The Summertime Squeeze

I’ve been busy enjoying the warm weather, spending time with family and friends, and making the most of the long days. But, as the saying goes, all good things must come to an end. 🙁

I had a great time on my trips to California and Northern Michigan. I felt lucky to get out to see some fantastic places and meet some great people. Although, I wish I had the chance to get out of the country. Maybe next year!

In July, my nephew Perry was visiting my parents in the Traverse City area. We’ve been coming up to the area since I was very young. My late grandmother had a summer home in the area since the 1970s.  

On Saturday, a very hungry and enthusiastic Perry, grabs his cheeseburger and the relish.  After he puts the burger down on the table, he squeezes the relish so hard he shoots 1/4 of the bottle all over his plate.  He is immediately upset.  Before he started yelling, I said to him 

“Do you know that you can learn something from that relish mess?” 

He giggles.  

“Everyday traders make their money from squeezes, just like you squeezed the relish bottle and everything came out”.  

He doesn’t get it, but I tried.  

“Do you know what the stock market is?”. 

“No”.  

“Do you know what corn is?”

 “Yes”  

“The price of corn goes up and down because of squeezes”.  “Small squeezes move the market a little bit, and the large squeezes move the market a lot.”  

“When you squeeze the relish so hard it shoots out everywhere, you’ve created a huge squeeze.” He giggles.

What are the most significant squeezes? The tail events. They bring the gobs of unwanted relish on the unsuspecting as they are forced to sell or cover at bad prices.  

Have a good labor day weekend.

April 2, 2022

hey, hey

A few weeks ago, I saw an interesting statistic on a football player from the Chicago Bears and I realized that it could teach a lesson for tail hedgers.  I know not everyone is interested in American football, but being from Chicago, football is something that I cannot ignore.  Hopefully, using sports as a metaphor will be a little more exciting than the usual tail hedge terminology.  Which, quite frankly, is kind of boring. 

Khalil Mack, a defensive end, was drafted in 2014 by the Oakland Raiders.  He played four seasons of outstanding football and became a well-respected player.

In 2018, the hapless Chicago Bears decided to sign Mack to a much larger contract.  Unfortunately, they ended up not getting much in return. 

What mistake did the Chicago Bears make?  They overpaid for the same performance! Mr Mack did not exceed his previous level of play in Oakland.  

I am not trying to play Monday morning quarterback. Selecting the proper players and building a winning team is not easy, unless you are the New England Patriots. However, perhaps the Bears might have asked themselves whether paying five times the old contract was worth it. 

Overpaying for tail hedges or any option for that matter can hurt just like overpaying for defensive ends.  That is why we are trying to hedge when prices are cheap and no one is demanding our hedges.  

Rising prices for protection do not guarantee that you will lose money, you just have less room for error and need future performance to exceed expectations.  If Khalil Mack exceeded his performance with the Raiders while he was with the Bears, his contract would have looked less ridiculous.  

Buying a tail option for a moderately high price might turn out ok if the market has a large crash.  The Expectation of future performance would be closer to realized performance.  Similar to realized versus implied volatility. A subject for another post!

Price always matters.  The cure can be worse than the disease.  For the Chicago Bears, passing on Mack might have cost them nothing.  Passing on an expensive hedge because it is too late might make more sense than overpaying.

Best,

James

PS-  The Bears never made the playoffs with Mack. Two losses in the wildcard round.

Ben Bernanke needs to feel like his life means something—contributed to society in some important way. Making significant contributions to the evolution of new tools of monetary policy lets him leave a mark. There is nothing unusual about this need because it is felt by many people, but perhaps not with the same intensity as Dr. Bernanke.

Monetary policy in the 21st century covers the important central bankers in the period — Arthur Burns, Paul Volker, and Alan Greenspan — and their approaches to combating problems with the US economy.

Bernanke is clear that those managing the Federal Reserve are getting better at using monetary policy to produce positive outcomes. The new tools of quantitative easing and forward guidance should be part of fixing the economy during downturns. Unfortunately, there is very little evidence that monetary policy makes much difference to the overall prosperity of a country.

Ultra-low interest rates inflated house prices and risk-taking by banks ultimately culminated in the biggest banking blowup since the 1930s in 2008. Bernanke explicitly denies that monetary policy had anything to do with it; he has no idea that debt and risk were building up as interest rates went lower and lower since Volcker slayed inflation in the late 1970s.

There’s no evidence that debt-based growth works. Today, we have much more debt but in different places.

Bernanke lays out the major themes of the book in the beginning with a thesis. New policies have been undertaken by the Federal Reserve because of new economic developments in the 21st century: “The first of these developments is the ongoing change in the behavior of inflation and, in particular, its relationship to employment’.

The former Fed chairman is referring to the Phillips curve, which proposes a relationship between unemployment and inflation. The simplest form of this relationship is running a regression to show the outcome of lower unemployment is higher inflation. This was the problem in the 1970s, which was much more problematic than most initially thought it would be.

As Bernanke ascended through the banking profession, he no longer believed that inflation and unemployment were strongly linked; instead, he thought employment could be strong without rising inflation.

But in the 1970s, economists did not think that unemployment could rise while inflation continued to remain high and rising. Clearly, the Philips curve is not that reliable. It does not make sense to declare a “new era” that allows ultra-low rates when in the 1970s economists were shocked by the developments.

That’s the first strike against Bernanke.

The second development is “the long-term decline in the normal level of interest rates”. This argument is not substantiated at all. As far as I can tell, Bernanke thinks interest rates will be at zero until humans become extinct. Why will they be low forever? Today, we are close to 6% and Bernanke missed the Covid-19 inflation.

The third part of his thesis is that “final long-term [financial] development is the increased risk of financial instability”. Bernanke believes if the economy has a crisis that the Fed should intervene and can fix problems without any kind of long-term risk. The problem with this idea is that over time, it is like suppressing a large forest fire at the expense of smaller ones or letting a small bridge collapse early with minimal damage. Dr. Bernanke thinks saving the banks saves the economy, but that assumes the banks were not making bad loans to begin with. The loans are still bad.

Jerome Powell borrowed Bernanke’s interventions from the 2008 crisis and ended up with the worst inflation in forty years. The Federal Reserve practically had to be dragged kicking and screaming to raise rates after inflation took off. This terrible mistake has still not been completely fixed.

Bernanke believed that there is no connection between money supply and inflation. Sometimes that might be true, but if I sent every American $20,000 and let them not pay part of their bills for a few years, the odds of inflation would rise. The 2020 monetary policy was a huge failure, which was done partially because of Bernanke’s carelessness about the relationship between money supply and inflation.

After the COVID-19 inflation disaster, experimental monetary policy will undergo much more scrutiny. In the long run, economic growth comes from skilled entrepreneurs using the resources they have in front of them to build something amazing. The cost of capital is only one component. Apple and Microsoft were formed during periods of high cost of capital. We must learn the lessons from the past; we must refuse to trial experimental monetary policy.