Sunday, March 30, 2014

Broken contacts

by Economist

Finance, not economics, may explain copper’s recent plunge

THE copper price has long been held to signal the state of the global economy as reliably as the metal conducts electrons. But that reputation—never fully deserved—is now in tatters. Copper’s plunging price (see chart) says a lot about China, but little about the rest of the world.

China consumes about 40% of global copper production. But not all of that goes straight into manufacturing or construction. Chinese companies have also been using copper as collateral for their hard-currency loans: “buy, store, hedge and pledge” in the words of one trader. That has led to an overhang, with far more of the metal stockpiled than users need. Any change in the conditions that created this stockpile can have a big effect on the price.


A sign of this is that when the Chinese economy slows, as seems to be happening now, with manufacturing activity weakening for a fifth consecutive month, those stockpiles rise. CRU, a metals researcher, now says the copper-market surplus this year will be four times bigger than it previously estimated, with forecast production outpacing demand by 140,000 tonnes.

Chinese data are notoriously opaque, so judging the real health of the country’s copper-consuming industries is hard. A rebound in growth later this year could revive demand for the metal. But other factors are piling pressure on to the copper price. One is a growing wariness among creditors, following a corporate-bond failure this month (the first since the 1990s). As banks worry about their customers’ abilities to service debts, Chinese firms are finding it harder to get loans. This is making some sell their copper to raise cash.

Another factor is that Chinese regulators are cracking down on companies using copper stockpiles for speculation. Joel Crane of Morgan Stanley, an investment bank, argues that the authorities are targeting the “shadow-banking network” used by companies to evade controls on hard-currency lending. Chinese importers have long used letters of credit issued by banks for raw-material imports as a way of raising funds which they then use for other purposes. Such shadow banking created lucrative arbitrage possibilities for those able to take advantage of the difference between local and international interest rates. This is a useful dodge when times are good, not so when scrutiny increases. A reform in mid-2013 made companies holding copper for collateral keep it onshore, rather than in bonded warehouses, raising the cost of storage.


A similar story seems to be unfolding with iron ore. China accounts for half of world steel production, so the iron-ore price is hypersensitive to any downward flicker in demand. Iron-ore stocks at Chinese ports are at record highs. China is also trying to substitute its own, lower-quality ore for the higher-grade imported stuff. It wants to cut overcapacity and pollution, including using the financial markets to put pressure on the steel industry through higher interest rates and tighter credit. Companies who used iron ore as collateral for their borrowing may now have to use it for debt repayments instead.

Copper bears fear that this could easily get out of hand. But the likelihood is more a slow unwinding of positions than a crash. Goldman Sachs, another bank, notes that it is not in the Chinese authorities’ interest to shut down commodity-financing deals altogether. It makes more sense just to increase the hedging and storage costs of those firms using commodities to speculate. Stephen Briggs of BNP Paribas, also a bank, notes that the “few hundred thousand tonnes” involved in these deals is only a small part of a 20m tonne market.

The truth may be that jitters in China have just accelerated a change in perceptions about copper: from chronic deficit to surplus. This stems from the impending extra metal coming this year and next from new mines in places such as Mongolia, Peru and Mexico. Speculators may come and go, but at least copper, unlike gold, has a comfortably wide range of uses.

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Gold Is Tarnished

by WSJ

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Cool Video: Europe's Shifting Borders over the past 1000 Years

by Marc Chandler

This Cool Video was posted on Owen Zidar's blog and appears to have been originally posted by Nick Mironenko.  In about 3.5 minutes it shows the changes in the European borders over the past millennium. 

As one country or another tried to increase its sphere of influence, wars were often fought. The increase in one country's sphere of influence came at the expense of another's in Europe. Is there another way?  

The post-WWII settlement is predicated precisely such an alternative. To ensure peace, the border settlements of WWII (Oder-Neisse agreement) were regarded as permanent. There were notable exceptions, of course, but we shouldn't let them obscure the larger agreement. Rather than fixed spheres of influence, the settlement was based on variable shares of the world economy.

The variability of a country's share was determined by its economic prowess. One can punch above their weight, as it were.  It shifts the focal point of competition to the means of production from the means of destruction.  So, as you watch the video below, remember that nearly every border change is associated with a war. 

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Have We Reached Peak Putin?

by Charles Hugh Smith

The capture of a few pawns has cleared the chessboard, but the strategic choices already made have greatly reduced Putin's room to maneuver.

No tree grows to the sky. Once extremes are reached, trends reverse, often with symmetry: the decline often matches the ascent.
Which leads to an interesting question: have we reached Peak Putin?

Let's start our inquiry by noting that pundits from across the political spectrum are all busily chainsawing events up to fit into their little boxes of existing narratives:Cold War Redux, World War 3, neo-Nazis, etc.
One key driver of this stale parade of pre-packaged opinion is the instinctive urge to cheer for whatever team is on the field opposite the U.S. and President Obama.This natural urge leads to indefensible hypocrisy along the lines of "Brand X Imperialism bad, brand Y Imperialism good." If you oppose Imperialism and Great State meddling, then you can't oppose one brand of Great State meddling and support another brand.
Let's stipulate a few things to get them out of the way, so we can we proceed beyond the chainsaws and little ideological boxes.

1. Russia used its energy leverage over Europe with such great gusto that the blowback will reduce that leverage. Europe is scrambling to develop other sources of natural gas, and doing anything less would not be acting in Europe's self-interest.
2. Massing conscript troops and an army with limited ability to maintain its supply chain once inside Ukraine is another example of sparking blowback that will last for years and perhaps decades. Pressing your energy boot on Europe's neck was bound to create a strategic response, and massing troops on Ukraine's border has the same consequence.
3. While Putin's popularity is sky-high, domestic support for invading Ukraine is low. Should the poorly paid conscripts start coming home in body bags, Putin's domestic support will be revealed as an inch deep and a mile wide.
4. Russia's energy pacts with China and India are positive developments for Asian peace and development. China and India need more energy, Russia has surplus to sell--it's win-win not just for these nations but for the world. The peaceful trade of energy is a major plus for everyone.

5. But selling energy to Europe and selling energy to China and India are not equal: China and India have seen the way Russia has exploited its energy leverage in Europe, and Russia will find it has precious little political leverage over China and India, who will be sure to develop alternative sources of natural gas. The loss of political leverage over Europe will not be offset by an equivalent gain of leverage over China and India.
6. Russia has ruthlessly exploited its monopoly over natural gas by charging politically influenced prices: Poland, for example, pays a lot more for Russian natural gas than Germany, even though the gas flows through the same pipeline.

7. Once Russia loses pricing power in Europe, it will not gain pricing power over China or India. Those nations have other sources and cannot be held hostage in the same way Poland et al. are currently held hostage.
This means Russia will be earning considerably less per therm of energy once it ships natural gas to China and India.
Slowly but surely, the global natural gas market is becoming more integrated. Those currently charging cartel/monopoly prices will see their energy earnings decline.
8. In terms of national income, Russia is as dependent on energy earnings as any other "resource curse" oil exporter. The loss of pricing power in Europe and a decline in energy income will become headwinds for the Russian state.
9. Putin's domestic popularity flows from nationalist pride in the Olympics and in reclaiming Crimea. But now that those high points are past, Putin's options are not so lopsided in his favor.
Threatening (or invading) Ukraine reminds everyone in Europe why they fear Russia, and why Russia is not truly European. Domestic support in Russia for annexing part of Ukraine is low, for good reason: who wants to be responsible for the costs, financial and political?
10. Reclaiming Crimea makes for good theater and is a geopolitical plus, but it does nothing to reverse Russia's real problems, which include corruption, wealth inequality, low birth rates, etc.
11. Russia's military looks good on paper and in photos, but it's not as prepared to mount a sustained campaign within Ukraine as advertised. Asymmetric warfare doesn't respect lines on a map.
12. If Putin had set out to reinvigorate NATO, he would do exactly what he has done to date. Anyone thinking the U.S. Deep State is in despair about Putin's moves has it backwards: everything Putin is doing is fueling blowback and resistance in nations that were potentially friendly to Russia. Nothing tells you who your friends are quite like troops massing on your neighbor's border.
As a refresher, here's a map of pipelines connecting African natural gas fields to Europe.

