bubble hunter

Bubble Fighter

2009-12-02T19:30:00.001+01:00

WSJ article suggest that FED is likely to change its passive approach to building bubbles in asset prices. One problem is that economists don't have models that prescribe how much interest rates should go up when asset prices or financial leverage run to excess.

Organic mechanics – complex networks in finance. FT article

2009-11-27T09:38:00.003+01:00

In today’s FT you can find a very interesting article about implementation of complex networks in finance. The article is also an indication that more and more economists became aware that “Efficient Market Hypothesis” does not explain market behavior and that there are better models (i.e George Soros reflexivity or Andrew Lo Adaptive Markets Hypothesis). Full article you can find here

Risk appetite gets into alarm zone

2009-11-23T13:12:00.003+01:00

You don’t need to look at risk appetite indicator (short description of the index you may find here) to know that optimism spreads across markets. But the above attached chart is giving a good visualization of the current market situation. As John Maynard Keynes famously said “Successful investing is anticipating the anticipations of others”. Along this line high risk appetite may be signal that this rally is maturing and soon the optimistic assumptions may be put under test.

Financialization of Commodity Markets: Nonlinear Consequences from Heterogeneous

2009-11-23T11:14:00.001+01:00

Just read quite interesting paper form central bank of Argentina. Authors’ claims that that high discrepancies between spot and fundamental commodities prices tend to be corrected relatively fast, while small misalignments tend to persist over time without any endogenous correcting force taking place. This is quite non-intuitive conclusion. Isn’t it?

Commodities corner: Sugar futures bubble ready to burst - an update

2009-11-20T14:27:00.001+01:00

Over the past few months, sugar has been on accelerating upward spiral, hitting a 28-year high at USD24 cents per pound. On September 1rd In analysis posted on this blog I stated that sugar prices exhibit a “bubble” characteristic. Fitting LPPL model I came to conclusion that bubble get into critical zone. The critical zone describes the maturation of a systemic instability forewarning of an inevitable crash. Since the beginning of September the sugar prices abandoned the „super-exponential” growth pattern and start to widely oscillate which goes along the prediction of the LPPL model

Here you can download a PowerPoint presentation. This presentation is aimed to show a more detailed analysis of the sugar#11 futures contract prediction and the methods used to make and test them. Specifically they are LPPL model, LPPL fitting procedure

Two interesting papers worth reading

2009-10-23T11:52:00.001+02:00

Complex Systems: From Nuclear Physics to Financial Markets

Multifractal analysis and instability index of prior-to-crash market situations

Enjoy!

Latvia - (small) Lat devaluation on cards

2009-10-22T12:48:00.012+02:00

Earlier this week heavily exposed to the Baltic region Swedbank reported its third straight quarterly loss. Swanbank also acknowledged that it was planning for a possible currency devaluation but said it’s seeing signs that credit quality in the Baltic region is beginning to stabilize. Indeed the worst may be over but its cleaver to prepare for devaluation in Latvia as the move would help country to recover faster and possibly would limit credit losses.

Just to give a brief characteristic of the country I should say that Latvia peg its currency just after the country won independence from the Soviet Union in 1991. In the recent past on the Latvia’s acceptance into the EU, the economy experienced a huge boom with the growth rates well above 10% per annum. The boom was driven by very strong credit growth financed by FDI inflow mainly into nontradable sectors ( real estate, retail and financial services). As time passes the imbalances built up. The wages went strongly up, the inflation level exceeds the EU level which further eroded the country competitiveness, current account gap top 25% of GDP in 2007.

There were several seeds of economic instability (bad mix policy – too loose fiscal policy combined with lack of monetary sovereignty) but among them most important was positive feedback mechanism from banking sector to private non-financial sector which fueled the housing bubble.

