September 20, 2008

The end of free markets?

Dear Friends and fellow investors

I’d like to attempt to share my perspective on one of the most memorable weeks in financial markets. Yesterday, the financial markets reacted extremely bullish to the news that the U.S. government was crafting a sweeping bailout plan for the battered financial services industry. The plan to mop up mortgage debt is said to cost $700 billion - so what? The U.S. government seems to have an unlimited balance sheet and a few more hundred of billions (give or take) just means more US treasuries owned by foreigners and a further dilution of the value of the US dollar. Should we be concerned? I would say very much so.

Nobody could possibly put a cap on potential losses - $700 billion appears to be an arbitrary number and without a realistic assessment of the potential risks we are basically letting our government write blank checks. While this sort of open-ended bailout plan is a questionable idea, what concerns me equally is the fact that we’re showing signals of an end to the free markets. When the SEC, presumably under a lot of political pressure, curbed short-selling on 799 securities of financial institutions, that to me is the worst signal for a free market and even a free market economy.

Let me be straight on this…short selling (i.e. selling what you don’t have) may be a concept that is alien to many people; some even consider it unpatriotic to do so. And while I am not generally recommending short selling to average investors, fact is that a market can often not function, certainly not function efficiently, without short sellers. For instance, we cannot have a functioning Options Market if market makers aren’t allowed to cover their positions by shorting stocks. In “short”, “short sellers” are not the culprits, nor are they to blame for the mortgage meltdown.

In our foreign exchange business, we have been telling clients for the past decade that they should carefully evaluate whether or not to invest in the Saudi Stock market or other markets of GCC countries. Our rationale was very simple: These markets don’t allow investors to sell short; often in a major market decline, they wouldn’t even let investors sell their existing positions either. Instead, so our rationale, they should invest in the “safer” international markets and preferably in US markets because they are free markets in an open and free market society.

I am not alone in this assessment.

  • Yesterday Alan Greenspan declared: “Banning Short Sales is a terrible idea”.
  • Jim Cramer, the co-founder of added: “We are approaching financial stone age…”

This bailout plan may be a temporary fix, but in my view it will more likely be aimed at treating symptoms only. And what it really boils down to: the average Joe will be footing the bill. It is even more appalling when you learn of some of the exit packages of the outgoing CEO’s of the miserably failing financial institutions. In my little book of common sense, a failing company cannot possibly endorse multi-million dollar exit packages and neither should our government.
You could also argue that, by taking on a huge amount of leveraged debt, our Treasury has effectively become the largest hedge fund in the world. Sometimes hedge funds make huge profits but they too can be on the wrong side of a trade. Scary to think of the consequences of our government potentially buying Pandora’s box…

A government bailout plan on this massive scale is essentially market/price manipulation. And historically speaking, market prices have never been successfully manipulated in the long term. Market interventions only provide temporary short term fixes; eventually prices tend to move towards at an equilibrium price established by supply and demand.

On an economic and social level, market manipulation reminds of the great socialist experiment that eventually ended with the fall of Communism. While I’m cautiously optimistic about yesterday’s market reaction, I am not so sure if I like the signs of things to come…

Good luck and good trading!

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