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Why is the ECB hesitating on monetary easing?

The Eurozone's unemployment rate is at 12% and holding while the area's youth unemployment is at staggering 24%. Private lending is still contracting (see post) and disinflationary pressures persist even within the "core" states (see chart). The price stability situation in the "periphery" is starting to look outright deflationary - see chart.  The euro is still at mulit-year highs, putting pressure on the area's export businesses. At the same time monetary conditions continue to tighten as the area's central banking system balance sheet approaches pre-LTRO levels.

unit = mm € (source: ECB)

Given the situation, most central bankers would take action. A simple policy change for example could be to suspend the sterilization of securities already held by Eurosystem - see post. But the ECB is hesitating. Why? Here are some reasons:
1. This may upset some folks but the reality is that the ECB is notoriously indecisive as it is pulled into various directions by the member states. Many forget that the institution is relatively new (just over 15 years in existence) and the shock of the recent crisis had left the organization a bit paralyzed. It rarely takes a decisive action unless it's forced by the markets to do so. The decision to "save the euro" only arose as Spain approached the point of "no return".
2. The ECB is also somewhat distracted as it prepares to take on the massive task of regulating the area's banking system - a responsibility that was not initially part of the central bank's charter.
3. The ECB does not have the dual mandate of the Fed and is only focused on price stability. The central bank views the area's horrible unemployment problem as being outside of its "jurisdiction". While technically correct, many central bankers would regard this narrow interpretation of the rules as shortsighted.
4. The hawks at the ECB continue to view the disinflationary pressures in the euro area as transient.

Reuters: - The ECB is running official interest rates at a record low but unlike other major central banks has resisted calls to follow that move with outright "quantitative easing" to pump more money into the economy.
[Bundesbank President Jens] Weidmann said that about two thirds of the falloff in euro zone inflation to 0.7 percent, the lowest since the economy was deep in recession in 2009, could be attributed to falls in energy and food prices.
"Monetary policy should respond to such factors only in the event of second round effects," he told a conference in Berlin, saying he would not talk about current monetary policy ahead of the ECB's monthly policy meeting next Thursday.
"With regard to the rate of inflation at the moment, the euro area is not in a self-enforcing downward spiral of price decreases, which is nominally the definition of deflation," he said.
5. The ECB has been heavily focused on the recent improvements in corporate growth, particularly the PMI indicators. Markit indices for example show a steady recovery from the 2012 lows.

Mario Draghi has been speaking about these improvements lately but he continues to ignore some warning signs hidden in these numbers.

Markit: - Policymakers will be encouraged by the survey in terms of the signs of sustained recovery. However, concerns will persist regarding the deflationary forces, especially in the periphery. With prices charged by manufacturers and service providers both falling again in March, there remains an argument for further stimulus, especially if the rate of growth of activity cools again in April.
6. The central bank is also hanging its hat on improving sentiment surveys in the euro area - see Twitter post. The thought is that if consumers and businesses are happy, credit growth will somehow stabilize. Perhaps. But the mood of these crisis-weary survey participants can easily turn if the area's labor markets do not heal soon.
7. The policymakers are also betting on the fact that the rapidly falling long-term rates in the Eurozone periphery will provide some "natural" stimulus to the area's economy. Indeed, as the markets perceive lower risks of default, the yield declines on longer-dated periphery sovereign paper have been quite spectacular. The OMT backstop provided by the ECB has certainly helped.


The reason behind these recent sharp declines in yield however has to do with bets on disinflationary pressures and a subsequent easing action by the ECB.

Reuters: - Spanish, Italian and Portuguese bond yields hit multi-year lows on Thursday, with speculation about further European Central Bank monetary policy easing prompting investors to seek the bigger returns offered by lower-rated assets.
Should the ECB fail to act, these yields will inevitably rise. It is also important to note that low government borrowing costs are no guarantee of stimulus to the private sector. The private sector can not or is unwilling to borrow, reducing the impact of lower benchmark rates.
Ultimately the ECB could be right and some day the Eurozone economy will heal itself - as the banking system is "restructured". But that was also the attitude in Japan years ago as the nation undertook its banking reform. Yet deflation in Japan persisted for years. Is the ECB willing to take that chance?

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When Inequality Isn’t

By John Mauldin

Getting Old Has Its Rewards
The Usual Suspects
The Myth of Increasing Income Inequality
South Africa, New York, Europe, and San Diego

“An imbalance between rich and poor is the oldest and most fatal ailment of all republics.”

–Plutarch, Greek historian, first century AD

“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

“Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”

–Frédéric Bastiat, “That Which Is Seen and That Which Is Unseen,” 1850

“Still one thing more, fellow-citizens – a wise and frugal Government, which shall restrain men from injuring one another, shall leave them otherwise free to regulate their own pursuits of industry and improvement, and shall not take from the mouth of labor the bread it has earned. This is the sum of good government, and this is necessary to close the circle of our felicities.”

–President Thomas Jefferson, first inaugural address

Plutarch argued over 1900 years ago that it was income inequality that lay at the heart of the failure of the Greek republics. Other writings of that period demonstrate that the leaders were worried about the distribution of wealth in society. The causes of unequal distribution have certainly changed over time, but it seems to be built into our DNA to obsess over what we have relative to what others have.

That we are living in the most splendid golden age in the history of humanity – if by golden age we mean that for the world at large there is less hunger, longer lives, less poverty, better healthcare, better and more universal education, and a host of other factors that are manifestly superior as compared to 2000, 1000, 200, 100, 50, and even 20 years ago – is patently evident. We are far from the world Thomas Hobbes described in 1651 in Leviathan when he said “[T]he life of man [is] solitary, poor, nasty, brutish, and short.” He would be amazed at the relative abundance achieved by mankind in the last 463 years.

And still, authority after authority the world over, in rich country and poor, from the President of the United States to the leaders of some of the most impoverished nations, describes income inequality as a fundamental injustice and the source of many problems .

We have spent three letters (so far) dealing with the topic of income inequality. The topic is everywhere in our daily conversation and in economic research. I’ve dealt with many of the facts of income inequality in these three issues and will try to conclude the topic this week. We’ve discovered so far that income inequality is a fact; however, income mobility has remained roughly the same over the last 40 years. That is, a person’s chances of rising from a lower stratum of wealth distribution to a higher stratum is approximately the same as it was in 1975.

We have liberals and progressives who use data to demonstrate the correlation between income inequality and recessions or slow growth and then erroneously equate correlation with causation. I think we have sufficiently shown the absurdity of their conclusions. This week we will look at some of the actual causes of income inequality, and in an argumentum ad absurdum I will offer “solutions” that I guarantee can absolutely reduce income inequality just as easily as taking money from the rich and giving it to the poor. In fact my solutions are far more direct, as they affect the causes rather than the effects of income inequality. I must warn you, however, that if you harbor a religious passion for pursuing higher taxes rates on the rich and rely on income inequality as your excuse, you may not be happy with my suggestions or with the rather inconvenient facts I present.