Simply credit growth was stimulating the home prices which were taken as collateral for loans. The more quickly the credit was flowing in the higher were the house prices. This process continues until the credit was unable to grow fast enough to further stimulate the house prices. At that time the private indebtedness top 125% of nominal GDP. (More detailed analysis of that process you may find in the previous post here or in Adrian and Shin paper ). The bad news is that this process works in reverse too (lower prices of homes lead to liquidation of loans which makes the decline more precipitous). In case of Latvia the credit bust was compressed in short time period which had catastrophic consequences on home prices. The figure below is a chart of home prices in capital of Latvia. Now the household’s holds negative equity as the home prices deflated but the nominal debt remained unchanged which suggest that more credit related loses lays ahead. As the households remains heavily indebt the recovery is likely to be very sluggish (L-type recovery is possible)

To get a better insight in situation I just implemented a simple balance sheet approach to Latvia. This analytical approach is different than ESA95 approach and it’s focused to examine balance sheet of the country and potential misalignments and vulnerabilities (more on that methodology here). In particular case of Latvia I focus on credit and currency misalignments so this is not a comprehensive approach. Figure 2 is a excel balance sheet of Government sector, Commercial banks sector and Private –non bank sector (click to enlarge the figure).

First observe that government indebtedness is low(ish) both in local and in foreign currencies. Second somehow modes net liability position of commercial banks masked the fact that the majority of the commercial bank assets consists around EUR 8.5bn (Lat12bn) in FX loans to the domestic nonbank sector. In words FX-risk of the banking system simply has been transferred in credit risk which was quite “natural“ as majority of the local banking sector assets are in foreign hands.

Without the coordinated IMF/EU/WB programs the country balance sheet gaps would not be sustainable would end up with currency crises. As I read IMF lead program as financing bridge to adopt euro (in 2012?) and extricate Latvia from currency risk. However this strategy is very difficult to implement as the government has to cut spending to meet the Maastricht criteria among dramatic economic downturn. In words this strategy is unlikely to win sustainable political support. But this is the minor problem. The major problem is fixing LAT to euro at too low level (maintaining overvaluation i.e. Portugal peg its currency too low to euro which had negative implication for the GDP growth). Latvia to repay the debt would need to increase the competiveness to be able to generate the current account surplus. Amid the crises the Latvian C/A deficit shrunk rapidly but this was achieved by collapse of domestic demand and import. Unfortunately amid weak external demand export also drop but leaser than import which ends up in small C/A surplus.

The easiest way to increase the country competitiveness would be allow currency to depreciate if not then the competitiveness may be raised by adjustment on the real side of economy (decreasing wages etc. which is rather painful process). In case of Latvia because of large FX misalignment devaluation is not a cost free solution but implemented orderly would increase the quality of the credit portfolio in the medium term as it would it would promote higher employment. The orderly devaluation would not necessarily jeopardize Latvian plan to join euro soon(ish) as in ERM2 mechanism currency can fluctuate -+15%. from the central parity. An orderly and small Lat devaluation seems to be a plausible solution.To make it orderly both banks and government has to be prepared. If the Swedbank is preparing for possible devaluation maybe Latvian government is preparing for devaluation too but this is only my interpretation and I may be wrong.

This Time is Different: Eight Centuries of Financial Folly

2009-10-09T10:35:00.006+02:00

Preview of new book by Reinhart and Rogoff is now available in Google Books (link here). I just read this book and i must say that Reinhard and Rogoff have compiled an impressive database, which covers eight centuries of government debt defaults from around the world. This historical study gives what they call a "panoramic view" of the unending cycle of boom and bust, showing how claims that "this time is different" are invariably proven wrong.

Reinhart and Rogoff shows that financial crash typically follow real-estate bubbles, rising indebtedness and gaping current-account deficits. It also shows that financial meltdowns are followed by state bailouts which led to deterioration in government finances. Must Read!!!

This book is an extended compilation of series of working papers (links to some of them you may find here 1 ,2 ,3 )

How the Fed Can Avoid the Next Bubble?

2009-10-06T21:41:00.002+02:00

Interesting article from WSJ. This time Nouriel “Doom” Roubini and Ian Bremmer calls Fed to Establishing financial stability—in addition to price stability and growth. Its needed but difficult target to aim it also requires changing/updating economics toolbox (look at the previous posts).

