3/5/21: Margin Debt: Things are FOMOing up...

 Debt, debt and more FOMO...

Source: topdowncharts.com and my annotations

Ratio of leveraged longs to shorts is at around 3.5, which is 2014-2019 average of around 2.2. Bad news (common signal of upcoming correction or sell-off). Basically, we are witnessing a FOMO-fueled chase of every-rising hype and risk appetite. Meanwhile, margin debt is up 70% y/y in March 2021, although from low base back in March 2020, now back to levels of growth comparable only to pre-dot.com crash in 1999-2000. Adjusting for market cap - some say this is advisable, though I can't see why moderating one boom-craze indicator with another boom-craze indicator is any better - things are more moderate. 

My read-out: we are seeing margin debt acceleration that is now outpacing the S&P500 acceleration, even with all the rosy earnings projections being factored in. This isn't 'fundamentals'. It is behavioral. And as such, it is a dry powder keg sitting right next to a campfire. 

8/3/2014: FTT - More Benign Estimates of Impact?

In recent years, I have written extensively about the problems relating to the introduction of a Tobin-styled FTT, including as proposed by the european authorities.

Last year, I cooperated with an academic survey of the extent literature on FTT across various asset markets and instruments. Using meta analysis that study concluded that on the net, FTT will likely result in:
1) revenues well below those expected by the policymakers, and
2) significant reduction in markets efficiency and price discovery, including potential for adverse changes in liquidity risk environment in the markets for major financial instruments.

This February, a new working paper, titled "A General Financial Transactions Tax: Motives, Effects and Implementation According to the Proposal of the European Commission" by Stephan Schulmeister (WP: 461/2014 Österreichisches Institut für Wirtschaftsforschung, February 2014 Source: http://www.wifo.ac.at/wwa/pubid/47125) summed up "the main arguments in favour and against a FTT" and provided "empirical evidence about the movements of the most important asset prices."

The author shows that "long swings [in the asset prices] result from the accumulation of extremely short-term price runs over time. Therefore a (very) small FTT – between 0.1 and 0.01 percent – would mitigate price volatility not only over the short run but also over the long run."

In this, the paper conclusions are not novel.

It is generally accepted that efficiency-enhancing FTT will require extremely low rate of taxation in order to 'separate' HFT activities from long-only investment activities. The premise for this is well established in the literature: it is believed that higher order volatility in the markets is induced by HFTs and not by long-only or covered shorts positions.

Alas, I am not entirely convinced that we should be concerned with higher order volatility. Short-lived multiple-sigma events - capturing imagination of the media and the public - are not as disruptive as structural crises. And we all know that structural crises have nothing to do with either naked shorting, leveraged shorting or HFTs. These crises are not caused by the active trading. They are caused by active and sustained fraud or passive and sustained failure to enforce existent regulations, or both. On behavioural side, they are also caused by the 'exuberant expectations' - a situation where individuals mis-price directional risks. None of these causes is subject to FTT constraints if the tax is set at the levels where it is not impeding lucidity and price discovery.

So from the very top, the rationale presented in the paper to support FTT introduction (high frequency volatility) is distinct from the rationale presented by the EU leaders for introducing FTT (structural crises).

It is worth noting that Schulmeister puts heavy emphasis in the causality argument on the feed through from HFT to algos, relying on short shocks propagation mechanism via algos-induced changes in the trend.

The problem with this argument is that

1. It ignores the existence of arbitrage opportunities (lack of contrarian algos is hardly consistent with Schulmeister's worldview)
2. It also fails to account for reversion to the mean property of algos.

The paper "discusses the most important implementation issues if only a group of 11 EU member countries introduces this tax (without the UK). If London subsidiaries of banks established in one of the FTT countries are treated as part of their parent company, overall FTT revenues of the 11 FTT countries are estimated at € 65.8 billion, if London subsidiaries are treated as British financial institutions, tax revenues would amount to only € 28.3 billion."

The problem with the above that while the amounts are small, potential disruptions to the markets generated by, say, a 10bps tax can be significant. Take equities portfolio, returning 5% pa gross FTT will reduce the base by 0.1% or 0.2% on trade covered by a derivative contract. Thus, for full execute of a simple long-only strategy, involving simple one-direction hedge, the total tax exposure under the 0.1% FTT is 30 bps. Which is consistent with a 6 percent drop on gross return.