I would like to begin this week’s letter with a quote that might at first appear to have nothing to do with income inequality, but it strikes me that it is at the heart of the argument advanced by those who favor more progressive taxation. Charles Gave argues that there is a correlation (and he sees causation) between the financial repression perpetrated by central banks and the reduction of growth in the developed-world economies. And he links the low-interest-rate policies of central banks to an increased Gini coefficient and income inequality. Those of us who are of a more classical economic persuasion will find this correlation more attractive than we do the supposed one between income inequality and recessions. And we will see that the logic behind Charles’s argument is more compelling.

The simple fact is that there are many correlations to be found in the economic world, and politicians find economists useful in supplying justifications to support almost any policy. The fact that economists might not agree on the data that is used in this way is immaterial to politicians who are simply looking for an excuse to do what they want to do anyway. In this regard, economists perform the same function as shamans and witch doctors in tribal societies, who regard the entrails of sheep or some other unfortunate animal and predict the future, which generally corresponds to what the chief wants to hear. Economists are far more advanced than that, of course. We painstakingly gather data and develop complex computer models to show what our politicians want to hear.

I realize that I argue at the extreme and that most economists are actually well-intentioned and trying hard to figure out how the world works. But they cleave to economic theories in much the same way that people hold religious beliefs to try to explain how the world functions. These theories often predetermine the conclusions economists come to when they analyze data. Maybe someday we will have more precise models and better theories, but until then it is probably best to be somewhat humble in setting forth our conclusions.

Now, let’s devote a few moments of our attention to six paragraphs from Charles Gave’s latest note ( – subscribers only) (emphasis mine):

I read everywhere that the US budget deficit is contracting because government consumption is falling as a percentage of GDP, now that the worst of the crisis has passed. This would be very good news indeed; however, I am not so sure that this decline is for real. In fact, I believe it is an accounting illusion.

Over a period of time long [interest] rates, if left to their own devices, always converge to the nominal GDP growth rate (this was called the “golden rule” by Economics Nobel laureate Maurice Allais, and [this] is the core belief in Knut Wicksell’s theory). However, a central bank can fight against this natural tendency by maintaining short rates at abnormally low levels, as the Federal Reserve did from the early 1970s until 1980 and again since 2002. During these two periods long rates were conspicuously lower than growth rates, violating the golden rule.

If negative, the difference between long bond rates and the economic growth rate is effectively a subsidy paid by the saver to the government. In short, this difference measures the amount of financial repression taking place in an economy. The fact that it is not paid to the Treasury does not mean it doesn’t exist. It is a tax paid by a nation’s savers – e.g., pensioners in Peoria….

This shows us that US savers have been paying a virtual tax equivalent to between 1% and 2% of GDP almost every year since 2002 – a sign of the “euthanasia of the rentier” central to every Keynesian analysis. The problem is that subsidizing government spending ultimately leads to lower productivity, slower structural growth and higher financial-crisis risk. We saw a similar euthanasia from 1966 to 1980, when the real structural growth rate of the economy was also in collapse…. The re-imposition of that dreadful tax by Alan Greenspan in 2002, only to be further aggravated by his successor Ben Bernanke, is a key factor behind the falling structural growth rate, the financial crisis and the subsequent slow recovery.

Unnaturally low funding costs undermine the structural growth rate of the US economy, because of capital misallocation. The losers in this deal are usually ordinary folk. Pensioners get no interest on their savings, while rich investors use cheap capital to chase up the cost of property, oil, etc. The Gini coefficient rises, as the poor are seldom asset-rich, and real disposable incomes take a hit as prices rise. Sometimes banks are pressured to make up the shortfall with consumer loans to the struggling classes – adding to the bonfire when the inevitable financial crisis comes.

At the end of the day, it is simple. Savings equal investments, so any tax on savings leads to lower economic growth over time. We may be seeing declining ratios in government spending as a percentage of GDP, but this is really an accounting decline. Financial repression means the government is still taxing the savers, leaving less aside for meaningful investment in the future.

Charles’s fellow Frenchman, Bastiat, argued (as I quoted in the opening of the letter) that in economics there is both what we see and what we don’t see. Charles argues that what we see is declining government spending as a percentage of GDP, but what we don’t see is the “contribution” of financial repression and a tax on savers in making up the difference.

With regard to income inequality, what we see is the growing gap between the 1% and the rest of the world. What we don’t see (because it is not often talked about in the New York Times or economics journals) are the natural and real reasons for that inequality. Most of the reasons for income inequality are in fact things we do not want to discourage. While we could devote multiple chapters of a book to each reason (and there is a massive amount of research on each), today we’ll stay focused on the big picture.

Getting Old Has Its Rewards

The most significant factor in income inequality, which some research suggests is close to 75% of the problem, is that  human beings get older. And the older you get, the more money you make and the more net assets you typically have. Let’s look at a few charts to give us a visual picture.

At every point across the net worth curve, the older you are the more likely you are to be wealthier, up until the time you cross into serious retirement and begin to consume your savings.

Furthermore, your income tends to rise the older you get (again, up until retirement age). The data shows that the peak earning period stretches between ages 45 to 65. This is not a shocking revelation, but it doesn’t get mentioned often enough in the debate about income inequality.

I think you can make the case that rising income inequality is significantly attributable to Baby Boomers reaching their peak income years. There are other factors, of course, but the demographics are what they are. Boomers are reaping the rewards from investing time and money in themselves and their businesses over 40+ year careers. They are able to develop and capitalize on three factors. (I’m pulling these off the top of my head; there may be more.)

1. Savings compounded over 40+ years in the workforce

2. Skills developed over 40+ years in the workforce

3. Networks developed over 40+ years in the workforce

It therefore seems logical that income inequality should be rising as the pig in the US population python reaches age 45-65.

The question that goes begging is … what happens next? What happens if medical technology allows Boomers to extend their lifetimes, and perhaps dramatically?

If you really want to start pondering very-long-term issues, what happens when medical technology allows the next generation of elders to live not a mere 10 years longer but to the age of 120 or 150? Will the age at which people are subjected to the Soylent Green solution be 130 instead of 30? Sadly, that will be a problem my kids get to deal with. But I digress.

Academic scholars are beginning to argue that conclusions about income inequality should be adjusted for age-related reasons. You can see one such paper, from Norway, with links to many others, at The authors demonstrate that age factors are significant across a range of countries and that when you adjust for age, income inequality (with the obvious exception of the extreme 1/10 of 1%) narrows dramatically.

(Hopefully we will see a detailed research paper on aging and income inequality written by retired North Carolina State professor John Seater in an upcoming Outside the Box.)

The Usual Suspects 

While it may be inconvenient for those who want to blame income inequality on factors deemed politically correct, it should not come as a shock that much of the inequality can be attributed to characteristics that most people hold as positive values.

A report from the American Enterprise Institute gives us a good summary. Notice in the chart below that while the income of the highest fifth of the US population is almost 18 times that of the lowest fifth, there is only a 3.5x differential when it comes to the average earnings of the people actually working and making money in the household. It is just that high-income households have more than four times as many wage earners (on average) as poor households.

And married and thus two-earner households make more than single-person households. That seems obvious, of course, but it is a significant factor in income inequality. That doesn’t make the plight of the single working mom any better or easier, but it does help explain the statistical difference. And it does make a difference in lifestyle. Marriage drops the probability of childhood poverty by 82%.

And as we noted in previous letters on income inequality, education is an important factor, too. The relationship between families with higher incomes and the educational attainment of their children is also quite statistically significant.

