Martin Kronicle

According to George Soros, Greece is basically meeting the conditions that the IMF would impose. He also said something much more ominous: we haven’t yet corrected the imbalances which have created the crash of 2008.

Protecting your capital at this stage should be your first priority. True it always should be your first priority, however, as I mentioned in my post about the potential #1 crisis, the current correlation between commodities and equities is nearly 1:1.

Whether your a trader or an asset allocator, I would suggest that you use protective stop orders – mental or GTC – or at a minimum have an uncle point to protect your capital. It can take a VERY LONG TIME for the markets to come back.

On a side not, is it me, or does it sound like there is a helicopter in the background?

It’s not portfolio heat, nor hedge funds and their alleged manipulation of natural gas, nor is it the current, nearly 1:1 correlation between commodities and equities.

It’s sovereign espionage and hackers as described in this great article called Researchers Trace Data Theft to Intruders in China from the NYT.

The Toronto spy hunters not only learned what kinds of material had been stolen, but were able to see some of the documents, including classified assessments about security in several Indian states, and confidential embassy documents about India’s relationships in West Africa, Russia and the Middle East. The intruders breached the systems of independent analysts, taking reports on several Indian missile systems. They also obtained a year’s worth of the Dalai Lama’s personal e-mail messages.

My guess is that if they can hack into email accounts, and take over PC’s (not Macs) and turn them into zombies, why couldn’t they zombie a Windows-based computer with:

1) a keylogger to capture your orders;

2) malware that will send all your orders to the spy thereby disclosing all your trades and account balances;

3) software that will enact wire-transfers (probably harder to do); or

4) intercept your orders and modify them so that your “new orders” tank the market, your equity, and possibly your firm.

As one blogger puts it, What say ye?

The Business Insider delineated 14 possible crises that could shake up the markets if they occurred. All 14 are “headline grabbers” and the talk of Twitter, but there is one that went unnoticed and I haven’t seen it mentioned on the WWW: correlation risk between equities and long-only commodities.

All you need is one unsuspected event in the US – forget the 14 in the article – and you’ll see your portfolio lose more than you might realize.

Stocks are leading the Bull markets, while commodities are following, as stocks are forecasting positive GDP growth. Moreover, there is more available capital to buy stocks than to buy
commodities, so this has also helped stocks outperform commodities recently. Thereby, commodities have been in a long trading range (in aggregate) from June 2009 to date, only creeping up.

However, amazingly the long-only commodity universe has had a tremendous positive correlation with stocks since January 2008; the S&P 500 has a 97.92% and 98.32% correlation to the DJUBS and the S&P GSCI (Long Only) Commodity Indexes, respectively.

Interestingly, the appreciation of these commodity indexes as represented by their ETNs (DJP and GSP was +25.5% and +37.1%, respectively, from March 2009 through the end of March
2010, while the S&P 500 has rallied 72.86% during such time period.

Due to the highest correlation I have ever seen between two different asset classes (even Long- Term U.S. Government Bonds have only a 93.9% historical correlation to Intermediate-Term Government Notes), if growth is lower than expected (3%-4%) both commodities and stocks should decline.

Source: EAM Partners, LP

That means you’re not going to see any diversification benefits in the short-term if the S&P goes south and you are a long-only investor. Worse, because the correlation to equities is so high, you’re going to lose on your long-only commodity investment(s) at the same time, making the % hit to your portfolio much greater than you may be expecting.

Besides Robert Mundell, I was blessed to study with Jagdish Bhagwati. He was as entertaining as he was knowledgeable – he was hilarious actually. Here is a clip from Reason.tv, but you should read the whole transcript as the entire interview did not make it on tape.

Brief excerpt from the transcript:

Jagdish Bhagwati: When you look at a trade agreement like NAFTA, it’s about that thick (holds his hands about two feet apart). When I debate people like Lori Wallach of Public Citizen, she arrives with a lot of books, and among them is this NAFTA treaty she carries for effect. I hope she gets a hernia from doing this often enough, because it looks pretty heavy to me. I wouldn’t be carrying it around. Anyway, she shows this book and asks, “Is this free trade?” And mad as she is, she’s right to raise that issue. You should be able to say maybe in 10 pages that in these sectors we are going to liberalize and so on. But nine-tenths of what’s in these agreements are things which have nothing to do with trade. Labor standards, environmental standards, intellectual property rights. If I were Jane Fonda, in order to sell more workout tapes, I could put into the agreement a clause that the president of Mexico has to do his exercise to my tapes. And it would go in, because ours is a lobbying culture and nobody really would know that it’s there. Because who opens these things except the lobbyists?

So many developing countries are now waking up to the fact that they’re being sold a bill of goods in the form of trade agreements.

reason: You have been on the short list for a Nobel Prize in economics for your contribution to trade theory. Could you explain what your main contribution is?

Jagdish Bhagwati: My breakthrough in trade theory was very simple, as all breakthroughs are. Back in the 1950s, when the case for free trade was widely regarded as less compelling analytically than today, protectionists had one very powerful argument on their side. They noted that a country necessarily benefits from free trade only when markets are perfect—that is to say, only when market prices reflect true social costs can we expect these prices to guide allocation correctly. Take pollution. Say your production process makes you spew things into the air and water but you do not have to pay for this pollution. Then the social cost of harming others is not being taken into account by you and hence your production costs are less than the “correct” social costs.

So you could take two points of view. The time-honored view was that when there is such “market failure,” or what might be better called a “missing market,” the case for free trade was compromised and any form of protectionism was justified. I argued that if you had a market failure, fix that, and you are back to perfect markets and the legitimacy of free trade. So, for example, you can have a polluter-pay principle on the environment. If you do that, then there’s no damaging spillover which has not been taken into account.

The proper policy response then is not to abandon free trade but rather to fix the market failure and then to embrace free trade. This was a revolutionary thought. For 200 years, serious economists had abandoned free trade in the presence of market failures of one kind or another.

You can also see the 2-part interview I did with commodity manager Bill Dunn, Chairman of Reason Foundation.

Nick Gillespie is editor in chief of Reason.tv and Reason.com. Hit & Run was named by Playboy, Washingtonian, and others as one of the best political blogs. You can follow him on Twitter @nickgillespie.

“When someone shares something of value with you and you benefit from it, you have a moral obligation to share it with others.” – Chinese Proverb