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Risk Of Grexit And GLD

Background of the difficult economic conditions of the eurozone and the threat of Syriza’s victory in Greece. GLD has already priced in the threat of Syriza since November 2014 and has been rising steadily. Those who wants the safe habour of gold has already gone in. Risk of Syriza overtipping its hand for a quick fix to high debt with a primary budget surplus even though there are indications that Syriza will be moderate in power. Time to hold for those with GLD exposure and observe future developments and for those without exposure to initiate it. Difficult Times For The Eurozone Gold has been used been used as a medium of exchange since historic times and especially in times of turmoil. In modern times, with the creation of bank notes and the 1971 closing of the gold window, paper money is the medium of exchange and its power lies in the ‘full faith and credit of’ whichever government that is issuing the note. Now the full faith and credit of the United States Government is still valid in the market especially in a time where the U.S. economy is growing strongly (11 year high of 5% GDP growth in the third quarter of 2014), the U.S. Dollar (USD) is strong and most importantly the state of the union is strong. However the same attributes cannot be said for the eurozone. The eurozone economy is faltering at 0.2% growth for the same third quarter 2014 when the U.S. is growing strongly. The euro, as represented by the CurrencyShare Euro Trust ETF (NYSEARCA: FXE ), has declined by 23% since 05 May 2014 as seen in the chart below and this decline has accelerated since October 2014 which coincided with a dovish European Central Bank (ECB) decision. (click to enlarge) Lastly there is the issue regarding the state of the eurozone. The integrity of the eurozone had been tested in 2012 when Greece almost elected Syriza who came in second into government. This sparks the famous line by ECB President Draghi to ‘do whatever it takes’ to preserve the euro. The Rise and Threat of Syriza on Eurozone Now with the snap General Election on 25 January 2015, Syriza has defeated the previous government New Democracy to form the next government of Greece and its firebrand leader Alexis Tsipras would be youngest Greek Prime Minister at age 40 in 150 years. The whole reason that Syriza poses an existential threat to the whole eurozone project is quite simply because it does not want to pay its huge external debts. Its policy platform is anti-austerity, the repudiation of debt in essence and more social spending. This is what got it in power in the very first place which pleased the Greek population and at the same time send an earthquake to the rest of the eurozone. This whole political instability came about from the failed election of President of Greece. The President of Greece is a largely ceremonial role held currently by the incumbent Karolos Papoulias for 2 terms of 5 years each. His second term is set to end in March 2015. The President of Greece is elected by the Hellenic Parliament in Greece and has to be done latest 1 month before he is set to leave office as decreed by the Greek Constitution. The Prime Minister of Greece Samaras brought it forward to December 2014 but he was unable to secure a 2/3 majority of parliament vote for his candidate on the first 2 rounds of voting on the 17th and 23rd. The third round of voting on the 27th also failed to produce the reduced 3/5 majority of 180 votes which triggered the election for a new parliament on 25 January 2015. The new parliament will have to vote for the new president again by February 2015. Safe Harbor of GLD If you are a rich or middle class citizen (with enough money beyond the hand to mouth existence to be worried) in Europe and you are faced with the possibility that the euro note you hold can either be worthless or in the more optimistic case, be exchanged back at a steep discount to the national currency, what will your natural options be? You will avoid European equities and bonds because they are denominated in euros. You might want to change into a currency like the USD that will hold its value or you might want to buy physical gold which is harder to devalue or you might want to invest into a gold ETF denominated in the USD like GLD to avoid the storage and insurance costs. This is why we can see that the value of gold, as seen in the SDPR Gold Trust ETF (NYSEARCA: GLD ), has rose steadily since 03 November 2014 whenever there is a hint of potential political instability in Greece. (click to enlarge) As we can see, the market is forward looking and has began to price in the Greek instability before the formal vote in the Hellenic Parliament. Gold investors started to buy when the rumor of the a potential change in government given the weakness of the current Greek coalition government. This is why we are unlikely to see a sudden spike up in GLD now because the market has sufficient time to build their long position. Even for those who are less connected, they will have seen in coming last month when the rounds of Presidential election failed in Parliament. History of Debt Concession However