Some minor corrections and clarifications follow.
Within the context of the mortgage industry debacle precipitated
financial crisis it appears there is something even more sinister
making for the crazy markets:
http://tinyurl.com/3czmpr
Actual URL for above:
http://www.forbes.com/home/opinions/2008/02/06/croesus-chronicles-
darkpools-oped-cz_rl_0207croesus.html
The quants and their systems may be unintentionally setting up the
world markets and financial systems for a crash. Automated arbitrage
systems appear work fine until an underlying market fundamental
changes, like sudden changes in the the value of real estate or some
set of commodities.
The problem with modern portfolio theory is its fundamental
assumption, that the market activity is actually based on stochastic
processes. It is assumed that all fundamentals are known by all the
participants and very quickly "priced into the market". All that is
left is due to random fluctuations. I think a large part of the
variance in the random distributions is not random at all, but rather
merely due to variables and functions not understood, but which test
well for being random distributions. An example of this might be the
effects of a feedback loop between publications (reporters) and
politicians, and further, the changes in cycle time, amount, quality,
distribution, and uncontrolled distribution of information brought
about by the internet.
Of greater concern is the fact market transactions are increasingly
instant computer trades rather than trades by open and manual bidding
systems. This vastly increases the "velocity of money" within the
market place in times of a crises, and the velocity is further
increased when the buyers and sellers are mostly computers too. We
are moving toward the point where the ultimate crash could take
place in seconds.
The velocity of money V is the average frequency with which a unit of
money is spent, the dollar turnover rate, the frequency of dollar
spending per unit of time. For a discussion of the velocity of money
see:
http://en.wikipedia.org/wiki/Quantity_theory_of_money
and also see:
http://en.wikipedia.org/wiki/Velocity_of_money
There you'll see Milton Friedman's famous equation:
M*V = P*Q
V = P*Q/M
where M is the money in circulation, and P*Q is the gross domestic
product, the sum of the values of all transactions in a given period
of time. The value of a transaction is the unit price time quantity
for the transaction. This is expressed in the equation of exchange:
M*V = Sum[i=1,n] p_i*q_i
In a computer generated crash, a huge amount of the world's capital
can cycle around between multiple investors instantly, i.e the
velocity V -> inf. Let F represent the values of all non stock
market transactions:
F = Sum[i=1,x] p_i*q_i
and G represent the sum of the values of all stock market transactions:
G = Sum[i=x+1,n] p_i*q_i
This means
V = (F+G)/M
and if F remains fixed, yet the market transaction values for some
period go toward infinity, then we have as:
as G -> inf, V -> (F+G)/M = (F+inf)/M = inf/M = inf
This means
V = P*Q/M -> inf
if
G -> inf
i.e. the velocity of money goes to infinity if the velocity of money
in any subset of the economy goes to infinity. Since the quantity of
goods Q would remain fixed in the final seconds of collapse, it
rigorously must be that, since P*Q/M -> inf, either (or both):
P -> inf, or M -> 0
and neither case is good. Such a collapse can, however, be triggered
by a sudden reduction in Q, through the collapse of derivatives, e.g.
futures contracts, which are in effect commodities manufactured from
nothing, yet which require real money to buy. If I have this right
(and I am definitely not an economist!) in the end either price goes
toward infinity, or money supply goes toward zero, or both. Since we
are in a global economy, this appears to apply to the global money
supply.
It is now of concern that, unlike the way things unfolded in
1929-1932, a total market collapse, as well as the bankruptcy of many
brokerages, arbitrage houses, and banks, could be almost completely
over before even a hint of it ever hits anyone's screens. The only
effective means of insurance is to be pre-positioned at all times.
The standard means of providing pre-positioned insurance is to keep a
percentage of assets in personally held gold or other commodities not
held as securities for debt. However, as economic crisis looms as an
obvious possibility, gold, silver, mining stocks, etc, and their
downside risks, become unaffordable.
I think I have found a reasonable method of achieving some degree of
pre-positioning at this late date, at least for US citizens. That is
to buy I-bonds and/or TIPS. The US treasury has recently limited the
purchase of I-bonds to $5,000 per person per year for actual bonds
(down from $30,000) and another $5,000 per person if held in your
personal TreasuryDirect account. See:
http://www.treasurydirect.gov/
Treasury inflation protected securities (TIPS) can also be purchased
through TreasuryDirect periodically, or purchased in the marketplace
at any time through a brokerage and then transferred to your personal
treasury account. There is a $5M individual limit on TIPS. Many
brokerages are not safe repositories for securities in the event of a
complete meltdown because they have large market exposures, and if
nearly all brokerages fail then brokerage insurance is worthless. If
inflation runs rampant then FDIC insurance is comparatively worthless
as well. If a brokerage is used for holding pre-positioning insurance
securities, like actual TIPS, or even instruments of lesser security,
like TIP, GLD, or GDX ETFs, mining stock, etc, then it should be a
brokerage that does not have any market exposure itself. (Edward
Jones is an example of such a brokerage as far as I know.) AFAIK,
TreasuryDirect can not be used for IRAs, so a brokerage is necessary
if IRA funds are to be placed into TIPS for protection. If I-bonds
or TIPS are held to maturity, unlike typical bond funds, or even the
TIP ETF, no principle can be lost, and they probably gain a lot of
interest. I-bonds can be held beyond maturity and still earn interest
which is tax sheltered until redemption. Their current interest rate
is 4.29 percent. TIPS have fixed redemption periods, and inflation
and interest gains are taxable annually. If inflation runs rampant,
the returns for either instrument can be substantial. Most of all,
having some money tucked away for a rainy day can provide some peace
of mind in troubled times.
I hope this personal opinion, though from a source with highly
dubious qualifications, may be of use to someone. At least hopefully
economics, though known as the dismal science, is at least closer to
on topic here than religion.
Horace
