Fluid dynamics within the markets

Approximately 10% of all companies listed on Nasdaq and NYSE fell by more than 10% over the past week. Its like a magnitude 5 earthquake happened and the entire market goes into panic mode.

During this occasion, it is fascinating to observe at a macro level the flow of money within the system.

Sources of liquidity

  • the white house administration has cut taxes over the past 2 fiscal years between 2017 and 2018.
  • the Federal reserve increase money supply through the repo market and by lowering interest rates
  • Central banks around the world lower interest rates
  • the high US dollar signals that money from around the world is flowing into the US market

High pressure areas

  • the price of gold moves steadily upwards
  • the price of US Treasury bonds signaled by the fall in US Treasury yield moves steadily upwards
  • the SnP hovers near all time high
  • Companies classified as value stocks are trading at all time high multiples

Anomalous vacuum

  • Companies classified as growth stocks are trading at huge discounts versus all time highs

Once the psychological impact of the current set of stimulus wears off and assuming the supply of money stays constant within the US market, it is very likely money will start flowing from high pressure areas to fill up the anomalous vacuum described above.


LA trip to visit Johnson

  • Textile and clothing companies need to forecast demand to reduce inventory cost
  • Building a team is the most important thing
  • in times of volatility buy put options on VIX and long Gold
  • Small business owners
    • are supporters of protecting US businesses against intellectual property theft by Chinese companies
    • consider Chinese company methods of manipulating accounting statements fraudulent
    • consider news reported in major news networks to be fake
    • consider Democrats to have given away to many privileges to other countries thereby putting the US economy at a disadvantage
  • Real estate development
    •  Bulk of building materials are imported from China and subjected to taxation
    • put on hold until trade war is over to avoid incurring tariffs as production cost
  • Real estate hard money loans
    • usual fees
      • 2% transaction fee
      • 10% annual interest rates
    • Preferred customer fees
      • 1% transaction fee
      • 9-10% annual interest rates

Key insights from mooncake festival at house of Jerry and Liza

Technology trends

  • Companies are increasing shifting their service from one-off on premise licensing deployment monetization to cloud based SaaS recurring subscription models
    • revenue hit in the short run
    • increased customer LTV in the long run
    • affected publicly traded companies will experience short term discounts to their shares
  • Artificial intelligence versus Augmented intelligence
    • companies are increasingly shifting away from automatic insight generation to systems that help decision makers simulate and model potential outcomes when specific policies are executed
    • demand is shifting from insight generation to data cleaning services
  • Corporate adoption of artificial intelligence
    • CEOs are increasingly considering how to leverage AI as a tool for their trade
    • primary use case is figuring out how to increase their sales volume
    • experiencing challenge on how to apply AI on in-house data to achieve monetization goals
  • Rise of deep vertical data networks
    • EverString – provides sales lead refresh for all client companies ends up becoming a large database for decision-making executives information, approximately 6 million records
    • StreetSine.sg – cleans up real estate data to help agents better price houses for sale by utilizing in-house agency ends up becoming a large database of high quality real estate data
  • Crypto-currency
    • Bit coin is still the main poster child
    • general population still skeptical about libra
    • main argument is still to remove central bank controls
    • main adoption hurdles
      • writing throughput volume
      • a stable store of wealth
      • starting to be using as a means to facilitate transaction in China
      • Inability to increase or decrease currency supply in times of need is going to be hard as a means to provide much needed stimulation during economic recessions and inflations

US/China trade war

  • sources of conflict
    • technology theft
    • forced technology transfer
    • unfair trade practices like subsidized state owned Chinese companies operating in the export markets
  •  economy
    • China is experiencing inflationary deleveraging
      • local farmers are not growing critical food sources
      • critical food supplies are imported
      • price of imported goods are denominated in US reserve currency
      • shifting of supply chain out of China to
        • Vietnam
        • India
        • Taiwan
      • capital flight
        • Li Ka Shing moved funds out from Hong Kong in 2013 to Europe
        • raising funds for US Venture capital from China was easy prior to Chinese and US government shut down
    • US is experiencing deflationary deleveraging
      • businesses are concerned about macro environment and are reducing fixed investments
      • manufacturing is slowing due to decreased demand both locally and overseas
      • consumer spending and confidence is still strong
  • Chinese domestic concerns
    • Potential US meddling in Chinese domestic affairs – Hong Kong’s demonstration and demands
      • Revoking of National Education
      • Revoking of extradition bill
      • Resignations of HK Chief executive
      • universal suffrage: freedom to elect their own leaders
    • destabilized situation presents a challenge for Xi JinPing’s party to retain control of power over former Jian Zemin’s faction
  • value system
    • US is a highly rule based system
    • China’s system of control is highly subjective to the individual in power.  Direct government intervention in the distribution of wealth is a major source of concern