now that Syriza has formed the new government,it remains to be seen how far its leader Tsprais will go to fulfill his campaign promises. It is clear that he will want to extract some sort of concession from the Troika. The prior Greek government managed to extend the loan repayment period from the original 7 years to 15 years in July 2011 and interest rates were cut to 3.5% for a mega loan of $109 billion euros loan package. This is the start of the second and ongoing Economic Adjustment Program for Greece after the first program which saw loans of $110 billion euros from May 2010 to June 2011. It is also in this period where we saw a soft default on a debt restructuring deal which concluded on 09 March 2012 on $205.5 billion euro of debt. This caused the ISDA to call a Credit Event which triggered $3.5 billion of credit default swaps and let Fitch to downgrade Greek debt from ‘CCC’ to ‘Restricted Default’. All in all, through this soft default option, Greek debt holders lost a massive $107 billion euros, a record for sovereign debt losses. Is this the calm before or after the Storm? As far as the market is concerned, the eurozone has survived this crisis of soft default with the help of the ECB when other organization were unable to convince the market. This soft default option is therefore unlikely to affect the market drastically. In other words, the extent and pretend scheme coupled with significant haircut works to preserve the eurozone even if it caused dismay to bond holders. Now the market is waiting to see if Syriza will actually dare to defy the Troika and simply walk away from its debt given the consequences. As this Reuters report shows, even as early as 04 November 2014 (coinciding with the rise of gold prices), when Syriza gets closer to power, it has proceeded to soften its stance from the choice of hard default to renegotiation. The German/ Creditor’s position is clear. They are willing to accept a debt restructuring but they will not accept a hard default or any cancellation of debt. This will weaken their position with other debtor countries like Poland, Ireland and Spain. The only risk now is that Syriza will overtip its hand when asking for concessions to the point where it is unacceptable to the Creditors. This is a possibility given the nature of his fiery speech and the expectations of quick relief from the Greek public. (click to enlarge) Source: Google There is a possibility that he will be too engrossed about the quick fix of Greek 175% debt to GDP ratio, which is higher than the rest of Europe. There is also the temptation to turn the Greek’s primary budget surplus of $3.3 billion euros for year 2015 to a current account surplus if they don’t pay off their external debts. The real risk is that Tsprias might then be too willing to leave the eurozone and underestimate the possibility of the hyperinflation tragedy. This might happen when the drachma is reintroduced at a point where the international market has no confidence in it shortly after a massive debt default. Conclusion GLD has appreciated way before the actual victory of Syriza and those who wanted to hold gold already has gold exposure in their portfolio. These are the cautious ones. For the vast majority of the public, it is the fear for systemic unrest on the scale of Lehman Brother collapse that will bring them into gold in doves. This fear will only occur when there are clearer signs of a disorderly Greece Exit (or Grexit). While we believe that Syriza was only posturing to gain power and it might be slightly more aggressive than the outgoing New Democracy government, there is also a serious risk that the inexperienced Syriza will overturn its hand and oversee the expulsion of Greece from the eurozone under its watch. There might be other forces that might tilt the balance inside and outside Syriza towards a cold calculation of benefits and costs that might result in unexpected results. There is still market confidence in the USD and GLD. For those who are upset about the lack of audit for GLD, consider it from the faith and credit angle. Based on the market capitalization of $30.78 billion and last known daily volume of 6.27 million, it is clear that there is market confidence in GLD and you can liquidate it quickly when you need it. However for those in Europe who are worried about capital controls, then it will make sense for them to hold physical gold but they will have to incur cost for storage and insurance. Then there is also the security risk for holding gold against theft or worst. For them, in today’s world without capital controls in Europe, GLD will be a good way to hold their wealth. For investors in general, they would do well to hold onto their GLD holdings especially for those who heeded my earlier advice to buy GLD in my earlier article, The SNB Catalyst For GLD . That article also explored the potential European instability from a different perspective. For those who have nil exposure to GLD, this will be a good time to gain exposure when there will be a brief lull in prices as the market wait and observe the actions of the new Greek government and the official response from the Troika who represent the Creditors.

