PREDICTABILITY AND PANIC

Prepare for more frequent and extreme volatility. New and powerful influences, ranging from social media and financial technology to algorithmic trading and esoteric valuation models, will increasingly upset market stability and bring unprecedented rewards and unpredictable disaster.

Predictable market conditions will be upset by sudden unpredictable movements.

Financial markets can be predicted reliably only when the world does not change.

Even during periods of stability, judgment based on expectations and assumptions as much as hard facts and economic analysis, form the basis for buying and selling decisions. Market crashes and financial crises are a continuing and breathtaking reminder that markets are irrational and uncertain. Taken to an extreme, the combustible combination disrupts global markets and societies.

Without considering uncertainty and irrational human behavior, free markets and free trade will transmit financial instability all over the world. Investors must be prepared for this. If important social functions such as infrastructure investment, scientific research, or social welfare services are organized around financial markets, those institutions become as fragile, uncertain, and as irrational as financial markets.

Instead of proceeding with caution after a crisis, finance is more typically empowered further, sowing the seeds of the next crisis. Unknown and potentially disastrous financial instruments, typically not understood, pose even greater risks. Allowing growth in financial derivatives to protect leverage and debt instruments seemed to make the most sense after a crisis, whether LTCM in the 1990’s, the 2008 financial crisis, or even Archegos most recently. It’s just that no one understood the full consequences of what they were doing, and like any new financial product that promised to be a sanguine solution, it led to runaway growth, and then disaster. We still see runaway leverage and the unrestricted use of derivatives endangering financial institutions and posing a systemic risk to an interconnected global financial system.

Prudence, Speculation, and Excess

The credit default swap is a particularly illustrative example. On the surface, credit default swaps seem to offer protection from credit risk, but, looking more deeply, they are an endless avenue for speculative excess. Credit default swaps emerged in the early 1990s as an insurance product for investors who bought risky corporate debt. Investors could take out a credit default swap to ensure the debt they owned against default. If whoever issued the debt went bankrupt, the credit default swap would pay out.

But there was no requirement that anybody who took out a credit default swap had to actually own the asset it was insuring. Therefore, credit default swaps transformed into a vehicle for speculation. Hedge funds and other speculators essentially gamble that other companies will go bankrupt. In the 1990s, when the idea of regulating and restricting the runaway use of derivatives, especially credit default swaps, was proposed, it was immediately shut down.

“Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary” Alan Greenspan told Congress. “It would serve no useful purpose and impede the efficiency of markets to enlarge standards of living.”

Of course, that would be true if these professionals knew what they were doing. But they do not, and the consequences of this naïve comment became obvious very quickly.

Pretending Markets Are Efficient

They are not.

Parties who engage in derivatives contracts are eminently capable and don’t pose any systemic or greater risk beyond their own financial transaction, right?

Wrong. Derivatives and highly leveraged investments typically end in disaster. Most recently, we have the example of the hedge fund Archegos blowing up from being overleveraged (which is putting that mildly). Investments are still made knowing this because it is believed that net gains will outweigh net losses, which has always proven to be false, and, bewilderingly, needs to be proven over and over again.

Another dangerous falsehood, best expressed by Citigroup’s CEO before the financial crisis, that “as long as the music is playing, we will dance.” What he forgot to realize is that when the music stops, there is no seat left for anyone. Keynes even wondered, “what’s the price of a security no one wants to own?” The decline in value is anything but orderly, predictive, or gradual.

From a historical perspective, a brick or two is usually taken down in the name of contributing to “market efficiency” from the wall protecting markets from irrational contagions, interconnected movements, and unpredictable investment outcomes. These range from the repeal of Glass-Steagall (a law that intended to prevent government guaranteed deposits being used as a cheap source for risky investment activity), to the loosening of bank mergers allowing for national banking networks within one single organization – all using the same risk management models. This consolidation didn’t so much achieve economic efficiency as it consolidated nationwide economic risk into a handful of large financial institutions – what could go wrong? See 2008.

Progress in Financial Markets Tends to Mean More Risk and Speculation

Progress, defined as diminishing regulation, allowed speculative mania using derivatives, credit default swaps, and extreme leverage. Economists enraptured by the promise of rational market progress argued that larger firms with more diverse lines of business would be more stable, better able to hedge against risks, and compensate for losses in isolated lines of business. They did not worry about the management difficulties posed by overseeing firms with hundreds of billions of dollars in assets across dozens of different business lines or the prospect of an unforeseen shock in one sector taking down an entire conglomerate.

This is what happens when policymakers who have no market experience wave their hand and allow complexity and scale to mask enormous risk.

We Got It Wrong, but We Can Make Markets Efficient.