US/Mexico and world issues

  • NAFTA agreement was too one side and failed to take into account large  imbalance between the two economies
  • US’s arrangement of allowing Mexican tax payers the right to claim dependents ultimately resulted into tax claims and refunds for entire extended families in Mexico. This has the effect of subsidizing Mexican’s at the expense of Americans living along the rust belts
  • Its observed income inequality is becoming prevalent across the entire world not just within US and China.

Related readings

Book summary: Understanding big debt crisis by Ray Dalio

The economic system

Functions of money

  • A store of wealth
  • a means of exchange

Two types of cycle

  • economic cycle
    • tied to production activity and output
  • credit cycle
    • the underlying basis is trust
    • capital employed as a means of production
    • when trust breaks down and credit starts to tighten credit cycle is said to be in the contraction phase and deleveraging occurs

Types of deleveraging

  • inflationary deleveraging
    • generally occurs when country’s currency is not a reserve currency or when currency is pegged to a specific commodity like gold
    • foreign lenders are unwilling to roll over existing credit or provide new credit leading to credit contraction within the economy
    • price of good rises during an inflationary deleveraging
  • deflationary deleveraging
    • generally occurs when country’s currency is a reserve currency
    • money is hoarded as cash instead of being utilized to support economic activity
    • domestic lenders are unwilling to provide credit leading to credit contraction within economy

Methods of deleverage

  • Austerity – spending less
  • Debt defaults / restructuring
  • Central bank print money and making purchases or providing guarantees
    • hard to implement if currency is tied to the gold standard
  • Transfers of money and credit from those who have more than they need to those who have less
    • will generally trigger exodus of funds

Beautiful deleveraging

  • Reduced debt to income ratio
  • improved economic activity
  • improved financial asset prices
  • bring nominal economic growth rate above nominal interest rate

Ugly deleveraging

  • bank runs
  • bankruptcies
  • severe unemployment
  • hoarding of gold
  • war / riots

Noteworthy similarities in period prior to WW2 and present day 2019

  • Dire income inequalities where 40% of the wealth is owned by 1% of the population
  • Rise of populism
    • Hitler
    • Franklin DeRoosevelt
    • Winston Churchill
  • rise of protectionism
    • US launches trade war against Canada
  • Rise of militarism
    • Hitler Germany
    • Japan
  • Continue professing by politicians that there is nothing wrong with the economy
    • President Hoover attempts to allay fears
  • Extreme volatility in the financial markets
  • riots due to economic hardship
  • sudden shifts from relatively free trade and interconnected supply chains around the world to protectionism and trade war through the use of tariffs
    • US versus Canada trade war
  • Out break of war
    • WW2
    • increase

Noteworthy case studies and observations

The war economy – Germany during WW1

  • GDP will tend to improve during war time as countries involved in war borrow heavily through the issue of bonds to finance production of war equipments
  • GDP will start to deteriorate after period of war is over as it transits back its prior state
  • GDP of the loosing faction will tend to be more severely affected during the post war period as they get slabbed with war reparations – WW1
  • Nature of loans during war period
    • Loans will initially be denominated in local currency due to high levels of patriotism
    • As war drags on and there are no signs of a positive outcome and loans becomes harder citizens will have either exhausted their loanable assets or are not confidant in the government’s ability
    • Further loans will need to be borrowed from foreigners which might result in loans denominated in foreign currencies