The AEI report ends on this positive note:

Bottom Line: Household demographics, including the average number of earners per household and the marital status, age, and education of householders are all very highly correlated with household income. Specifically, high-income households have a greater average number of income-earners than households in lower-income quintiles, and individuals in high income households are far more likely than individuals in low-income households to be well-educated, married, working full-time, and in their prime earning years. In contrast, individuals in lower-income households are far more likely than their counterparts in higher-income households to be less-educated, working part-time, either very young (under 35 years) or very old (over 65 years), and living in single-parent households.

The good news is that the key demographic factors that explain differences in household income are not fixed over our lifetimes and are largely under our control (e.g. staying in school, getting and staying married, etc.), which means that individuals and households are not destined to remain in a single income quintile forever. Fortunately, studies that track people over time indicate that individuals and households move up and down the income quintiles over their lifetimes, as the key demographic variables highlighted above change…. And Thomas Sowell pointed out earlier this year in his column “Income Mobility” that:

Most working Americans who were initially in the bottom 20% of income-earners, rise out of that bottom 20%. More of them end up in the top 20% than remain in the bottom 20%. People who were initially in the bottom 20% in income have had the highest rate of increase in their incomes, while those who were initially in the top 20% have had the lowest. This is the direct opposite of the pattern found when following income brackets over time, rather than following individual people.

It’s highly likely that most of today’s high-income, college-educated, married individuals who are now in their peak earning years were in a lower-income quintile in their … single younger years, before they acquired education and job experience. It’s also likely that individuals in today’s top income quintiles will move back down to a lower income quintile in the future during their retirement years, which is just part of the natural lifetime cycle of moving up and down the income quintiles for most Americans. So when we hear the President and the media talk about an “income inequality crisis” in America, we should keep in mind that basic household demographics go a long way towards explaining the differences in household income in the United States. And because the key income-determining demographic variables change over a person’s lifetime, income mobility and the American dream are still “alive and well” in the US.

The Myth of Increasing Income Inequality

Now let us turn to to a fascinating if lengthy article from the Manhattan Institute. The report is by Diana Furchtgott-Roth, and it’s a treasure trove of data. It is exceptionally well footnoted and uses the same data available to all researchers from government sources. It just offers the data up in a manner that doesn’t play to a progressive/liberal narrative that is looking for an excuse to increase taxes and engage in income redistribution. Let’s look at her introduction:

Published government spending data by income quintile show that the ratio of spending between the top and bottom 20 percent has essentially not changed between 1987 and 2012. In terms of total spending, inequality is at the same level as 1987.

Why do other measures show increasing inequality? First, many studies use measures of income before taxes are paid and before transfers, such as food stamps, Medicaid, and housing allowances. Including these transfers reduces inequality.

Second, many studies do not take into account demographic changes in the composition of households over the past 25 years. These changes include more two-earner households at the top of the income scale and more one-person households at the bottom. Studies that show increasing inequality are capturing these demographic changes.

Third, some of this increase in measured inequality is due to the Tax Reform Act of 1986, which lowered top individual income-tax rates from 50 percent to 28 percent, leading more small businesses to file taxes under individual, rather than corporate, tax schedules (Joint Committee on Taxation, “General Explanation of the Tax Reform Act of 1986” (H.R. 3838, 99th Congress, Public Law 99-514), May 4, 1987).

A superior measure of well-being that avoids these pitfalls is real spending per person by income quintile. Spending power shows how individuals are doing over time relative to those in other income groups. These data can be calculated from published consumer expenditure data from the government’s Consumer Expenditure Survey. An examination of these data from 1987 through 2012 shows that inequality has not changed. [Emphasis mine]

Is Inequality Increasing?

Ask almost anyone the most important economic facts about income distribution in America, and you are almost certain to hear that income distribution has worsened dramatically over the past generation and over the past decade in particular, with people at the top getting a bigger fraction of total personal income.

But measuring inequality is not simple. The choice of the measure of income, along with the measure of the household unit, substantially influences the results of the inequality measure. Should income be measured before the government removes taxes, or after? Should income include government transfers such as food stamps, Medicare, Medicaid, unemployment benefits, and housing supplements? Furthermore, should wealth measures be included?

In order to measure inequality, disposable income is the most accurate measure. This is what Americans can spend to make themselves better off. Hence, income should be measured after taxes are paid because households cannot avail themselves of tax revenue for expenditures. Similarly, income should include transfer payments because those are available for spending.

The report goes on to give us in detail a number of charts and data in support of the conclusions listed above. Those interested can read it for themselves, and those who wish to argue with it need to offer reasons why the analysis is not valid. Let me offer a couple of interesting observations I get from reading the report.

As noted above, there is a high correlation between income inequality and single-person households. The data from the US Census Bureau shows that the number of single-person households has more than doubled in the last 50 years. Is it any wonder that income inequality in an absolute sense – as measured by household (which is the standard measure cited in the press and used in most academic economic studies) – has risen dramatically during that time?

You can slice and dice the data (and Furchtgott-Roth does) by gender, age, marital status, family status, and so on. None of the outcomes are other than what you would expect them to be.

A few more interesting tidbits:

Another factor that can influence measures of inequality is changes in the tax code. The Tax Reform Act of 1986 lowered the top individual tax rate to 28 percent, and the corporate rate to 35 percent (Joint Committee on Taxation, “General Explanation of the Tax Reform Act of 1986” [H.R. 3838, 99th Congress, Public Law 99-514], May 4, 1987). In 1986, the top individual rate was 50 percent, and the top corporate rate was 46 percent, so small businesses would pay tax at a lower rate if they incorporated and filed taxes as corporations With the implementation of the Tax Reform Act of 1986, the top individual tax rate of 28 percent meant that small businesses were often better off filing under the individual tax code. Revenues shifted from the corporate to the individual tax sector. In the late 1980s and 1990s, that made it appear as though people had suddenly become better off and income inequality had worsened. This had not happened; rather, income that had been declared on a corporate return was being declared on the individual return. This makes any comparisons between pre- and post-1986 returns meaningless.

Finally, inequality appears greater because the cost of living varies substantially in different parts of the country. College graduates tend to move to locations with higher costs of housing, food, and services, such as New York, Boston, Washington, D.C., and San Francisco. College students prefer these cities because they have amenities such as museums, theaters, shopping, and restaurants. As more well-educated people move into these locations, they become more attractive.

What this means for the study of inequality is that high incomes are less valuable in high-cost locations. A $200,000 salary goes further in Mobile than in New York, for instance, and if more $200,000 wage earners move to New York, the distribution of income is more unequal.

Low-income individuals spend a higher proportion of their income on food and clothing, and high-income people spend more on services. The price of food and clothing, nondurables, has been rising more slowly than the price of services, which are disproportionately consumed by higher-income individuals.

I’m going to include one chart from her study, as I find it pretty well demonstrates her point. It turns out if you use actual expenditures on individual items, not much has changed over the last 25 years. There are some significant differences in a few items such as education and clothing, but by and large the ratios among income quintiles for real expenditures per person have not changed all that much. That is not what you would conclude from stories in the press. Note: this is about expenditures and not incomes.

At the beginning of this letter I promised you a “solution” to income inequality. Let me offer this one tongue-in-cheek, as an argumentum ad absurdum.

We simply need to penalize the incomes of older people, take away any advantage there is from being married, reduce opportunities for education, penalize people for working more than 35 hours per week, and of course levy a significant tax on any accumulated savings. This will quickly reduce inequalities of income. It has the slight disadvantage that it will also destroy the economy and create a massive depression; but if the goal is equal outcomes for all, then communist Russia might be the model you are looking for. Except that even there the bureaucrats and other insiders did quite well.

And speaking of insiders and cronyism, that is a serious part of the problem of income inequality. This report from the Heritage Foundation offers some real meat:

While many on the Left – particularly the Occupy Wall Street movement – confuse the two, free-market economics could not be more different from crony capitalism. Whereas the free-market system treats all players equally, from the largest conglomerate to the smallest mom-and-pop shop, crony capitalism rigs the rules of the game in favor of the entrenched big players.