Thus, even if FTT were to deliver reduced short-term volatility, since long-only holders face a new tax, equivalent to roughly 1/5th of the CGT (if CGT is set at 30%). This is hardly immaterial.

Another issue arises in the context of the numerical estimates presented in the paper. The upper envelope estimate of EUR65.8 billion is based on the assumption of zero migration by institutions. EUR28.3 billion lower envelope estimate is based on the assumption that some migration is possible to the UK, with such migration triggering FTT application only to one side of trade (the side domiciled in FTT-imposing country). Alas, obviously, the exercise fully ignores the possibility to both sides of the trade migrating to non-FTT jurisdiction.

3/2/2012: Big Bad Speculators & Little Red Riding Hoods

That "Gotcha..." moment, you know... speaking last night at a round table discussion on the future of Europe, I was confronted with a question from the audience and a fellow panelist remarks in the same vein that, roughly speaking, attributed the entire current crisis in Europe to the derivatives markets and speculative investment. More than that, the same were blamed for everything from the environmental disasters to increases in commodity prices. Some parts of the Left just love the idea of finding a "capitalist" (even arch-capitalist - aka speculative) root to every problem - the "Gotcha..." thingy of pseudo intellectualist disdain for facts as much as for 'speculators' and 'markets'.

This of course does not mean that financial instrumentation, speculation or other forces of the financial markets did not contribute to the crisis, but it is a distinct claim from the one made by those proposing that they caused the crisis single-handedly.

By sheer accident, looking through some old research papers, I came across this study from the ECB: Lombardi, Marco J. and Van Robays, Ine, Do Financial Investors Destabilize the Oil Price? (May 20, 2011). ECB Working Paper No. 1346. Available at SSRN: http://ssrn.com/abstract=1847503

The study looks into the large oil price fluctuations that were observed in the recent years. In particular, the study considers the role of financial activities in the determination of oil prices.

Per study (emphasis is mine):

"The oil futures market has indeed become increasingly liquid, and the activity of agents that do not deal with physical oil, the so-called non-commercials, has greatly increased. This led some to hypothesize that inflows of financial investors in the futures market may have pushed oil prices above the level warranted by fundamental forces of supply and demand, whereas others argue that the impact of financial activity on the oil spot market is negligible or non-existent beyond the very short term."

The paper studies "the importance of financial activity in determining the spot price of oil relative to the role of oil market fundamentals", using a sign-restricted structural VAR model. The model allows the study authors to separate financial activities into two types: stabilizing and destabilizing. This is achieved by postulating a model that links "the oil spot market to the futures market through a no-arbitrage condition", so that:

• Destabilizing financial shock is identified as one that creates "a deviation from the no-arbitrage condition, thereby ...driving oil futures prices away from the levels justified by oil market fundamentals. 
• Stabilizing financial activity is defined as "driven by changes in oil supply and demand-side fundamentals". 

In addition, the econometric framework adopted in the study allows to identify four different types of oil shocks:

• an oil supply shock
• an oil demand shock driven by economic activity 
• an oil-specific demand shock which captures changes in oil demand other than those caused by economic activity, and 
• a destabilizing financial shock (such as a spike in speculative activity).

The results suggest that 

• Financial activity in the futures market can significantly affect oil prices in the spot market, although only in the short run. 
• The destabilizing financial shock (speculation) only explains about 10 percent of the total variability in oil prices.
• Shocks to fundamentals "are clearly more important over our sample. Indeed, looking at specific points in time, the gradual run-up in oil prices between 2002 and the summer of 2008 was mainly driven by a series of stronger-than-expected oil demand shocks on the back of booming economic activity, in combination with an increasingly tight oil supply from mid 2004 on. Strong demand-side growth together with stagnating supply were also the main driving factors behind the surge in oil prices in 2007-mid 2008, and the drop in oil prices in the second half of 2008 can be mainly explained by a substantial fallback in economic activity following the financial crisis and the associated decline in global oil demand. Since the beginning of 2009, rising oil demand on the back of a recovering global economy also drove most of the recovery in oil prices."

However, the study did find that financial investors "did cause oil prices to significantly diverge from the level justified by oil supply and demand at specific points in time. In general, inefficient financial activity in the futures market pushed oil prices about 15 percent above the level justified by (current and expected) oil fundamentals over the period 2000-mid 2008, when the volume of crude oil derivatives traded on NYMEX quintupled. Particularly in 2007-2008, destabilizing financial shocks aggravated the volatility present in the oil market and caused oil prices to respectively over- and undershoot their fundamental values by significant amounts, although oil fundamentals clearly remain more important."