Connectedness of financial systems around the world – the 1930s Great Depression

USA 1930s deflationary deleveraging chain of events
  • investors buy financial assets and utilize increasing financial asset prices as collateral to buy more financial assets
  • government increases interest rate to tighten monetary policy and bring down inflation
  • brokerages increases margin interest rates
  • investors who cannot afford margin interest rates starts unwinding their positions leading to fall in financial asset prices
  • fall of financial asset prices triggers margin calls on other investors who borrowed to buy financial assets. This vicious cycle continues and confidence starts deteriorating and credit starts unwinding
  • bankers attempt to prop up asset prices and boost confidence by buying assets. Efforts were not enough, and asset prices continue to decline – as much as 90%
  • other entities are impacted
    • actual companies start experiencing problems getting credit
    • banks whose assets are in financial assets experience solvency issue due to rapidly deteriorating
  • bankruptcies and unemployment rate increases
  • government steps into prop up the market by lowering interest rate
  • interest rate is at all time low, investors lacking confidence is unwilling to provide credit many started withdrawing cash from banks causing bank runs. They also started hoarding gold.
  • There is an international shortfall of USD
Europe 1930s inflationary deleveraging chain of events
  • Confidence worldwide gets affected by US market deleveraging
  • Germany whose WW1 reparation denominated in USD experiences were mainly financed through the issuing of bonds experience difficulties finding buyers for new bonds.
  • investors loose confidence in ability of German government to repay bonds and start believing in the probability of a default
  • investors started dumping bonds and withdrawing gold from the German economy
  • inflation ensues
  • UK have many banks with assets tied to German bonds. Investors are concerned that UK will get affected and started withdrawing gold in droves.
  • UK government and German government decoupled their currencies from the gold standard, lowered interest rates and allowed exchange rates to decline
USA 1930s inflationary deleveraging chain of events
  • USA continues to peg their currency to the gold standard but experiences continued outflow of gold because gold is now considered to be priced too cheap against USD when compared to other European currencies that have gone off the gold standard
  • USA bans the purchase of gold, decouples their currency from gold and allow exchange rates to float freely
  • The world economy starts recovering

Key insights from weekend with Jerry, Liza, Ada and Dan

On US/China trade war

  • 25% tariff basically wiped out whatever profit margin importing from China could bring
  • China’s labor cost have been increasing over the past few years that it is no longer a competitive advantage
  • China’s main advantage is the expertise they built up over the years. A company can easily spin up 25 manufacturing lines in China very quickly
  • US companies are all rapidly shifting their manufacturing activities out of China
  • New locations are Taiwan, India and Vietnam
  • Chinese staff that were retained by Google are now flying to new manufacturing facilities spun up in these countries to oversee the spin up process

On alternate data

  • Real estate
    • the rise  of platforms like AirBnB has lead investors to seek out alternate data that can help predict short term rental yield as opposed to long term rental yield in a neighborhood
    • government agencies are seeking such data to detect neighborhoods where they should focus their efforts to crack down illegal subletting on AirBnB
  • Sports
    • being able to predict strategy coaches of football teams will employ in real time will help support strategies
    • being able to predict starting line in close to real time and the corresponding outcomes will be valuable for coaches in making play decisions

On HongKong/China protest

  • Public opinion is the agenda for the ongoing protest is now getting really murky
  • Airport has stopped operations, it’s hard to even get in and out of the country
  • Foreign Chinese nationals are supportive of protest in HongKong
  • Topics pertaining to Taiwan, Tibet and TianAnMen massacre are sensitive topics amongst mainland Chinese
  • Funds of funds from Hong Kong are still very liquid

Book summary: The Asian Financial Crisis by Shalendra Sharma

This book describes how the 1997 Asian Financial Crisis transpired.

Impacted countries

  • South Korean
  • Indonesia
  • Thailand
  • Malaysia
  • Singapore
  • Hong Kong
  • China

Key lessons

  • Only 2 of these three conditions can be allowed to be true without causing inflationary recession
    • Fixing the currency exchange rates against other reserve currencies
    • Control over domestic interest rates
    • Control over capital inflow
  • On foreign capital flows
    • huge volume of foreign capital flows into a country
      • economic growth rate increases
      • inflation rate stays low
    • huge volume of foreign capital flows out of country
      • economic growth rate decreases
      • inflation rate goes up

Common pattern across countries

The build up

  • Long periods of high export lead GDP growth attracts high levels of foreign investments. Huge volume of foreign funds originated from Japan which was having a very loose monetary policy
  • Countries peg their exchange rates to reserve currency to ensure stable prices for both imports of raw materials and exports value added products
  • Countries currencies are not reserve currency, hence foreign loans were denominated in foreign currency
  • Excessive leverage within the country by domestic parties who take on short term loans denominated in foreign currencies at lower interest rates to finance long term projects that generate returns in domestic currencies
    • Stocks are purchased with borrowed money. These stocks are then further used as collaterals to borrow more money
    • Real estate are purchased with borrowed money. These real estates are then further used as collaterals to borrow more money
  • Moral hazard due to corruption of financial system
    • banks are arm twisted to finance projects that are not financially viable by governments and politicians