Whereas the free-market system celebrates and encourages competition, crony capitalism is about shielding the powerful and well-connected from competition. Subsidies, which have no place in a free-market system, form a basic staple of crony capitalism, as do waivers and bailouts.

In the long run, Americans pay a heavy price for this marriage of business and government. Crony capitalism forces taxpayers to subsidize well-connected players and restricts opportunities for the rest of us. As Paul Ryan has explained:

Pitting one group against another only distracts us from the true sources of inequity in this country—corporate welfare that enriches the powerful and empty promises that betray the powerless…. That’s the real class warfare that threatens us: a class of bureaucrats and connected crony capitalists trying to rise above the rest of us, call the shots, rig the rules, and preserve their place atop society. And their gains will come at the expense of working Americans, entrepreneurs, and that small businesswoman who has the gall to take on the corporate chieftain.

If you’re really serious about dealing with income inequality, you need to worry about equality of opportunity in education, and specifically about making sure that the education system is radically reformed by taking it out of the hands of bureaucrats and unions. We need to make sure the economic and legal playing field is level by getting government favoritism and bureaucratic meddling out of the way and making the pie larger for everyone. However, as I demonstrated a few weeks ago, a natural outcome of doubling the size of the economic pie over the coming 15 years will be that there is an even greater differential between those who have next to nothing and those who have accumulated the most. The only way to prevent such an outcome is to keep the total economic pie from growing, and that doesn’t seem like a very good economic policy.

I think it is appropriate to close with another quote from the concluding remarks of President Thomas Jefferson in his first inaugural address:

[A] wise and frugal Government, which shall restrain men from injuring one another, shall leave them otherwise free to regulate their own pursuits of industry and improvement, and shall not take from the mouth of labor the bread it has earned.

Income inequality will not be solved by taxing the rich at higher levels. At some point, that “solution” would reduce savings and therefore investment and thus shrink the total potential for economic growth. To argue any differently is to argue with basic economics and simple math. The goal should not be equality of income or wealth but equality of opportunity. The role of government should be to make sure the playing field is level and the rules are simple and fair.

What constitutes a level playing field will change over time as society becomes richer and technology progresses, but the principle should remain the same. There is a place for the governments of developed economies and their societies to establish safety nets, including healthcare. But these are safety nets, not substitutes for personal endeavor and achievement.

In summary, in the last four weeks we’ve seen that while income inequality is real, increasing taxes and redistributing income is not the answer if the true goal is to improve the incomes and lifestyles of everyone. If we do that, we will actually make the problem worse rather than better.

South Africa, New York, Europe, and San Diego

I finish this letter tonight from Cafayate, Argentina. Sunday I start the trek back to Dallas, where I will be for eight hours – and then take off for 12 days in South Africa. That will mean three straight nights in airplanes, a first for me. I will need that vacation resort, with lots of massages and hydrotherapy, to unwind me. I’m going to try something new this trip and post a few pictures and comments to Twitter. Follow me if you like. After South Africa I’m back home for like a day before I have to run up to New York to do some videos. Then it’s back home for a few weeks (or so it appears) before I head to Amsterdam, Brussels, and Geneva. I’ll come home for a few days and then head to San Diego for our Strategic Investment Conference – one of my real highlights of the year. And then I’ll be home for more than two whole weeks before heading to Tuscany for a few weeks of vacation. Whew. I will be ready to relax at the end of all that travel.

I urge you to consider coming to the Strategic Investment Conference, May 13-16 in San Diego. We have the most phenomenal list of speakers of any conference in the country, I think. If you are trying to figure out how to deal with the Code Red world and find opportunities for capitalizing on the misalignment of government policies, both here and abroad, I think you’ll find no better place to do so. You will be with like-minded people (including the speakers, who typically hang around and meet the attendees!) for three days, and we’ll go deep into ways to position your portfolios for what lies ahead.

Also, I will be speaking for Peak Capital Management on April 24 in Dallas. You can find out more and secure a place by clicking on this link.

There are interesting contrasts here in Northern Argentina. The remarkably fertile valley in which Cafayate is situated is surrounded by towering mountains that change colors dramatically throughout the day. During the trip up to Guafin to see my friend Bill Bonner’s vast collection of rocks and sand interspersed with marvelous little fertile valleys, we encountered some of the most rugged and spectacular canyons I’ve ever seen, either in person or photos. It is as if the Andean gods were competing with each other to create the most stark sculptures imaginable in sandstone and granite. It must have been a violent time, as the players with rocks were clearly throwing them in every which direction, including backwards. The locals keep referring to these 10,000-18,000-foot mountains as the “foothills” of the Andes. And yes, off in the distance you can see the snowcapped ranks of the real mountains. This country is different from the green majesty of the Rockies, not to mention the barrenness of the Big Bend country of South Texas.

I doubt that it will be a short or easy trip, but I do need to somehow figure out how to cross the Andes at a few points. That’s on my bucket list. And from talking with fellow travelers (including an enthusiastic David Kotok), I have put Patagonia on that list as well.

Argentina is an odd mix. Beautiful people, and by that I mean beautiful in terms of graciousness and style, hospitality, and (am I about to make a politically incorrect statement?) their almost anti-French way of accepting strangers into their midst. They are industrious and hard-working, and to look around the country you would think it is quite prosperous.

And yet at least a half a dozen times in the past hundred years Argentina has completely destroyed the value of its currency, wiping out generations that were unable to protect themselves from the devastation wreaked by government bureaucracy. Famine, disease, pestilence, and natural disasters have all attacked the human species, but there are times when I think there is no more pernicious or wicked force than human government. Ensconced down here in what is admittedly a hotbed of radical libertarians, I find myself calling into question my optimism about government and the future of our country. A pessimist is someone who sees the problems in every opportunity, and an optimist is someone who sees the opportunities in every problem. For whatever reason, I find myself constitutionally firmly planted in the latter camp, but sometimes I wonder.

I know the problems our country faces. I’ve written about the problems that the rest of the world faces – and yes, we all confronted them every day in the media. Most of the problems are created by well-intentioned people who have decided they know better than you how to run your own life and business. But the road to hell, as my Less-Than-Sainted Dad often told me, is paved with good intentions. It is the unintended consequences of someone’s good intentions (even our own) that always end up biting us in the ass.

It is time to hit the send button, for which you are probably grateful, as I’m in a rambling, philosophical mood, and you need to go on to more important topics. I will report to you next week from Kruger Park, South Africa. Assuming that I can avoid the lions until I begin my weeklong speaking tour for Glacier next Sunday, starting from Cape Town. It is going to be a fascinating two weeks.

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Sharp dip in trade volumes in India's commodity exchanges

by Commodity Online

Trading volume of commodity exchanges fell 51 per cent to Rs 3.43 lakh crore in the first fortnight of March due to decline in volumes across the board except farm products.

30 Mar 2014

MUMBAI (Commodity Online): Sharp dip wwas witnessed in commodity futures trading volume in 2013-14 with total turn over from April 1 2013-March 15 2014 falling 40% to Rs 98.57 lakh crore against Rs 164.79lakh crore in the corresponding period last fiscal. The impact of commodity transaction tax and over all bearish trends in commodities impacted overall trading sentiments, according to analysts.
Except agri-commodities, all other categories of commodities witnessed fall in trade volume.

Trading volume of commodity exchanges fell 51 per cent to Rs 3.43 lakh crore in the first fortnight of March due to decline in volumes across the board except farm products.