Ghost In The Machine, Part 1

The way out is through the door. Why is it that no one will use this method? ― Confucius (551 – 479 BC) Tanzan and Ekido were once traveling together down a muddy road. A heavy rain was still falling. Coming around a bend, they met a lovely girl in a silk kimono and sash, unable to cross the intersection. “Come on, girl,” said Tanzan at once. Lifting her in his arms, he carried her over the mud. Ekido did not speak again until that night when they reached a lodging temple. Then he could no longer restrain himself. “We monks don’t go near females,” he told Tanzan, “especially not young and lovely ones. It is dangerous. Why did you do that?” “I left the girl there,” said Tanzan. “Are you still carrying her?” ― Nyogen Senzaki, “Zen Flesh, Zen Bones: A Collection of Zen and Pre-Zen Writings” (1957) In 1995, David Justice had a superior batting average to Derek Jeter (.253 to .250) In 1996, David Justice had a superior batting average to Derek Jeter (.321 to .314) In 1997, David Justice had a superior batting average to Derek Jeter (.329 to .291) Yet from 1995 – 1997, Derek Jeter had a superior batting average to David Justice (.300 to .298) ― example of Simpson’s Paradox, aka The Yule-Simpson Effect (1951) A student says, “Master, please hand me the knife,” and he hands the student the knife, blade first. “Please give me the other end,” the student says. And the master replies, “What would you do with the other end?” ― Alan W. Watts, “What Is Zen?” (2000) Such in outline is the official theory. I shall often speak of it, with deliberate abusiveness, as “the dogma of the Ghost in the Machine.” I hope to prove that it is entirely false, and false not in detail but in principle. It is not merely an assemblage of particular mistakes. It is one big mistake and a mistake of a special kind. It is, namely, a category mistake. ― Gilbert Ryle (1900 – 1976) The trouble with Oakland is that when you get there, there isn’t any there there. ― Gertrude Stein (1874 – 1946) Dr. Malcolm: Yeah, yeah, but your scientists were so preoccupied with whether or not they could that they didn’t stop to think if they should . ― “Jurassic Park” (1993) It’s a big enough umbrella But it’s always me that ends up getting wet. ― The Police, “Every Little Thing She Does is Magic” (1981) Everyone who lost money on the SNB’s decision to reverse course on their three and a half year policy to cap the exchange rate between the CHF and the Euro made a category error . And by everyone I mean everyone from Mrs. Watanabe trading forex from her living room in Tokyo to a CTA portfolio manager sitting in front of 6 Bloomberg monitors to a financial advisor answering a call from an angry client. It will take me a bit of verbiage to explain what I mean by a category error and why it’s such a powerful concept in logic and portfolio construction. But I think you’ll find it useful, not just for understanding what happened, but also (and more importantly) to protect yourself from it happening again. Because this won’t be the last time the markets will be buffeted by a forex storm here in the Golden Age of the Central Banker. A year and a half ago, when I was just starting Epsilon Theory, I wrote a note called ” The Tao of Portfolio Management .” It’s one of my less-downloaded notes, I think largely because its subject matter – problems of misunderstood logic and causality in portfolio construction – doesn’t exactly have the sexiness of a rant against Central Bank Narrative dominance, but it’s one of my personal favorites. That note was all about the ecological fallacy – a pervasive (but wrong-headed) human tendency to infer qualities about the individual from qualities of the group, and vice versa. Today I’ve got the chance to write once again about the logic of portfolio construction AND work in some of my favorite Zen quotes AND manage something of a Central Bank screed … a banner day! I’ve titled this note “The Ghost in the Machine” because it starts with another pervasive (but wrong-headed) human tendency – the creation of a false dualism between mind and body. I know, I know … that sounds both really daunting and really boring, but bear with me. What I’m talking about is maybe the most important question of modern philosophy – is there a separate thing called “mind” or “consciousness” that humans possess, or is all of that just the artefact of a critical mass of neurons firing within our magnificent, but entirely physical, brains? I’m definitely in the “everything is explained by neurobiology” camp, which I’d say is probably the more widely accepted view (certainly the louder view) in academic philosophy today, but for most of the 19th and 20th centuries the dualist or Cartesian view