The economic headwinds

  • countries face increasing export market pressure
    • Competition at the low end of the export markets from China
    • Competition at the high end of the export markets from Japan
  • Japanese government instructs central bank to tighten monetary policy to reduce real estate. This severely restricted liquidity from Japan and reduced availability of short term foreign loans to affected countries

The crash

  • Borrowers within these countries increasingly experienced difficulties rolling over their foreign denominated short term loans to finance their long term illiquid domestic projects
  • Many of them started defaulting on their loans
  • Foreign investors started getting spooked and started withdrawing their funds or refusing to allow their loans to roll over
  • Non-performing loans builds up amongst banks within these countries
  • Capital flight continues causing downward pressure on the exchange rates of these countries
  • Countries continued defending their exchanges rates by buying up their own currency and selling off foreign reserves (assets held in foreign currencies)
  • Countries deplete their foreign reserves and are unable to uphold their exchange rates. Since most debts are denominated in foreign currencies, they are not able to print money to pay off these loans.
  • The economy grinds to a halt and hyper-inflation occurs within their financial system at this point
    • domestic production stops and locally produce foods is no longer available for sale
    • due to shortage of foreign reserves imported products become very expensive in local currency
  • Countries approach IMF for loans to tide through this liquidity crunch.
  • IMF steps in and with a lack of understanding of the economic patterns imposes these requirements:
    • Countries required to impose high domestic interest rate. It has the effect of further reducing the money supply within these countries causing more defaults domestically.
    • Countries will reform the financial systems to remove cronyism lead financing
  • Riots ensures and Anti-establishment governments get elected in some countries

The recovery

  • IMF releases the misstep in policies and relents
    • Countries lower their domestic interest rates to increase liquidity within their financial system
    • Countries allow their exchange rates to float freely
  • Relatively cheap asset prices within these countries starts attracting foreign investments again

Why banks are trading at or below net book value

After the 2008 financial crisis, legislations like the Volcker Rules to inhibit big banks from behaving like hedge funds. They are no longer allowed to engage in any forms of trading or financial innovation which leads to excessive multiplying of money supply leading and excessive leveraging within the banking systems.

Their income is thus restricted to investment banking commissions and net interest incomes.

Related references

Long-Sought Volcker Rule Revisions Land on a Changed Wall Street

Book summary: The Savings and Loan Crisis – Lessons from a regulatory failure

This book documents the series of regulatory missteps from the 1980s to the 1990s that lead 50% of savings and loans in the US to insolvency. During this period the total number of savings and loans decreased from 3,234 to 1,645.

Operating mechanism

The savings and loans are a special group of banks that are encourage to grow by the US government to enable affordable housing after the world depression.

They take in short term savings deposits at lower interest rates and lend out long term mortgages at higher interest rates. They profit through the net interest income generated between the short term interest rates and the long term interest rates.

Events leading to massive failure

  • During the Vietnam war, inflation which drove short term interest rates increase. This cannibalized SnLs’ profit margins.
  • De-regulation of short term interest rates which lead to increased competition by other banks for deposits.  This lead to the inability to attract deposits at feasible rates to finance SnL’s long term illiquid mortgage loans.
  • The US government instead of recapitalizing these insolvent SnLs opted to de-regulate by allowing them to enter into other high yield investment instruments. This is in hopes of they will be able to rebuild the capital and thus minimize the amount of burden to be imposed on tax payers
  • Entrance of new entities
    • mutual funds competed for deposits
    • Freddie Mae and Freddie Mac competed for mortgages
  • SnLs ventured out of their areas of expertise and started buying into high yield corporate junk bonds and unsecured commercial loans.
  • With minimal equity stake in the game due to years of erosion and an implied government guarantee for a bail out in case things go south, SnLs began aggressive leveraged into these positions.
  • The US government reversed it stance and past regulation against SnLs holding high yield investment instruments. The forced liquidation of relatively illiquid positions further exacerbated the situation.