An example of “financial efficiency,” Citigroup, was formed after the repeal of Glass-Steagall. This allowed it to merge with Travelers Insurance and acquire nationwide mortgage lenders. So did Bank of America, and other financial institutions that would be undone by the financial crash of 2008. These institutions, led by Citigroup, would receive astronomical amounts of federal assistance (with Citigroup receiving more federal assistance than any other US financial institution). But in 1999 and 2000 when important regulations were lifted, nobody seemed to care about what consequences these actions would eventually create. This is why Jamie Dimon famously said when asked to define a financial crisis, “it’s something that happens every 8 to 10 years or so.”

Efficiency and consolidation instead focused risk within fewer players and therefore made the entire financial system weaker. Banks argued vociferously regarding the benefits of these transactions, but it ended disastrously because the entire financial system was no more efficient, but the concentration of firms put the industry in a substantially riskier position. The banks that lobbied for and benefited from reduced regulations needed to be bailed out by the federal government a few short years later.

Once again, the financial markets were led into disaster by an expert consensus that had attempted to substitute the clamor of the real world for a set of harmonious abstractions.

It will happen again.

Regulations had been eliminated in 2000 after the best eight years of economic life the country had experienced in more than three decades. Of course, that is never the time to allow recklessness, including the idea that “self-regulation” could be effective. It’s like tossing the lifeboats overboard because it’s smooth sailing so far…or not putting a roof on a house because it was built on a sunny day. But the iceberg is over the horizon and it will eventually rain.

New analytical tools and technologies appear to make worrying about unforeseen risks obsolete. But this naïve belief in technology’s ability to understand and predict catastrophic risk is a fundamental cause of that very catastrophe.

Stability is illusory because in an uncertain world, unforeseen changes can have seismic effects. The pandemic is only the latest example, but there are always greater risks inherent in markets than is acknowledged, and most investment strategies do not accurately reflect the risk that certain investments are assuming for a given return. Safety can be an illusion if the risks are not well understood, both systemic and undiversified.

As we have seen, oversight, regulation, or any sort of self-imposed moderation will continue to be ineffective or nonexistent, and always trail behind the most dangerous and detrimental market developments. Financial weapons of mass destruction continue to multiply and are now available via smartphone in everyone’s pocket.

Expect more and greater turbulence.

Visit Us :-  Nick Mitsakos

Inequality and Wealth Creation by Nick Mitsakos

 Inequality and Wealth Creation

Inequality is not an appropriate measure of economic performance or wealth creation.

Inequality is a relative and comparative statistic. It shows how wealth is distributed, which is not that meaningful, and certainly should not be the basis of economic policy. Essentially, inequality is a comparative metric and not an absolute one. That is, if everyone does better but a few people do much better, inequality increases, and this is seen as something bad even though everyone is better off. It is used to create misleading policies that focus on redistributing wealth that is created versus policy that should be focused on enabling greater and more distributed wealth creation – not wealth capture. Policy should focus on how to best create wealth for more people. The absolute degree of wealth creation is beside the point relative to other people. Creating opportunity for the most people is what matters.

As an example, overall wealth has increased over the last 30 years for every population group, but for the highest group, it has increased more substantially. But, why is that a problem? Instead, it is a natural and unavoidable outcome of the free market.

Here’s the analogy: if you want to hold a lottery, the prize has to be disproportionately large to have the most participants to raise the most capital. The simple goal is that net outflows (prizes) are smaller than the net inflows (contributions or purchased tickets). This is very similar to business opportunities and wealth creation.

As an economy, we want as many contributors to wealth creation – entrepreneurs and new businesses driving economic growth – as possible. The only way to do this is to enable market participants to have the greatest possible reward without restrictions. Most businesses will fail (much like most lottery tickets lose). But, because we have increased the number of willing participants, we also increase the opportunity to create the most wealth – the most businesses, jobs, and economic growth, as well as increasing the tax base from both businesses and individuals. So wealth creation, even if it is concentrated mostly in a handful of people, benefits the overall economy and society much more effectively than any attempt to limit that upside or redistribute it through politically popular but inefficient and demotivating policy.

Creativity Creates Monopolies

Not that there’s anything wrong with that.

Seismic innovations have generated widespread “creative destruction.” Innovations continue to wreak havoc upon the technology and traditional business models of incumbent competitors and transform the economic underpinnings of society. The more traditional framework of economic competition is giving way to a world of natural monopoly in which high octane data processing and instantaneous information distribution enable the production of new goods with small marginal costs.

Google, Amazon, Apple, Facebook, Netflix, eBay, and Microsoft are some of the obvious examples of this. These companies are fundamentally monopolies within their industry sectors. No one wants the second most pervasive search engine, office software, online retailer, streaming service, or auction site.