was clearly dominant, and it was responsible for a vast edifice of thought, a beautiful cathedral of philosophical constructs that was … ultimately really disappointing and empty. It wasn’t until philosophers like Gilbert Ryle and Van Quine started questioning what Ryle called “the ghost in the machine” – this totally non-empirical but totally accepted belief that humans possessed some ghostly quality of mind that couldn’t be measured or observed but was responsible for driving the human machine – that the entire field of philosophy could be reconfigured and take a quantum leap forward by incorporating the insights of evolutionary biology, neurobiology, and linguistics. Unfortunately, most economists and investors still believe in ghosts, and we are a long way from taking that same quantum leap. There is an edifice of mind that dominates modern economic practice … a beautiful cathedral where everything can be symbolized, where everything can be securitized, and where everything can be traded. We have come to treat these constructed symbols as the driver of the economic machine rather than as an incomplete reflection of the real world things and real world activities and real world humans that actually comprise the economy. We treat our investment symbols and thoughts as a reified end in themselves, and ultimately this beautiful edifice of symbols becomes a maze that traps us as investors, just as mid-20th century philosophers found themselves trapped within their gorgeous constructs of mind. We are like Ekido in the Zen koan of the muddy road, unable to stop carrying the pretty girl in our thoughts and trapped by that mental structure, long after the far more sensible monk Tanzan has carried the girl safely over the real world mud without consequence, symbolic or otherwise. The answer to our overwrought edifice of mind is not complex. As Confucius wrote in The Analects , the door is right there in front of us. Exiting the maze and reducing uncompensated risk in our portfolios does not require an advanced degree in symbolic logic or some pretzel-like mathematical process. It requires only a ferocious commitment to call things by their proper names. That’s often not an easy task, of course, as the Missionaries of the Common Knowledge Game – politicians, central bankers, famous investors, famous economists, and famous journalists – are dead-set on giving things false names, knowing full well that we are hard-wired as social animals to respond in ant-like fashion to these communication pheromones. We are both evolved and trained to think in terms of symbols that often serve the purposes of others more than ourselves, to think of the handle rather than the blade when we ask for a knife. The meaning of a knife is the blade. The handle is not “the other end” of a knife; it is a separate thing with its own name and usefulness. The human animal conflates separate things constantly … maybe not a big deal in the kitchen, but a huge deal in our portfolios. Replace the word “knife” with “diversification” and you’ll get a sense of where I’m going with this. Here’s what I mean by calling things by their proper names. The stock ticker “AAPL” or the currency ticker “CHF” are obviously symbols. Less obviously but more importantly, so are the shares of Apple stock and the quantities of Swiss francs that AAPL and CHF represent. Stocks and bonds and commodity futures and currencies are symbols, not real things at all, and we should never forget that. The most common category error that investors make (and “category error” is just a $10 phrase for calling something by the wrong name) is confusing the symbol for what it represents, and as a result we forget the meaning of the real world thing that’s been symbolized. A share of stock in, say, Apple is a symbol. Of what? A limited liability fractional ownership position in the economic interests of Apple, particularly its free cash flows. A futures contract in, say, copper is a symbol. Of what? A commitment to receive or deliver some amount of real-world copper at some price at some point in the future. A bond issued by, say, Argentina is a symbol. Of what? A commitment by the Argentine government to repay some borrowed money over an agreed-upon period of time, plus interest. A currency issued by, say, Switzerland is a symbol. Of what? Well, that’s an interesting question. There’s no real world commitment or ownership that a currency symbolizes, at least not in the same way that stocks, bonds, and commodity contracts symbolize an economic commitment or ownership stake. A currency symbolizes government permission. It is a license. It is an exclusive license (which makes it a requirement!) to use that currency as a medium for facilitating