IMF Needs to Spot New Investment Bubbles: Geithner

2009-10-06T12:37:00.001+02:00

CNBC just reports that U.S. Treasury Secretary Timothy Geithner called on the International Monetary Fund to provide rigorous surveillance to spot new investment bubbles (link here). IMF pays a central (and successful) role resolving the current crises and politicians keep to brothering the role of the fund. Despite the Fund success in dealing with the crises it failed to send a warning signal before the crises broke out. Still may be questioned whether rare high impact events may be predicted but I think is worth trying to broad the fund surveillance toolbox with complex system tools which may give some better insight into the stability of the system as a whole. Unfortunately so far the Fund keeps working with models which prove to be wrong indicators ahead of the recent crises (i.e. chapter 3 of new WEO). I think that there is urgent and general need to extend the economists toolbox with the out-of-equilibrium models

The leverage cycle , tipping points, black swans and red dragons

2009-09-30T14:10:00.026+02:00

Until recently economists were certain that finance has absolutely nothing to offer macroeconomics on the level theory or practice. In the center of economic theory were money supply and interest rates. However In real world when a homeowner takes out a loan and using say a house as collateral, he must negotiate not only just the interest rate, but also how much he can borrow. In other words equally important to interest rate is leverage rate. Let’s take a look on a simple example (I took this example from John Geanakoplos paper The Leverage cycle who together with Hyun Song Shin deserves credit for excellent analysis of leverage and collateral for functioning the financial system)

If the house costs USD100k he borrows USD80k and pay USD20k in cash we say that the collateral rate is USD100k/USD80K=125% the leverage is USD100k/USD20k =5 loan value is USD80k/USD100k = 80%. If then the value of the house raises let say by 20% collateral rate rises to 150%, the loan value drops to 67% and the leverage drops to 4.

In general leverage falls when value of total assets rise. For households, the change in the leverage and change in size of balance sheet size are negatively correlated. However the picture for financial intermediaries is very different. (This is well documented in the series of papers by Hyun Song Shin. Here you can find a link to her web page at Princeton University).

First let’s assume that the bank or other financial intermediary wants to maintain a constant leverage ratio of 10. It keeps securities worth 100 finances is assets with debt worth 90.

--------ASSETS ---LIABILITIES
Securities 100---- 10 Capital
------------------------90 Debt

Now let’s assume that value of securities increases by 1% to 101. Now the balance sheet looks like this:

-------ASSETS ---LIABILITIES
Securities 101 ---11 Capital
-----------------------90 Debt

Leverage drops to 9.18 but the banks wants to keep it constant at 10 and it has to purchase securities worth 9 and finance this purchase with additional debt. Thus, an increase in the price of the security leads to an increased holding worth 9 So the demand curve is upward sloping

---------ASSETS ---LIABILITIES
Securities 110 ---11 Capital
------------------------99 Debt

This mechanism works in reverse too. If now the securities prices fall so the value of assets kept on balance sheet inches down to 109 the leverage now is to high 109 to 10= 10.9. The bank has to adjust down its leverage by selling securities worth 9.

---------ASSETS--- LIABILITIES
Securities 109 ---10 Capital
-------------------------99 Debt

Thus a fall in the price of securities leads to sales of securities which mean that the supply curve is downward sloping. Leverage targeting entails upward sloping demands and downward sloping supplies.
But in real world financial intermediaries are far from being passive in adjusting their balance sheets. Leverage sector (banks, brokerage houses, hedge funds etc.) uses Value at Risk models to adjust their balances sheets. Adrian and Shin showed that procyclical leverage can be traced to the counter-cyclical nature of VaR.

In other words greater demand for the assets tends to put upward pressure on its prices, and then there is a feedback effect in which stronger balance sheets feed greater demand for the asset which in turn raises the asset price and lead to stronger bigger balance sheets. This process if unchecked can lead asset prices up to the shy and then down to the hell (as this process works in reverse too)

(chart reproduced from Adrian and Shin )

That’s why in absence of intervention leverage becomes too high in boom times and too low in bad times (bust). As result , in boom times asset prices are too high, and in crisis time they are too low. This is the leverage cycle.

Eastern Europe boom and bust

Investment bank portfolios are marked to market but the commercial banks balance sheet is not directly affected by changes in asset prices. The reason behind is that usually the biggest item on the balance sheet of commercial banks are loans to consumers (credit) which are not mark to marked. Figure 1 is a scatter chart of the change in leverage and change in total assets of 5 biggest Ukrainian banks (2000-2008). I choose Ukrainian banks as Ukraine and Baltic countries (Lithuania, Latvia, Estonia) suffers in the aftermath of financial crises the worst GDP contraction in whole CEE region. Although I had access only to limited number of observations but most of the observations are concentrated along the vertical line which suggest that Ukrainian commercial banks were targeting constant leverage ratio.