Technology and innovation have led to business models where monopolies are a natural outcome for successful companies.

It’s Not All Good

“Creative destruction” is two-sided – there is the creation of new and vibrant businesses, but there is also the destruction of not only incumbent businesses, but social structures and personal lives. An ignored calculation is whether or not the “creative” outweighs the “destruction.”

We have witnessed a combination of the emergence of new digital monopolies in the 21st century and our government’s failure to grapple with the legal challenges these create. Even as early as the initial dotcom boom and bust, government stood on the sidelines through a combination of lack of both understanding and foresight into what the potential societal consequences could be. Now, those consequences have become far too obvious. Among other things, this has resulted in grave social and economic problems. From the decimation of the news and music industries to the disruption of U.S. elections by foreign governments to rising levels of anxiety, depression, and suicide among young people.

It’s Still All About Wealth Creation for the Many

A variety of social ills, ranging from poverty to lack of opportunity to uneven economic outcomes have been described as the central problems to be solved, and the solution is seen as somehow alleviating inequality. This is incorrect. Enterprise and economic growth are driven not by the unique genius and vast fortunes of the very rich but by the purchasing power of the masses that create markets for new ideas. Without a market, no idea has economic value. Markets are created when many people have increased purchasing power. This purchasing power comes from wealth creation.

An underestimated and powerful tool – arguably the most powerful tool – is the wealth creation of the masses enabling additional consumption and overall value creation in the markets for those companies providing those new products and services. Today’s solutions are not mysterious. Wealth creation matters for the masses. Redistribution from the “lottery winners” to everyone else is not the solution. This was not what enabled prosperity in the 20th century, and a similar policy will destroy the potential for prosperity in the 21st century.

We’ve Seen this Before

This obvious solution goes back several hundred years. Even in the 17th century, unequal outcomes from entrepreneurial activities and business growth were an engine for social improvement because businesses were created that not only created substantial wealth for the creators of those businesses, but also new highly-paid employment opportunity for the masses, along with cost-effective products and services improving many lives. This equation has not changed.

What is described as great technological change causing extraordinary inequality and rampant capitalist abuses actually supports a high standard of living for the average American. Once again, focusing on inequality misses the point that progress is about wealth creation and rising income through new economic opportunities. Those opportunities must be created and the creators certainly “hit the lottery jackpot.” But many others enjoy increased incomes, better jobs, and careers in professions that would not otherwise exist if not for the “lottery winners.”

Business development, while coming with clear costs, generates net benefits. Even an extreme example like the Chicago meatpacking houses that had inspired Upton Sinclair to write “The Jungle” also made a better healthier diet available on a massive scale. The microprocessor, information technology, and the computer age, in general, deliver new wonders at a previously unthinkable scale, bring a new and better way of life for everyone while also delivering spectacular economic gains for some.

Are We Getting in the Way?

Against modern economic and commercial transformation, government policy that tries to manage the distribution of wealth while achieving full employment misses the point. Distributing what already is created while playing no role in its creation, but then criticizing and trying to limit that very creation is an absurd contradiction. Government policy, including onerous taxation and trade restrictions, appear misguided and certainly both inappropriate and in the face of bold new businesses and ongoing “creative destruction.”

Yes, You Are

While policymakers do not want to hear this, their policy tools are both anachronistic and ineffective relative to the power of a free market, unfettered capital allocation, and reward. Perhaps the majority of society does not want to hear that either, but it is how wealth is created for all, even if enormous wealth is created for some. Inequality is not a meaningful statistic and focusing on it only holds back progress and prosperity.

Digital Central Banks Are Here By Nick Mitsakos

Nick Mitsakos working with leading life scientists on artificial intelligence and its applications in medicine. Written several articles on this topic including "Medical Intelligence" regarding is one of the leading papers in this field. Continually active with Harvard universities, Kennedy School of Government, participating in seminars and public discussions which include some of the world's leading political figures, including the Prime Minister of New Zealand, the president of Taiwan, and the president of Germany.

IT’S A CRYPTOASSET, NOT A CRYPTOCURRENCY

Bitcoin is an innovative, rapidly expanding network for storing and exchanging value among investors. As discussed previously in our article, “Inflation, Profits, and Bitcoin,” Bitcoin has some interesting characteristics:

• A Bitcoin is a slot on a decentralized, permissionless, unhackable, peer-to-peer permanent computer network.

• Only 21 million Bitcoins will be produced and 18.5 million have already been mined and circulated.

• Demand continues to grow far in excess of supply.

If it’s an asset, does it have an inherent value, like gold?  Arguments about “inherent value” are, and always will be, meaningless. Is there really some kind of “inherent value” in gold? We just decided it was valuable to us. The same is happening with Bitcoin.