economic transactions within the borders of the issuing government, with terms that the government can impose or revoke at will for any reason at all. That’s it. There’s no economic claim or right inherent in a piece of money. As Gertrude Stein famously said of Oakland, there’s no there there. Why is this examination of underlying real world meaning so important? It’s important because there is no positive long-term expected return from trading one country’s economic license for another country’s economic license. There is a positive long-term expected return from trading money for stock. There is a positive long-term expected return from trading money for bonds. There is a positive long-term expected return from trading money for commodities and other real assets. But there is no positive long-term expected return from trading money for money. Unfortunately, we’ve been trained and encouraged – often under the linguistic rubric of “science” – to think of ANY new trading vehicle or security, particularly one that taps into as huge a market as foreign exchange, as a good thing for our portfolios. We are deluged with the usual narratives that alternatively seek to tempt us and embarrass us into participation. On an individual level we are told stories of savvy investors who look and act like we want to look and act, taking bold advantage of the technological wizardry (look! it’s a heat map! that changes color while I’m watching it!) and insanely great trade financing now at our fingertips in this, the best of all possible worlds. On an institutional level we are told stories of liquidity and non-correlation (what? you don’t understand what an efficient portfolio frontier is? and you call yourself a professional?), both good and necessary things, to be sure. But not sufficient things, at least not to cast the powerful magic that is diversification. There are only a few sure things in investing. First, taxes and fees are bad. Second, compound growth is a beautiful thing. Third, portfolio diversification works. At Salient we spend a lot of time thinking about what makes diversification work more or less well for different types of investors, and if you’re interested in questions like “what’s the difference between de-risking and diversification?” I heartily recommend our latest white paper (” The Free Lunch Effect “) to you. One thing we don’t do at Salient is include currency trading within our systematic asset allocation or trend-following strategies. Why not? Because Rule #1 for tapping into the power of portfolio diversification is that you don’t include things that lack a long-term positive expected return. Just because we can trade currency pairs easily and efficiently doesn’t mean that we should trade currency pairs easily and efficiently, any more than cloning dinosaurs because they could was a good idea for the Jurassic Park guys. The point of adding things to your portfolio for diversification should be to create a more effective umbrella, not just a bigger umbrella. I like a big umbrella just as much as the next guy, but not if I’m going to get wet every time a forex storm whips up. So if not for diversification, why do smart people engage in currency trading? There’s a good answer and a not-as-good answer to that question. The good answer is that you have an alpha-driven (i.e. private information-driven) divergent view on the terms of the government license embedded within any modern currency. This is why Stanley Druckenmiller is an investing god, and it’s why anyone who put money with him before, during, and after he and George Soros “broke the Bank of England” in 1992 has been rewarded many times over. The not-as-good answer is that you have identified a predictive pattern in the symbols themselves. I say that it’s not as good of an answer, but I’m not denying that there is meaning in the pattern of market symbols. On the contrary, I think there is real information regarding internal market behaviors to be found in the inductive study of symbolic patterns. This information is alpha, maybe the only consistent source of alpha left in the world today, and acting on these patterns is what good traders DO. But because it’s inductively derived, anyone else can find your special pattern, too. Or if they can’t, it’s because you’ve carved out a nice little parasitic niche for yourself that’s unlikely to scale well. More corrosively, the natural human tendency is to ascribe meaning to these patterns beyond the internal workings of the market, something that makes no more sense than to say that goose entrails have meaning beyond the internal workings of the goose. The meaning of the Swiss franc didn’t change just because you had a consistent pattern of market