Even in absence of asset price changes (loans, credit) there is potential room for feedback between the balance sheet size and asset prices through shifts in perceived risk.
As I mentioned earlier when the homeowner takes out a loan and using say a house as collateral, he must negotiate not only just the interest rate, but also how much he can borrow. If then the home price increases the collateral ratio raises which may give false impression that the credit risk is falling.

Figure 2 is a chart of average flat prices in capitals of Ukraine (Kiev), and Estonia (Tallinn). I choose home prices as a “natural estimator” of collateral value as credit boom in CEE was mainly driven by surge in number of mortgages. The chart shows that the prices not only raise but also its pace of growth accelerated as time passes reaching maximum in 2008. This was an effect of slowly (at the beginning) accelerating credit growth, which pushes up the collateral ratio and then shifts down perceived risks. Loan officers were more willing to lend as the collateral ratio keep exploding. The more credit was given the higher was the value of collateral the higher was the credit needed for purchasing home which further erodes the lending standards.
Positive feedback process between the credit and collateral value starts slowly at the beginning the credit is soundly based. But as the amount of debt accumulates, total lending increases in importance and begins to have leading appreciable effect on collateral values.

Figure 3 is a chart of commercial bank assets to GDP ratio in Estonia , Poland, and Ukraine. In Estonia and in Ukraine the ratio grows very rapidly which underlines growth of credit in leading role in the process of asset prices/value collateral surge.

Tipping points, Black Swans and Red Dragons

According to standard economic theory markets are fully efficient and only revelation of new important information can cause a crash. But standard economic theory neither can explain creation of the bubbles nor bust of it. The leverage much better explains the economic process of asset price boom and bust. Question is whether it is possible to predict coming asset price bust? According to Nassim Taleb author of famous book “ the black swan” high impact rare events are unpredictable as their share all characteristic of smaller events.

However Didier Sornette in series of papers showed that high impact rare events may be predictable as they belong to a statistical population, which is different from a bulk of the distribution of smaller events, requires some additional amplification mechanism. He argues that extreme events are even “wilder” than predicted by extrapolation of the power law distribution. He calls these outliers a kings or dragons. Emergence of these wild events requires a positive feedback mechanism which leads to increase cooperative of the whole system , leading to development of endogenous instabilities.

(chart reproduced from D.Sornette presentation)

This is complex system approach which is quite different forms “analytical” economics approach which favors decomposing system in components and analyzing it separately to understand the functioning of the whole. “Analytical” approach is destroying information about interactions/linkages between the parts of the system which may lead to some surprising “emergent” properties of the whole.

The emergent property of leverage sector (i.e Banks) comes competition which leads to synchronization of risk exposure. Let’s imagine a borrower who is coming to the bank for mortgage and says that another bank down the block offers him a credit in value of 110% of real estate he wants to buy instead of 50% he is getting here. If the bank would not follow competitors excessive lending policy its balance sheet would not grow fast enough to stop competitors from takeover, management could be replaced for unimpressive profits etc… Pretty soon both banks eases the lending standards which keep feeding positive feedback process from balance sheet size to asset prices.

The process continues until a tipping point is reached where total credit cannot increase fast enough to continue stimulating asset prices but the whole system is sharing similar risk (real estate). At that time system as a whole is very sensitive to even a small shock but the source of the crash lies in its emergent fundamental instability.

This tipping point is analogues of critical points studied in statistical physics and system before reaches that point may sending precursory signals which can be modeled by LPPL(Log –periodic power Laws.)

Lehman should not be allowed to fall

2009-09-21T12:22:00.012+02:00

I am about to mark the anniversary of the financial meltdown. In September 2008 bankruptcy of Lehman Brothers freeze the global financial system for several weeks. But the fall of Lehman was not the cause of the crises but rather a late symptom of cracks in the financial system caused by very high leverage. Financial intermediaries naturally leverage their balance sheets. But Chart 1 point to a strong positive relationship between changes in leverage and the size in balance sheet size which suggest a high procyclical in the leverage process of financial intermediaries.

