. Not sure if 1500mg of Vitamin C will help though! Some might say we should look towards or European brothers and sisters. Well think again! Swiss bank assets equal 6.8 times GDP and the banks of the once robust Celtic Tiger were as of late 2008 approximately 9.5 times Ireland’s GDP (http://www.nytimes.com/2009/03/05/business/worldbusiness/05swiss.html?scp=1&sq=Ireland%20Switzerland%20GDP&st=cse). Scary thought I know and a long way out most certainly, but inconceivable I doubt it!

Are there ways to reverse this inertia? Of course there are but it will require engineers of capitalism and society as a whole to embrace the “Scorched Earth” principal. We need look no further than the field of ecology for examples of how this principal has done wonders for certain ecosystems, most notably the native grasslands the US and Russia, the savannahs of South America and Africa, and the pinelands of the Southeastern US. It has been shown quite conclusively at this point that these systems require periodic fire and subsequently reset to a vigorous stages of early succession. However, fire can be grouped into 2 broad categories: i) infrequent, intense, and spatially expansive or ii) frequent, mild, and spatially discrete or patchy. The former tend to not only reset biological clocks but also hinder initial succession, while the latter simply tidy up the joint a little.

The economic analog would the S & P requiring category 2 and the DJIA category 1. Many will be hurt under either scenario, but the long-term health of our economy and more importantly (to some!) capitalism hinges on successful implementation of a Scorched Earth paradigm along with political discipline in the face of irrational rhetoric reflecting the irrational exuberance we all languished in during the good times. It seems at least qualitatively that macro-economic forces de facto subject the S & P to mild and infrequent resets, however, it also seems these same forces are determined to protect those in the DJIA from a category 1 type of disturbance. The results will be a complete divergence of the two indices and the apparent creation of 2 sets of rules. This type of contrived and against-the-grain muscling will blow up in the faces of all it’s proponents, including the politicians that champion(ed) it.

The globalisation of our economy is resulting in more nuanced and noisy data. Simply bailing out the To Big at the expense of the To Small will only exacerbate the problem. As it stands we are choosing cosmetic over structural/functional surgery. I for one would much rather look under the hood than take the word of the salesman wouldn’t you?

It was June 5th, 1997 a day that at first glance seemed quite innocuous. However, there was nothing insignificant about this day from a financial services perspective as it was the day that the Dow Jones & Company signed license agreements for three exchanges to begin trading in the nascent futures market (http://www.nytimes.com/1997/06/06/business/after-15-years-dow-jones-lets-futures-trade-on-its-average.html?scp=2&sq=Norris%201997%20futures&st=cse). Initially Dow Jones was hesitant for fear of excessive market manipulation, but later determined regulations were sufficient to allay such fears. According to an article at the time by Floyd Norris in The Times an editor at the Wall Street Journal John Prestbo felt “…that trading in the Dow derivatives would have little if any effect on market volatility.” Well this appears not to be the case at all. In looking at the historical record for the Dow Jones and NASDAQ I came across a very curious divergence that was initiated on or around June of 1997. It turns out that prior to that month and year what the Dow opened at was a fairly (R2 = 76%) robust linear predictor of their volatility throughout the day, previous day, and next day.

However, post-June 1997 this relationship was non-existent. The same is evident for the NASDAQ, however, the change in predictability declines by 26% vs the 76% for the Dow.
This is fascinating to me and I think it speaks to what we in the biological community refer to as “Buffer Capacity” or “Poise”. That is to say how well a system in this case the Dow & NASDAQ are equipped to handle a perturbations or in the ecological world invasive species. Regardless the point is that all those who were sure that futures were good for business writ large appear to be wrong and furthermore their contentions as to the level of volatility associated with futures are greatly underestimated, given that the data presented here demonstrate even short-term/daily swings in the market have become increasingly difficult to forecast post-futures. This happened to coincide with a considerable uptick in the ratio of Gross Domestic Purchases (BDPu) to Gross National Product (GNP), more than double the increase from 1980-1987.

It is becoming clear from this data that two things are happening at an accelerated rate in the markets: 1) volatility and risk are increasing at an unsustainable exponential rate and 2) the corporate world and financial “institutions” are working very hard to constrain the popular rhetoric so as to promote consumer spending at an equally unsustainable level. Why? Because the multi-nationals, banks, and insurers are assuming – and rightfully so to this point – that the former orgasmic spending will counterbalance the latter’s total disregard for future generations or their fiduciary responsibilities down the road.
This is the message our in-the-pocket of the banking industry Treasury Secretary and National Economic Adviser Timothy Geithner and Lawrence Summers will not tell us. The more this volatility increases the more the American citizen will pay for it, whether it be lessening mark to market accounting regulations, non-recourse loans for the folks engaging in the PPIP, or outright fraud in the case of AIG and the cozy relationship Geithner’s predecessor Henry Paulson had with virtually everyone on Wall Street. Consider that Bush told us to go out and spend after 9-11 and now this administration and congress are telling us that we should spend. Is spending the solution to everything? The solution is understanding that capitalism has tons of problems and one is the boom-bust nature of it all. Well in nature there are those systems that require fire to regenerate and if they don’t get it at timely intervals productivity stagnates. Furthermore, in these systems there are 2 types of fire regimes with one being frequent, mild, and spatially confined to small areas, while the other is an infrequent, spatially broad, and intense scouring of the land. We need the latter desperately, but what we don’t need is a bunch of tricky financial instruments and an over reliance on consumer spending to get us out of this. These amounts to using the frequent mild fire to resuscitate an ecosystem in desperate need of a complete overhaul. The fat cats on Wall Street might need this for their substantial egos and bank accounts, but it is time we decouple from this Oligarchic way of running things as Simon Johnson stated recently in The Atlantic. They can afford & indeed thrive on the amazing daily volatility of the markets, because they always get their share of the pie, but we can’t because we didn’t, don’t, and won’t if this aggregation of wealth continues based entirely on our insatiable appetite for stuff!
Norris F (1997) After 15 years, Dow Jones lets futures trade on its average. The New York Times (p 1). New York, NY