Lessons learned

  • Government meddling in market mechanism to further political agenda is generally a recipe for disaster
  • Venturing beyond circle of competence in search of high yield is generally a recipe for disaster
  • Overt or implied guarantee of government bail out is a source of moral hazard that leads to excessive leverage by operators which is definitely a recipe for disaster

Key lessons from When Genius Failed by Roger Lowenstein

When Genius Failed
When Genius Failed, Roger Lowenstein


This book documents the rise and fall of Long Term Capital Management. A hedge fund that specializes in government arbitrage

LTCM’s trading methodology

  • Yield for bonds of the same length of maturity with the different maturity dates issued by the US treasure will tend towards each other over time.
  • Bond’s past a specific time frame becomes less liquid hence gets discounted by fund managers
  • leverage up to 30X capital to short the over bought bond and long the over sold bond, essentially making the difference with little capital employed

Causes for LTCM’s failure

  • becoming overly reliant on their models
    • a period of continuous credit spread widening was followed by the Russian government bond default. LTMC continuously doubled down on their position assuming the trend would eventually reverse
  • not taking into account that unlikely long tail negative events. When they occur the impact tend to be very large
  • Excessive use of leverage
    • up to 30X as compared to 20X employed by most hedge funds
    • made possible by FOMO of all banks who were eager to profit by extending credit lines
    • partners borrowed money from banks using securities they own within the firm as collateral
  • The margins of any profitable trading methodology will tend to get eroded overtime as big banks start tapping into the same opportunities
  • Stepping beyond their circle of competence and expecting the same methodology to still work with international bonds
    • assuming political dynamics overseas (Russia) will be the same as within the US
  • banks unloading sections of their portfolio likely to be impacted by LTCM’s position after news of LTCM’s funds and positions they hold further exacerbated their problem
  • Winding an extremely large position is extremely difficult
    • not enough liquidity
    • will negatively impact price

Lessons for LTCM’s failure

  • guard against hubris / overconfidence
  • be self aware of your circle of confidence and staying within it
  • always check for faulty assumptions in your reasoning
  • avoid excessive use of leverage
  • monitor for long tail events that are emergent by nature
  • do not double down on any positions that did not performed up to expectation
  • guard information about your trades tightly
  • be wary of entering into positions with little liquidity
  • If your fund gets into trouble and you owe the bank a small amount of money its your problem, but when it is an extremely large amount of money it becomes their problem

Macro economic extension to loss aversion reversion to mean trading methodology – Government versus Government scenario

Trading Heuristics

Chain of events and decision making

The decision making processes from June 2019 after the federal reserve signal likelihood of cutting interest rate leading up to the 2019 August downward mean reversion of the SnP.

19th June 2019, Federal Reserve signals for first time likely decrease of interest rates

Federal Chairman expresses concerns about potential cross winds caused by US trade policies and its impact on their dual mandate.

10th July 2019, news paper reports SnP reaches all time high

SnP on the cusp of crossing 3000 threshold for the first time to an all time high. Market is euphoric. Trade issue between US/China yet resolved but discussions are underway.

Short positions SQQQ and SRTY were utilized as hedges against downward macro environment reversion risk when the SnP extended beyond 3000 to reach an all time high

1st August 2019, US announcement of 10% tariffs on US300 billion imports from China starting September 2019

on 1st August, 24 hours after actual interest rates cut, Trump signaled 10% tariffs on USD300 billion Chinese import. SnP dropped.

Exited SQQQ and SRTY for 10% capital gain after reaching 30SMA and 50SMA range. Net combined loss to portfolio was 0.5%.  Left remaining long positions open.

4th August 2019, Chinese response

On 4th Aug 2019, China’s exchange rate dropped for the first time below 7RMB/1USD.

5th Aug 2019 trading day

On 5th Aug 2019, China announced they will halt all imports of agricultural goods from US.

Portfolio continued declining an additional 2% on the trading day of 5th August 2019.

Closed all long positions with the exception of REITs

Decline overview

  • SnP
  • REITs
  • Value shares
  • Growth shares

6th Aug 2019 trading day

On the evening of 6th Aug 2019, China announced decision to control fluctuation of RMB exchange rates to USD

Bought into TQQQ and URTY at below 30SMA and 50SMA

7th Aug 2019 trading day

TQQQ and URTY automatically exited at the mid point between the two following highs and lows:

  • highest point  before Trump’s tariff announcement came into effect
  • lowest point after China’s halt on US agricultural imports and RMB/USD breaking 7 came into effect

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