Turnover of all the 17 commodity exchanges offering futures trading in the country, including MCX, NCDEX and NMCE, was Rs 6.96 lakh crore in the same period last year, according to the Forward Markets Commission data.

Trading volumes on the bourses have been hit after the imposition of commodity transaction tax. Besides, investors are also trading cautiously after the Rs 5,500-crore payment crisis came to light on National Spot Exchange Ltd (NSEL) a few months ago.

Turnover from bullion witnessed a maximum fall of over 62 per cent to Rs 1.16 lakh crore during March 1-15 from Rs 3.07 lakh crore in the year-ago period.

Similarly, business from metals like copper declined 60 per cent to Rs 59,345 crore from Rs 1.48 lakh crore. Turnover from energy commodities fell 54 per cent to Rs 73,715 crore from Rs 1.60 lakh crore.

However, there was an increase in the turnover of agri-commodities by over 17 per cent to Rs 94,680 crore during March 1-15 from Rs 80,913 crore in the year-ago period.

To boost the trading volumes, FMC has given freedom to national-level bourses to charge different transaction fee. It has also allowed them to levy different transaction fee based on delivery and non-delivery based contracts.

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US benefiting from reduced policy uncertainty


It is becoming increasingly clear that the Fed's taper, the slowdown in the central bank's balance sheet growth (chart below), is unlikely to damage credit expansion in the US.

Fed's balance sheet (YoY)

In fact - and many economists find this counterintuitive - the certainty of taper trajectory (which is effectively on autopilot) seems to be stimulating loan growth. In the post-financial-crisis world, periods of shifting government policy (both fiscal and monetary) had been quite damaging for the economy. The reduction in nearterm uncertainty with respect to the US fiscal impasse (see story on federal budget and on debt ceiling) is likely to be helping the situation as well. Loan growth acceleration in recent weeks has been quite pronounced.

Total loans in the US banking system (YoY)

This stabilization stands in sharp contrast to what is taking place in the Eurozone (see post) and seems to be fairly broad based. Small US banks, where credit growth had slowed materially in the wake of the US government shutdown, are now showing improvements in non-cash asset growth, especially corporate loans.

To be sure, much of this sudden recovery has less to do with banks suddenly easing credit and more to do with improving demand, especially in the corporate sector. That's because banks typically don't turn on a dime - they loosen credit policies far more gradually as a whole. This trend is therefore more indicative of bank credit facilities being drawn, particularly for working capital. Having said that, the Fed's senior credit officer survey does indicate lending standards easing in Q4 of 2013.
The data on loan growth is supported by high frequency survey results. Last week's ISI Bank Loan Survey index rose to the highest level since 2008. It is increasingly likely that the US economy will not only be able to withstand the gradual conclusion of QE3 but may actually benefit from the reduced monetary policy uncertainty.

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The Turnaround in Emerging Markets and VXEEM

by Bill Luby

While I have a long way to go before I become the next Manny Mota, yesterday I was delighted to be able to pinch hit for Steve Sears of Barron’s for the twelfth time, when I penned Emerging Market Stocks: Have They Hit Bottom? as a guest columnist for The Striking Price.

In the Barron’s article I talk about how rapidly increasing uncertainty and risk in emerging markets during January was largely responsible for the 31.7% VIX spike on January 24, but was nowhere near the levels of June 2013, at least as measured by the CBOE Emerging Markets Volatility Index (VXEEM).

I also used the VXEEM:VIX ratio and some other data to support the idea that emerging markets have likely bottomed and are poised for a bounce. I concluded the Barron’s column with a couple of options trade ideas to take advantage of a reversal in emerging markets.

When I wrote the article, on Tuesday, my position on emerging markets was very much a case of going out on limb. By Friday’s publication date, which includes Tuesday’s option pricing data, emerging markets had already experienced a significant bounce and my emerging markets thesis no doubt sounded much less provocative than it would have three days earlier.

EEM SPY EFA 032814


In any event, I strongly believe that emerging markets (EEM) and VXEEM bear close watching going forward, as the Fed moves toward a new policy direction, emerging markets grapple with rising interest rates in the U.S. and the global economic growth story has many critical ripple effects across the full emerging markets landscape.

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The Easiest In-Depth 10-Minute Market Analysis

By Chris Ebert

Here is a way to analyze the current stock market environment in about 10 minutes or less using just a few simple steps. The following analysis, now in its third year, is presented each weekend in order to give traders an edge in their trading by improving the ability to recognize the current market environment and speed the reaction to any changes in that environment.

This week: step by step instructions for a market analysis using stock options.

Where is the stock market today?

Stocks and Options at a Glance

*All strategies involve at-the-money options opened 4 months (112 days) prior to this week’s expiration using an ETF that closely tracks the performance of the S&P 500, such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY)

The first step in any form of stock-market analysis is to define the current environment for stocks. We want to know not just if a Bull market or a Bear market is currently underway, but how bullish or how bearish.

We do not need to actually trade stock options to glean insight from those options. Here, we will study the performance of just three of the simplest, most basic types of options; and those options will tell us a great deal about the current stock market environment.

The three option trades are:

  1. Covered Calls
  2. Long Calls
  3. Long Straddles

Now, we want these options trades to represent the stock market as a whole, not just an individual stock or a single sector of the economy; so we must use options that represent a basket of stocks. Indices such as the Dow, Nasdaq, and S&P 500 contain enough of a variety of stocks to give us a good idea of the general market. Here, we will use options on the SPDR S&P 500 ETF Trust, widely known by its ticker symbol “SPY”, which encompasses a wide variety of stocks in the S&P 500 index.

Not just any options on SPY will due. We don’t want the options to react too quickly to changes in the market that may not agree with the overall trend. This means we will avoid options that expire in a week or a month, as their analysis tends to produce too much noise. We will also avoid those that expire in a year or more, as they tend to not react quickly enough to produce reliable signals when the market environment changes. For our purposes, options that expire in 4 months (112 days) will suit us well.

One more thing: we can’t just use any old strike price for the options. We need something standard – something that will not change from week to week. For this we will use an at-the-money strike price, since it is always the same as the underlying share price.

What we will have, for each of the trades listed above, is an option on SPY opened 4 months prior to expiration using a strike price that was at-the-money at the time the trade was opened.

For this past week, ending March 29, 2014, this is how the trades performed:

  • Covered Call trading is currently profitable (A+). This week’s profit was 3.0%.
  • Long Call trading is not currently profitable (B+). This week’s loss was -0.2%.
  • Long Straddle trading is not currently profitable (C-). This week’s loss was -3.2%.

Using the chart above, we can see that the combination, A+ B- C-, occurs whenever the stock market environment is currently at Bull Market Stage 3.

What does the current Market Stage indicate?

Now that we know where the stock market is today, we can compare it to similar conditions that have existed in the past. For example, during this past week, ending March 29, 2014, the market entered Bull Market Stage 3. The following chart depicts the conditions the generally occur at each different market stage. Consulting the chart gives us historical conditions that have typically accompanied Stage 3.

Options Market Stages

Click on chart to enlarge

As can be seen on both of the above charts, the stock market tends to progress through the market stages in a particular order. That is – Bull markets tend to progress from Stage 0 through Stage 5, and then repeat those same stages over and over again, beginning at Bull Market Stage 0 and ending at Bull Market Stage 5.

Eventually, all Bull markets come to an end, and it is at that point where Bull Market Stage 5 fails to occur, and is instead replaced by Bear Market Stage 5. A Bear market tends to progress from Bear Market Stage 5 through Bear Market Stage 9, at which point it ends and a new Bull market begins at Bull Market Stage 0.

The progression of the market through the above stages does not always occur in textbook fashion. For that reason, we may find it quite helpful to look at the actual progression of the current stock market, as measured by the S&P 500, through the Options Market Stages, as it has occurred over the past weeks and months.