Chart 1 reproduced from Hyun Song Shin

In good times leverage and balance sheet size of financial intermediaries increase together when risks decrease measured (VaR). But when the loss distribution is exponential, the behavior of intermediaries conforms to the Value-at-Risk rule, in which exposure is adjusted to maintain a constant probability of default. In a system context, increased risk reduces the debt capacity of the financial system as a whole, giving rise to amplified de-leveraging by institutions through the chain of repo transactions. This process leads to a synchronized contraction of balance sheets which will cause stresses that show up somewhere in the system.

Chart 2 US Fedwired interbank payment network reproduced from K.Soramäki

In case of the financial networks it is crucial for its sustainability to know where the stresses may show up as its topology is highly disassortative. I.E.US FED payment system contains over 9500 participating banks but the core of the network with 66 banks accounts for 75% of the daily transactions. Distribution of the connections between participants in that network follows the power law distributions (few banks are hubs for thousands of others while thousands of banks in that network are only connected to few others).

The good news is that this type of network (scale-free network) is very resilient to accidental failure as random failure even large amount of banks is unlikely to freeze the whole system ( the random failure of banks will take only the small ones as they are much more plentiful than the hubs ).

The Achilles heel of the network is its dependence on hubs (large interconnected banks) . Recent research suggests that generally speaking, that the simultaneous collapse of only of 5-15% of all hubs can crash free scale network. Therefore the protecting the hubs of the system are essential for its functioning. Allowing Lehman to collapse which was a central hub in financial network was clearly against this rule and was a major and cost full mistake.

Conclusions are rather fairly simple:

1) Regulators/central banker should watch and limit the leverage in the financial system (not only target inflation)

2) core of the network should be protected at all cost but also should be subject of stricter regulations

The Chinese equity bubble - UPDATE

2009-09-08T16:43:00.001+02:00

Dieter Sornette and his team just released an updated version of its earlier paper on Chinese equity bubble. This version of the paper includes more details i.e. description of bubble detection tools etc. Link here

World stock market: approaching trend reversal?

2009-09-03T19:38:00.002+02:00

Another interesting implementation of LPPL model has been just published today. Stanislaw Drozdz and Pawel Oswiencimka in short paper predict that core stocks indexes will face significant correction. A quote:

Based on our ”finance-prediction-oriented” methodology which involves such elements as log-periodic self-similarity, the universal preferred scaling factor 2, and allows a phenomenon of the ”super-bubble” we analyze the 2009 world stock market (here represented by the S&P500, Hang Seng and WIG) development. We identify elements that indicate the third decade of September 2009 as a time limit for the present bull market phase which is thus to be followed by a significant correction

Sugar bubble ready to burst

2009-09-03T13:25:00.003+02:00

Over the past few weeks, sugar has been on such upward spiral, hitting a 28-year high. Growing demand in Brazil for sugar to be turned into ethanol, coupled with a sharp fall in Indian and Brazilian production, have both sent sugar prices sky high. Many think that the supply shortfall will extend through 2010. Then from fundamental perspective valuation current sugar valuation may be correct as the supply fall short behind the demand. But to speak of supply and demand as if they were determined by forces that are independent of the market participant’s expectations is quite misleading.

It’s true the situation is not so clear cut in case of commodities where supply is largely dependent on production and demand on consumption. But the price that determines the amounts produced and consumed is not necessarily the present price. On the contrary, the market participants are more likely to be guided by future prices, either as expressed in future markets or as anticipated by themselves. In either case it is inappropriate to speak of independently given supply and demand curves because both curves incorporate expectations about future prices.

Those expectations may become self-referential which will lead to the positive feedback process (the higher the price or the price return in the recent past, the higher will be the price growth in the future). Positive feedbacks, when unchecked, can produce runaways which beyond a certain point become unsustainable ending in crash. In short LPPL models developed by Sornette aims, at detecting the transient phases where positive feedbacks operating on some markets or asset classes create local unsustainable price run-ups. The result of the analysis is summarized bellow in figure 1.

I analyzed sugar#11 future time series between September 2007 and September 3 2009. The y axis is logarithmically scaled so that the exponential function would appear as a straight line. LPPL fit exhibit upward curvature which is clear evidence that the prices were growing “super-exponentially”. The projected crash dates are September 5-15 .It must be noted that a good fit of the model to the data series is not a 100% certainty for a crash, but it clearly points at a bubble formation.