So some speculation is harmful to fundamentals-determined pricing, although the study does not consider the potential benefits from speculation-induced greater liquidity in the markets (which was not the core objective of the study to begin with), but largely, 5-fold increase in speculative activity accounts for just 10 percent of prices variability. 

18/06/2011: Two papers - Commodities Speculation and Flat Taxes

Some interesting studies worth reading released in recent weeks.

First: Lombardi, Marco J. and Van Robays, Ine, paper "Do Financial Investors Destabilize the Oil Price?" (May 20, 2011). ECB Working Paper No. 1346. Available at SSRN: http://ssrn.com/abstract=1847503

The study results "suggest that …financial activity in the futures market can signi…ficantly affect oil prices in the spot market, although only in the short run. The destabilizing …financial shock only explains about 10 percent of the total variability in oil prices, and shocks to fundamentals are clearly more important over our sample.

Indeed, looking at speci…fic in the second half of 2008 can be mainly explained by a substantial fallback in economic points in time, the gradual run-up in oil prices between 2002 and the summer of 2008 was mainly driven by a series of stronger-than-expected oil demand shocks on the back of booming economic activity, in combination with an increasingly tight oil supply from mid 2004 on. Strong demand-side growth together with stagnating supply were also the main driving factors behind the surge in oil prices in 2007-mid 2008, and the drop in oil prices activity following the …nancial crisis and the associated decline in global oil demand. Since the beginning of 2009, rising oil demand on the back of a recovering global economy also drove most of the recovery in oil prices.

However, we …find that …financial investors did cause oil prices to signifi…cantly diverge from the level justi…ed by oil supply and demand at speci…c points in time. In general, inefficient …financial activity in the futures market pushed oil prices about 15 percent above the level justi…fied by (current and expected) oil fundamentals over the period 2000-mid 2008, when the volume of crude oil derivatives traded on NYMEX quintupled. Particularly in 2007-2008, destabilizing fi…nancial shocks aggravated the volatility present in the oil market and caused oil prices to respectively over- and undershoot their fundamental values by signi…ficant amounts, although oil fundamentals clearly remain more important."

Note - emphasis above and below is my own.


Another interesting study I came across is the Blumkin, Tomer, Sadka, Efraim and Shem-Tov, Yotam, paper "Labor Migration and the Case for Flat Tax" (May 31, 2011). CESifo Working Paper Series No. 3471. Available at SSRN: http://ssrn.com/abstract=1855947

The study examines the case for a flat tax in the presence of migration threats - in other words, in the case of open labour markets. The study considers a tax competition game between two identical countries populated with individuals with two skill-levels.

"We compare between a non-linear tax regime and a flat tax system and demonstrate that in the backdrop of a high-skill migration threat (due to a reduction of the migration costs faced by high-skill individuals), the re-distributive advantage of a non-linear system over a linear (flat) one is significantly mitigated." In other words, when high skills workers are mobile across borders (as in the case of advanced economies, and especially small open economies like Ireland), progressive taxation's main benefit over flat taxes (its actual redistributive 'progressivity') is reduced significantly.

"In the presence of migration, and in sharp contrast to the autarky case, a coordinated shift to a flat system (with its entailed administrative advantages), still allowing for fiscal competition between countries (by maintaining the countries' sovereignty over the welfare state generosity), is not too welfare-reducing; and when administrative costs are taken into account, such a shift may prove to be mutually beneficial for both countries."

"... taking into account the administrative gains associated with a flat system (relative to a non-linear tax regime), even when both countries may choose a general non-linear tax regime, an equilibrium where both do set a flat system in place is likely to form." So for two systems starting from a non-flat progressive taxes base, open labour policies will lead to a flattening of the tax systems.

The authors "...also confirm the race-to the-bottom hypothesis that suggests that migration reduces the extent of redistribution." This point should be salient for Ireland. As we all know, Ireland is currently experiencing very substantial outflow of skills, especially at the higher (internationally marketable) segment of skills distribution. This means that this trend alone will tend to lead to a reduction in the redistributive effectiveness of the existent taxation system progressivity. Thus, there may be serious grounds to consider flatter (not more progressive) taxes as the means to actually mitigate the effects of lost progressivity. Some food for thought.