What is the current trend in the Options Market Stages?

With the same three option trades as above, we can use the combination of the outcome of those three trades to determine the upper and lower limits of each stage using a little bit of algebra.

For example, we can determine the level of the S&P that would result in neither a gain nor loss for a Long Call trade – in other words, a 0% profit. If we perform this calculation weekly, we can then plot the resulting values on a graph. Since a 0% profit from Long Call trading is the dividing line between Long Call profits and Long Call losses, the resulting line on the graph will divide Bull Market Stage 2 from Bull Market Stage 3 (see previous chart to confirm that the only difference between Stages 2 and 3 is the profitability, or lack thereof, of Long Call trading).

Following the above procedure, we can calculate dividing lines for all of the Options Market Stages and then plot them all on a graph, such as the one below. Superimposing the actual performance of the S&P 500 on top of the Options Market Stages gives us a visual representation of how the S&P has progressed recently as compared to how it would be expected to progress in a textbook example.

Options Market Stages 03-29-14

Where might the market go next?

While the intent of this analysis is to provide traders with a current view of the stock market environment, there are some aspects of the analysis that lend themselves to forward-looking assessments. That is to say – the Options Market Stages can offer some insight into the future of the stock market. The reason for this ability is that we are plotting the profit or loss of the option trades at expiration. For example, we can calculate with absolute accuracy, the level of the S&P at the June expiration, 4 months in the future, that would result in a profit for a Covered Call opened now, in the month of March, 4 months prior to expiration. We are not predicting where the S&P will be in 4 months, because nobody knows for sure. Nevertheless, the data provided allows us to gain insight into the future.

Perhaps most obvious among these insights is the ability to predict the maximum level that the S&P is likely to reach in the next few months. For example, the S&P is not likely to go much above 2000, even under the most bullish market conditions, until at least mid-May. To exceed 2000 would cause Long Straddle trades to exceed 4% profits, something that Long Straddle trades rarely do. On the chart, the green line represents 4% profits on Long Straddle trades.

The next most obvious insight is that level of the S&P that would be indicative of a Bear market, from an option trader’s perspective, will vary greatly over the next several months. While it would take a dip to near 1700 in the S&P to currently signal a Bear market, that level at times moves to 1800 through June. To be considered bearish, Covered Call trading must experience losses. On the chart, the red line divides profits from losses, and thus bullishness from bearishness, respectively, should the S&P be above or below that line.

Perhaps not immediately obvious from the chart, is that future performance of the S&P sometimes tends to correlate with the current Options Market Stage. For example, the S&P often meets with brick-wall resistance if it rallies after entering Stage 3. That’s exactly how Bull Market Stage 3 got the nickname “the resistance stage”. Since the S&P did indeed enter Stage 3 recently, there is a good chance it will encounter strong resistance if it manages to rally back toward the neighborhood of 1880.

While studying the above charts, many of us are likely to notice what may appear to be a glaring error – that Bull Market Stages 0 through 5 are identical to Bear Market Stages 0 through 5. But, it’s not a mistake. The beginning of a Bear market is no different than a Bull market. That’s why so many traders are taken by surprise by a Bear market. The differentiation between Bull and Bear generally only occurs at Stage 5, when the failure to bounce higher off of support results in a loss of support, causing sidelined and short traders to be reluctant to buy stocks at the same time stock owners are motivated to sell -  the very definition of bearishness, while a bounce causes the opposite, stock owners reluctant to sell while sidelined and short traders are motivated to buy.

Almost done!

The above analysis is relatively simple, even though it attempts to employ some complex forms of analysis. There are influences from, among others, Elliott wave analysis, Relative Strength Index (RSI), moving averages and related crossovers (MACD) and Bollinger Bands. Yet, the whole analysis takes only a few minutes, even less if we just look at the charts.

It is often helpful to see the analysis from a different frame of reference. We may therefore benefit by breaking up the analysis into its separate parts, and then analyzing those individual parts. For a more in-depth examination of the Options Market Stages, the following 3-Step analysis is provided.

Weekly 3-Step Options Analysis: 

On the chart of “Stocks and Options at a Glance”, option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.

STEP 1: Are the Bulls in Control of the Market?

The performance of Covered Calls and Naked Puts (Category A+ trades) reveals whether the Bulls are in control. The Covered Call/Naked Put Index (CCNPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

Covered Call Trading

Covered Call trading did not experience a single loss in 2013, and the streak endures so far in 2014, continuing a streak of nearly lossless trading extending all the way back to late 2011. That means the Bulls have been in control since late 2011 and remain in control here in 2014. As long as the S&P remains above 1714 over the upcoming week, Covered Call trading (and Naked Put trading) will remain profitable, indicating that the Bulls retain control of the longer-term trend. The reasoning goes as follows:

•           “If I can sell an at-the-money Covered Call or a Naked Put and make a profit, then prices have either been going up, or have not fallen significantly.” Either way, it’s a Bull market.

•           “If I can’t collect enough of a premium on a Covered Call or Naked Put to earn a profit, it means prices are falling too fast. If implied volatility increases, as measured by indicators such as the VIX, the premiums I collect will increase as well. If the higher premiums are insufficient to offset my losses, the Bulls have lost control.” It’s a Bear market.

•           “If stock prices have been falling long enough to have caused extremely high implied volatility, as measured by indicators such as the VIX, and I can collect enough of a premium on a Covered Call or Naked Put to earn a profit even when stock prices fall drastically, the Bears have lost control.” It’s probably very near the end of a Bear market.

STEP 2: How Strong are the Bulls?

The performance of Long Calls and Married Puts (Category B+ trades) reveals whether bullish traders’ confidence is strong or weak. The Long Call/Married Put Index (LCMPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

Long Call Trading

Long Call trading was profitable for almost all of 2013 and thus far in 2014 except for a brief break from August through early October, The return to losses this March marks a shift in sentiment among traders, This is no longer the roaring Bull market that it was a few weeks ago. It is now a market that has lost momentum, so much so that buying Call options is not currently a profitable strategy. If the S&P fails to close the upcoming week above 1837, Long Calls (and Married Puts) will fail to profit, suggesting the Bulls have lost confidence and strength. The reasoning goes as follows:

•           “If I can pay the premium on an at-the-money Long Call or a Married Put and still manage to earn a profit, then prices have been going up – and going up quickly.” The Bulls are not just in control, they are also showing their strength.

•           “If I pay the premium on a Long Call or a Married Put and fail to earn a profit, then prices have either gone down, or have not risen significantly.” Either way, if the Bulls are in control they are not showing their strength.

STEP 3: Have the Bulls or Bears Overstepped their Authority?

The performance of Long Straddles and Strangles (Category C+ trades) reveals whether traders feel the market is normal, has come too far and needs to correct, or has not moved far enough and needs to break out of its current range. The Long Straddle/Strangle Index (LSSI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

Long Straddle Trading

The LSSI currently stands at -3.2%, which is within normal limits. Profits on Long Straddle trades will not occur this coming week unless the S&P exceeds 1898. Anything higher than 1898 indicates the presence of euphoria, often accompanied by lottery-fever-type bullishness, so the S&P exceeding that level this upcoming week would indicate that Bull market of 2013 was once again underway and the recent pullback was simply a pause in the uptrend. While 1898 is not out of the question this coming week, such a level would represent remarkable gains for the week.

Excessive profits on Long Straddle trades, such as those exceeding 4%, will not occur this coming week unless the S&P rises above 1969. Despite the presence of euphoria if the S&P was to reach that level, anything higher than 1969 this coming week would be absurd and would likely to result in some selling pressure. Historically, such absurd bullishness has been associated with subsequent pullbacks and, occasionally, Bull-market corrections. In any case, 1969 is almost certainly out of reach this coming week.

Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P falls to 1792. At or near that level a subsequent breakout is likely. That level is important to watch, as anything below it, should it occur, is likely to indicate a major Bull-market correction is underway, and the market would be at risk of breaking out into a lower trading range. As mentioned in Step 1, if such a lower trading range was to fall below 1714, it could be a very, very bearish signal, while a bounce from that level would be a strong indicator that the market had put in a bottom at a level of strong support.

The reasoning goes as follows:

•           “If I can pay the premium, not just on an at-the-money Call, but also on an at-the-money Put and still manage to earn a profit, then prices have not just been moving quickly, but at a rate that is surprisingly fast.” Profits warrant concern that a Bull market may be becoming over-bought or a Bear market may be becoming over-sold, but generally profits of less than 4% do not indicate an immediate threat of a correction.

•           “If I can pay both premiums and earn a profit of more than 4%, then the pace of the trend has been ridiculous and unsustainable.” No matter how much strength the Bulls or Bears have, they have pushed the market too far, too fast, and it needs to correct, at least temporarily.

•           “If I pay both premiums and suffer a loss of more than 6%, then the market has become remarkably trendless and range bound.” The stalemate between the Bulls and Bears has gone on far too long, and the market needs to break out of its current price range, either to a higher range or a lower one.

*Option position returns are extrapolated from historical data deemed reliable, but which cannot be guaranteed accurate. Not all strike prices and expiration dates may be available for trading, so actual returns may differ slightly from those calculated above.

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Re-Orientation--Russia Looks East

by Marc Chandler

In 1869 the U.S. completed the transcontinental railroad. With shipping interest in the Atlantic and Pacific Oceans, the partners of Brown Brothers, one of the key investment banks of the period, understood the golden spike as linking Europe and Asia. A little more than a century later, the center of gravity in the world economy has shifted. Since the early 1980s, trade over the Pacific has exceeded that over the Atlantic.

Now a new and profound re-orientation appears to be taking place. Traditionally, Russia looks westward to Europe for its energy exports, but now it is making important strides toward diversifying to the energy-thirsty Northeast Asia (China, Japan, South Korea, and Taiwan), which consumes as much, if not more, energy than the United States and Europe. In contrast to Northeast Asia, the traditional European market is sclerotic and officials are debating significant cuts in fossil fuel consumption over the next decade.


When the entire project, called the East Siberian-Pacific Ocean, or ESPO, pipeline is complete, it will be longer than the distance from New York to Los Angeles. While the collapse of the oil prices in mid-2008 threatened to delay construction, a deal struck with China in April of 2009 breathed fresh life into the project.

Transneft, Russia’s state-controlled pipeline company, has built a pipeline from the East Siberian oil fields in Taishet and Talakan to Skovorodino. The three-year and 1,700 mile long construction project was finished last year. Russia also completed modernizing port facilities in Kozmino and intends to build a pipeline from Skovorodino to Kozmino in the coming years, but in the meantime, will use rail to move the oil.

When the entire project, called the East Siberian-Pacific Ocean, or ESPO, pipeline is complete, it will be longer than the distance from New York to Los Angeles. While the collapse of the oil prices in mid-2008 threatened to delay construction, a deal struck with China in April of 2009 breathed fresh life into the project.

In April of 2009, state-owned China National Petroleum Company agreed to lend Russia’s Transneft and Rosneft $25 billion in exchange for building a trunk line from Skovorodino to the Chinese border roughly 40 miles south and guarantee supply of 300k barrels of oil per day for the next 20 years. China will build a 500 mile pipeline on its side of the border to its oil, gas, and refinery assets in Daqing. When the project is complete and integrated with the modern terminal and port facilities in Kozmino, which can accommodate those huge oil tankers, Russia could supply oil to Korea and Japan as well as China. The same general story holds for natural gas. The year-old facility in Sakhalin is operating at a third of its capacity and exporting 2/3 of the liquefied natural gas (LNG) to Japan as well as some to South Korea.

New Competition

The oil that will be carried by the ESPO pipeline is rather interesting itself, which may have a potentially significant impact. It is still early in the process, but the oil is reportedly of a higher quality than the Urals blend, apparently diesel rich and medium heavy sweet. The ESPO blend appears to be a particularly good fit for the refineries in China and Japan. Moreover, this type of oil is not readily available in the spot market. In June of 2009, Russia eliminated the excise tax on East Siberian oil

As the world’s largest oil producer, 10.02 million barrels per day in November of 2009, and with a 2.6% increase year-over-year, is aiming reach 11 million barrels a day in 2010, Russia is competing with OPEC and this new blend opens another front in that competition. Industry experts opine that the ESPO blend competes most closely with Oman’s oil and some suggest that it may even impact Saudi Arabia’s light crude. OPEC may counter with a new blend.

If the ESPO blend impacts OPEC, the Sino-Russian economic operation impacts the U.S. ability to project power in the region. The U.S. has failed to build upon the cooperation and good will of several Central Asian states (think the ‘stans) in the war against terror in Afghanistan in 2002. Additionally, the U.S. has suffered several setbacks, including the loss of bases in the region.

The Chinese-Russian agreement is both a reflection and extension of, the Central Asia’s reorientation eastward, at the increasing exclusion of the United States. At the same time, the economic cooperation between China and Russia is unlikely to prevent continued rivalry for influence in the region. Many of these newly independent countries will jealously protect their sovereignty, and seeking to offset the influence of China and Russia, may open unforeseeable opportunities for the U.S.


If the general argument sketched above is fair, the re-orientation has just begun and there are still a number of risks. Construction could be slow and such projects are often perceived to be fraught with fraud and corruption. They tend to take longer and cost most than initially anticipated.

There are numerous environmental concerns, including the proximity of the ESPO pipeline to Lake Baikal, the world’s largest fresh water lake. Some observers have also expressed concern about the potential for earthquakes in the region.

The new grade of oil is still somewhat uncertain and the quality parameters do not appear to have been fully determined. Russia also reportedly has its own way of doing business, which is different than what is customary in Asia.

More important, from a financial point of view, the relationship between the state and state businesses is ambiguous as the recent experience of Dubai World, Fannie Mae, and Freddie Mac, illustrate. This raises legal questions for investors in parts of the world for which property rights have yet to fully congeal.

Novus Ordo

The rise of China, and the industrialization and modernization of East Asia in general, is part of the re-orientation of the global economy. Europe seems to be the primary loser in this process. After all, the U.S. is as much a Pacific as Atlantic power and its share of the world GDP has remained relatively steady over the past few decades.

The biggest threat to open maritime commercial regimes, like Pax Americana and Pax Britannia before it, are more closed, land-based regimes which are typically less trade oriented, or more mercantilist (and typically more egalitarian). It is the parameter against the heartland; it is the successors of Athens clashing with the heirs of Sparta. The re-orientation of central Asia, including Russia, could pose such a geostrategic threat in the future.

More immediately, the investment opportunities may require higher levels of anticipated returns to compensate for the risks posed by lack of transparency and clear rule of law. On a macro-level, the currencies, bonds, and equity markets of Russia and China are unlikely to be influenced from these factors, even if there are individual company level or sector opportunities.

While investors and speculators in American railroads, one of the wild emerging stock markets for much of the 19th century, struggled to make money, the golden spike created unimaginable opportunities and forever changed the American landscape and social fabric. So too does the re-orientation of central Asia, particularly Russia, toward Northeast Asia represent a potentially significant shift in the contours of the world economy, unleashing new forces of creative destruction.

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