It’s a cryptoasset that has the safe haven characteristics of gold and will potentially compete with it for a place in portfolios. Bitcoin is not a currency and will not be adopted as a new medium of exchange. It is not a stable store of value, nor can it be easily transmitted and exchanged for any good or service at a consistently predictable value. But, that’s not important from an investor’s perspective.

It’s Gold….Sort of

While Bitcoin may not have a promising future as a digital currency, it shares key characteristics with assets that are stores of value, such as gold. First, its control is decentralized. Bitcoin is neither issued nor controlled by any entity, institution, or government, much like gold today. In times of heightened economic or political uncertainty, this decentralized control is part of gold’s appeal, and a role that Bitcoin could eventually play. Secondly, like gold, Bitcoin has a finite supply.

So far, Bitcoin’s price is extremely volatile, varying more than 70% so far this year (gold has varied almost 15% over the same time). While gold is nearly as volatile as equities, Bitcoin’s volatility is in a league of its own. Additionally, gold zigs when other financial assets zag, typically rising in price during stock market corrections. Bitcoin’s price behavior has been less consistent, at times showing no correlation to other financial assets, while at other times trading in lockstep with growth stocks. But just because Bitcoin may not behave like gold today doesn’t mean it won’t in the future. What would it take for these gold-like qualities to become more pronounced?

And This Means…?

Bitcoin has hit a key milestone to broad-based adoption. It is becoming an integral part of institutional investors’ portfolios. This creates a foundation of demand and potential floor to its price. Bitcoin remains incredibly volatile, and its correlation with other major assets has been inconsistent, but allocations are seen as suitable among an increasing number of investment professionals, and, increasingly, it is seen as an alternative investment equivalent to a derivative or other call options, given the potential for spectacular returns. The downside is well-defined while the upside can be asymmetric and significant.

Bitcoin is an emerging asset class, appropriate for institutional investors, a hedge against inflation, market volatility and developing into a reasonable option as a safe haven asset.

ECONOMICS, ADVANCED TECHNOLOGY, AND SOCIAL MEDIA

 Fundamental drivers for pricing valuations in public markets have changed. Now, there is a new interaction among factors unseen just recently. Advanced technologies such as artificial intelligence have had a profound impact on the tools available and analysis presented to even the most amateurish investor. Social media, such as Reddit, Twitter, and other platforms, have allowed access to information and influence from media “stars” driving demand in an almost herd-like mentality driving up prices, and causing extreme volatility. Finally, technology has enabled a trading floor to be in everyone’s pocket. That same trading floor allows access to any information on anything from anywhere, and communication with anyone or, via social media, receive communication and information (regardless of how dubious) from anyone about any security or investment strategy.

These factors will cause unprecedented market volatility, along with extreme price movements for well-known (or perhaps more accurately, well-publicized) companies and their securities. While the supply of securities remains somewhat constant, demand for those securities is increasing (sometimes exponentially) because many more investors are now chasing those same securities.

The price of anything cannot escape supply and demand dynamics. Recent IPO activity is an attempt to meet growing demand (and raise capital at attractive prices). The new supply from IPO’s, secondary stock issuances, and most recently and monumentally, SPAC offerings, still do not provide enough supply to quench a growing and overwhelming demand. The valuations, especially those given to the SPAC’s, are entering stratospheric levels that could hardly be justified under normal market conditions. Successful investors are the ones who understand adding return without corresponding risk is the most critical component of successful investing, especially given the new equation for valuation:

Economics + Advanced Technologies + Social Media = Price

These three components are now inexorably linked and constitute an influential role in determining valuation from now on.

The More Things Change…

The pandemic has challenged many preconceived notions about the economy, markets, and public policy — and has impacted the way we live. But the inescapable truth remains unchanged:

There is no magic answer. No solution other than superior skill enables an investor to earn a high return safely and dependably. That is even more true in today’s low-interest rate, low return Tower of Babel world.

— Nick Mitsakos

Nick Mitsakos - Investment Principles and Strategies

 

Nick Mitsakos have completed the first draft of my book, “Investment Principles and Strategies.” Chapters of the book are posted on the website and on Arcadia’s website. The chapters are condensed versions of topics ranging from principles in thinking about investments, to innovation and its role in society, to political and public policy, as well as international trade. Economic disruption, growth, global markets, and increasing influence of central banks have created a new investment environment, in my book attempts to address the critical issues this new investment environment creates.

Nick Mitsakos Managing Director Merchant Bank

Nick Mitsakos is an investor and entrepreneur. He has invested in and advised companies over 50 companies in the U.S., Asia, and Europe over the last 30 years, serving on over 35 boards of directors (Chairman of six).