behavior around the EURCHF cross. Deviation in the expected value of the Swiss franc in Euro terms did not become normally distributed just because you can apply statistical methodology to the historical exchange rate data. I get so annoyed when I read things like “this wasn’t just the greatest shock in the history of forex, it was the greatest shock in the history of traded securities! a 30 standard deviation event!” Please. Stop it. Just because you can impose a normal distribution on the EURCHF cross doesn’t mean that you should . And if you’re making investment decisions because you think that this normal distribution and the internal market stability it implies is somehow “real” or has somehow changed the fundamental nature of what a currency IS … well, eventually that category error will wipe you out. Sorry, but it will. I don’t mean to be snide about any of this (although sometimes I can’t help myself). The truth is that an aggregation of highly probabilistic entities will always surprise you, whether you’re building a baseball team or an investment portfolio. Portfolio construction – the aggregation of symbols and symbols of symbols, all of which are ultimately based on massive amounts of real world activities that may have vastly different meanings and underlying probabilistic natures – is a really difficult task under the best of circumstances for a social animal that evolved on the African savanna for an entirely different set of challenges. And these are not the best of circumstances. No, the rules always change as the Golden Age of the Central Banker begins to fade. The SNB decision was a wake-up call, whether or not you were directly impacted, to re-examine portfolios and investment behavior for category errors. We all have them. It’s only human. The question, as always, is whether we’re prepared to do anything about it.

The Swiss Remind Us Why You Should Always Own Some Gold

Swiss Franc moves throw a wrech in the global currency picture on Thursday. Gold rallies on the news. We think that some capital should always be allocated to gold. By Thom Lachenmann The overnight news about Switzerland left the markets in a frenzy this morning and were no doubt beacons of both fantastic and horrifying news for FX traders who missed the trade and woke up to mayhem. Switzerland’s central bank stopped pegging the franc to the euro, a move that we really can’t blame them for. In trying to “defend” the Swiss franc, the Swiss national bank had ran up quite a bill. So, they let the dam burst, and burst it did. It was a rule put in place in order to keep the currency from getting too strong, a concept that we find ridiculous to begin with. Currencies, of course, get stronger and weaker based on the overall health of the nation’s macro economy. Limiting the strength of your currency is a dopey thing to do, unless you’re an equity market trader with a full scale bullish position. Switzerland’s tactic of lowering interest rates on the franc while doing this didn’t seem to help at all and the franc skyrocketed to all time highs today. Euro to Swiss Franc Exchange Rate data by YCharts Of course, with the whole world expecting Europe to implement some type of economic stimulus, the Swiss Central Bank could have had a real quagmire on its hands trying to defend its currency if there was a flee from the euro. When countries stimulate the way the ECB could potentially do, it generally causes the currency to devalue in a sharp fashion. We were reminded of the benefits of having some gold in your portfolio today, as well. The commodity was up nearly 2% on Thursday after the Swiss news hit the wires. We think there’s a couple reasons that gold got the boost. First, obviously, people that are having “flights to safety,” as Reuters called it, are simply getting into the precious metal as a portfolio hedge or as a safe haven for capital. Secondly, we believe that the notion of Switzerland unpinning their currency from a major national bank reminds people about the true value of gold, when looked at as a non-recurring resource. Gold is held in reserves by these types of central banks for these reasons, and today’s move by the Swiss shows that not ALL countries have drifted into the “Keynesian Dream” that the US, China, and ECB are in. Swiss equities were crushed, down 11% when U.S. markets opened on Thursday morning. When countries take the “unpopular” but safe moves of thinking Austrian, gold flourishes. This type of move is a nice subtle reminder to note when we’re always going to think of gold as a great safe haven for investors and something that a well balanced investor should always allocate some portion of their capital too, whether it’s through funds or the physical commodity.