The Chinese Equity Bubble: Ready to Burst (NOW)

2009-07-13T19:44:00.003+02:00

D. Sornette et all just published interesting working paper on possibility of Chinese equity bubble to burst. A quote from summary:

Amid the current financial crisis, there has been one equity index beating all others: the Shanghai Composite. Our analysis of this main Chinese equity index shows clear signatures of a bubble build up and we go on to predict its most likely crash date: July 17-27, 2009 (20%/80% quantile confidence interval).

Larry Summers on EMH

2009-07-11T12:08:00.002+02:00

In today’s Financial Times you can find an interesting interview with Larry Summers, director of the US president’s National Economic Council. A quote:

The chief intellectual casualty of the current crisis has been the “efficient markets” school – the theory, associated with such erstwhile laisser faire gurus as Alan Greenspan, that market participants are governed by rational expectations and markets are self-correcting. As an academic economist, Summers has studied the shortcomings of that approach but, working on Wall Street gave him, he says, a more visceral understanding of the “self-referential” character of markets: “Markets are concerned with the ultimate health of economies and the like but they’re equally or more concerned with what the likely judgments of other market participants in the short run are.”

I’m not quite sure whether Mr. Summers is aware that he is proposes to extend economists tool box with non-equilibrium models. Nevertheless it may indicate that non-equilibrium models are silently leaking into main stream of economics. Efficient Market Hypothesis (EMH)has been falsified many times but I hope that this time it will be replaced by hypothesis better explaining how the market works. I think that G.Soros Reflexivity idea or MIT Andrew Lo Adaptive Market Hypothesis are good candidates to replace EMH for good.

Asset price misalignments and the role of money and credit

2009-07-08T14:41:00.003+02:00

ECB just released working paper on the role of money and credit indicators for detecting asset prices misalignments. This is most likely the second ECB publication on early warning asset bubbles indicators this year. Conclusion are quite intuitive that monetary and credit developments may be very useful in predicting asset bubbles burst. I have no problem with that conclusion because positive feedback loop from credit to house prices and again to credit was behind surge of house prices (also in Eastern Europe). I think that that to reduce price to price feedback (to avoid superbubbles creation) central banks should be more focused on credit growth and also closely monitor interactions between collateral valuation (i.e. house prices) and banks willingness to lend.

Poland then(30's) and now(00's)

2009-07-07T10:08:00.004+02:00

This chart is from Barry Eichengreen and Kevin O’Rourke column comparing today’s global crises to the Great Depression. Although the general conclusion of the comparison is rather grim (i.e. no signs of green shoots in hard data) but Poland in that comparison is doing relatively well. The fall in the industrial output is relatively soft. What is than the receipt for success? I think Poland is weathering the storm so well (in relative terms) because of several factors : 1) Underdeveloped banking system 2) less leverage 3) smaller gaps /macro imbalances 4) regulations/constrains for domestic households to borrow in foreign currencies. Only if Poland would use good times (2005-2007) to reform state budged then it could be a clear winner of the crises

S&P 500 - critical time

2009-07-03T15:39:00.007+02:00

It is fair to say that the global economic system is one of the most complex systems known in the biosphere. Compared to physics, economics differs in the important fact that the basic constituents, or “particles”, are already quite complex: human beings. So macroeconomic knowledge is insufficient tool to predict market trends as not only hard data are important but also how human beings think about macroeconomic reality.

John Maynard Keynes made a famous observation that much of individual economic behavior is due to “animal spirits” rather than long-term rational calculus so beloved by economic theorists and fundamental analysts.

That’s why I don’t want here to discus macroeconomic picture (i.e most recent US job readings) because it’s rather trivial task as we are still in negative feedback process (i.e. banks continue to tighten credit standards –> less credit available means lower demand -> lower demand means higher unemployment -> higher unemployment undermines creditworthiness -> banks continue to tighten credit standards etc)

What I would like to focus here on fact that series generated by some complex systems (i.e. financial markets ) are characterized by periodic or nearly periodic behavior. In these cases, the dynamics can be characterized by scaling laws. Such dynamics are usually denoted as fractal or multifractal, depending on the question if they are characterized by one scaling exponent or by a multitude of scaling exponents. Sierpinski gasket is one fine example of fractal

Some times its necessary to conduct series of tests to find the scaling factor but in case of S&P 500 the self similar pattern is clear at the first glance.

I simply repeat the analysis which I done last year and I got very similar scaling factor 2.7. In words it may indicate that S&P 500 is around critical time and that in August we may test the March lows.

Irrational Exuberance. LPPL signatures in EUR/PLN

2009-06-26T08:36:00.007+02:00

People like to go to excesses. I think that what started out with a tulip, maybe four-hundred years ago, and continued through the South sea bubble and all of those sorts of things ( Tronic bubble in 60’s, new economy bubble in 90’s). I’m not saying here that that all human choices are orthogonal to rational ones but in human nature is to heard. Herding can result from a variety of mechanisms, such as anticipation by rational investors of noise traders strategies, agency costs and monetary incentives given to competing fund managers, sometimes leading to the extreme Ponzi schemes, rational imitation in the presence of uncertainty, and social imitation. Many financial economists recognize that positive feedbacks and in particular herding is a key factor that can push prices upward (downward) faster-than-exponentially which if unchecked can lead to bubbles.

Roughly 10 years ago Johansen and Sornette proposed model that attempts to incorporate those ingredients into a traditional rational expectations model of bubbles proposed by Blanchard.

The Jochansen-Sornette model assumes the financial market is composed of two types of investors: perfectly rational investors who have rational expectations and irrational traders who are prone to exhibit herding behavior. The noise traders drive the crash hazard rate according to their collective herding behavior, leading its critical behavior. Due to the no-arbitrage condition, this is translated into a price dynamics exhibiting super-exponential acceleration, with possible additional so-called “log-periodic” oscillations associated with a hierarchical organization and dynamics of noise traders.

A+B*(t-tc)^C*(1+D*COS(w*LN(t-tc)+O)

This so-called log-periodic power law (LPPL) dynamics given by has been previously proposed in different forms in various papers. The power law A−B(t−tc)_ expresses the super-exponential acceleration of prices due to positive feedback mechanisms. The term proportional to cos(w ln(t-tc)+o) describes a correction to this super-exponential behavior, which has the symmetry of discrete scale invariance. This formulation results from analogies with critical phase transitions (or bifurcations) occurring in complex adaptive systems with many interacting agents. The key insight is that spontaneous patterns of organization between investors emerge from repetitive interactions at the micro-level, possibly catalyzed by top-down feedbacks provided for instance by the media and macro-economic readings, which are translated into observable bubble regimes and crashes.

In previous posts I fit the LPPL formula into several financial time series. This time I fit LPPL into EUR/PLN exchange rate. As it is seen on the chart the formula fits remarkably well into the data. Even more surprisingly the LPPL model explains not only the periods when the positive feedbacks let to the zloty overvaluation but also it fits well to the period when zloty was depreciating (2001-2003). This confirms the universality of the process described by LPPL formula which describes well not only bubbles but also antibubbles.

the global fiscal outlook is somber

2009-06-10T15:27:00.007+02:00

IMF has released a Staff position note: Fiscal implications of the global economic crisis. Conclusion of the note is simple the global fiscal outlook is somber. Present fiscal cost of the crises + aging populations in advanced economies will strongly contribute to increase in DEBT/GDP ratios in the future. Also this momentum may raise the question of fiscal solvency. What is then the next big thing?
a) rising inflation
b) fiscal insolvency
c) a+b
or c) (put here something optimistic)

Risk appetite remains low

2009-06-10T12:46:00.003+02:00

Surprisingly the net average positioning index remains almost flat despite recent rally. (The shot description of the index you may find in one of the previous posts). It may indicate that portfolios still remain underweighted. So it looks like this rally has still room to go

Polish language version of the bubble hunter

2009-02-13T15:13:00.001+01:00

I just created Polish language version of the bubble hunter link here. “Łowca Baniek” blog will be rather focus on the Eastern Europe, bubble hunter will remain my main conceptual notepad

Reflexivity and Eastern Europe (or can Ukraine be a Lehman Brothers of Eastern Europe?)

2009-02-13T14:52:00.005+01:00

I was expecting this article to come sooner or later but when I read it this morning in FT I cannot say that I’m happy because for the time being I’m still living in Eastern Europe.

Not so long ago the consensus about Eastern Europe economies was that they are FUNDAMENTALY sound and those economies should decouple from global slowdown. At that time I wrote that this is not sustainable process and that the decoupling will be followed by the recouping to the rest of the world . Now after the first wave of debt/currency crises went through the Eastern Europe the consensus story has been changed somehow into more doom and gloom story. But now some say that Eastern Europe is almost FUNDAMENTALY cheep (i.e. here)
I think this way of thinking is FUNDAMENTALY wrong as markets are not efficient pricing machines Some/Most market participants believe that the markets tend toward equilibrium but equilibrium is just only first approximation how the market works.

My critique is not new. Milton Friedman said that idea of fully efficient market is inherently contradictory. In order to remove market inefficiencies we must have traders who are motivated to exploit them. But if the market is perfectly efficient there is no possibility to make excess profits. While efficiency might be true at first order, it cannot be true at second order: There must be on-going violations of efficiency that are sufficiency large to keep traders motivated. The misconception of efficient market is even obvious now than ever before, because it was the intervention of the authorities that prevented financial market from the total meltdown, not the market themselves. Indeed non-equilibrium nature of the markets is especially visible in the sharp price movements occurring at the booms and (especially) crashes which are accompanied with massive price jumps. Question is how in first place the market gets to “critical” point. The Eastern Europe decoupling story was based on the fact that economic growth in recent years was strongly based on domestic demand. Domestic demand was continuously stimulated by credit growth and budget deficits. At the beginning of the process the credit growth was limited and its impact on the price assets was limited. However lending usually stimulates economy. A strong economy tends to enhance the asset values, increases country creditworthiness and also often tigers local currency appreciation. As the asset prices grows the banks are more willing to lend because (i.e.) the value of the collaterals is growing the more credit is available the stronger economy grows. This positive feedback process continues until a point is reached where credit cannot grow fast enough to stimulate economy. By that time the asset value strongly depends on the credit growth and as the credit growth fails to accelerate further the asset values starts to decline. At the “critical” point the process reverses. Declining prices of assets/collaterals decreases the banks willingness to lend which has depressing impact on economy. Since creditworthiness/collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans which in turn may make the decline more precipitous.

This is very, very simplified vision of the process which leads to asset bubbles. However one of the features of the process is that Economic FUNDAMENTALS ARE NOT EXOGENOUS to the process. Unfortunately is not my idea but George Soros reflexivity which he defines as a “two-way feedback loop, between the participants’ views and the actual state of affairs. People base their decisions not on the actual situation that confronts them, but on their perception or interpretation of the situation. Their decisions make an impact on the situation and changes in the situation are liable to change their perceptions”
(Unfortunately Soros is not good at math but it’s easy to show that his reflexivity idea is a system of differential equations. More formal model definition and solution to the systems of “Reflexivity” differential equations you can find here in excellent V.I. Yukalov D.Sornete paper).

But let’s come back to the main subject and let’s try to find out what may come next. Financial linkages/Interlinkages in Eastern Europe are very tight. With the increase in the foreign ownership of the banking system in Eastern Europe the degree of financial interlinkages among Western Europe and Eastern Europe has also grown substantially i.e. Austria’s lending exposure to Eastern European countries top 80% of GDP ( IMF Paper with the statistics you can find here). As the economy slows the processes which lift asset prices is in full reverse as investors starts to withdraw the money. The liquidation of the loans takes time: the faster it has to be accomplished, the grater the effect on the value of the collateral . In the bust the reflective interaction of the loans between collateral becomes compressed within very short time of period the consequences can be catastrophic (reflexivity works both ways)

For several years Ukraine economy was flying on cheep credit and high steel prices now both engines has been lost which is not only the case of Ukraine but also for several countries in the region (i.e. Romania, Bulgaria). And now we are in self reinforcing process of loans liquidation which reinforces the drop of asset prices. Because of the size of Ukraine and close financial interlinkages acrros the Europe the comparison of Ukraine potential default to Lehman Brothers bankruptcy and its implications for the whole financial system makes sense for me

End of Part ONE