Cairo and Dow Jones

These propositions seem very plausible to me:

1. If Egypt becomes an Islamic Republic, in the manner of Iran, that fact will be disastrous to world trade, especially disastrous to any industries that rely on getting crude oil from the eastern to the western side of the Suez canal, and this impending disaster would show up in devastated stock prices on, say, the DJIA and the S&P.

2. Highly liquid stock markets tend to discount reasonably foreseeable future events -- so that what is now likely to happen next year should show up in this year's stock prices.

Putting (1) and (2) together, it seems natural to draw the following conclusion:

3. If Egypt's likelihood of turning into an Islamic Republic has markedly increased in recent days, then one should have seen a sharp drop in the DJIA and the S&P.

So, let us add another fact to the mix:

4. The situation in Cairo has been getting, from all appearances at this distance, ever hairier and scarier since at least January 26:

So ... has there been a sharp drop in the indexes in NYC?

If you look at a chart of the DJIA covering the period from then until now, you'll see that there has been only one not-especially-sharp drop since the turmoil began. But that might have been a chartist's drop, caused by the approach of the psychologically important 12,000 number. The market subsequently recovered, broke through 12,000, and then went to 12,100. All as talk of whether Mubarak would leave was turning into talk of how quickly it could be arranged.

If this is a disaster in the making, why hasn't Wall Street reacted accordingly?

Oh, and what can we say of the chart of the S&P for the same period?

Again, there was a gentle swoop early-on in the period of the Cairo demonstrations. Again, this could be interpreted in chartist terms (the S&P fell just as it hit a round number, this time 1300.) Again, even if you don't interpret it in chartist terms, the fall didn't last long, and the rebound has since gotten us well above that 1300.

My only conclusion here is that one of my four propositions above must be incomplete or just wrong, because taken together they would lead to the conclusion that what is happening ... could not be happening.

The most likely conclusion, then, is that "Wall Street" as a collective entity knows something that I don't, and that to this collective entity there is no grave concern about Egypt going the way of 1970s Iran.

What about the market in crude oil? Surely if there were a good chance of a radical Islamicist takeover of Egypt, and speculators had figured this out, there would have been a sharp spike in the price of the stuff: right? Go to the light-crude price link I entered in this blog Thursday. Follow that, and then adjust the chart to show three months. You'll see that the recent high came before there was any trouble in Egypt. Thereafter, crude prices fell to as low as $85 a barrel. At that point, news from Cairo did cause a rise (but a modest one). After those first few days, crude oil prices have headed downward again.

All of which means ... what? Call me a mummy and wrap me in toilet paper if I know.

Reality is fractal

Mandelbrot was right. Reality is fractal. Just when you think you've discovered s straight line from A to B, you zoom in a bit and discover the zig-zags and the swirls.

Then you think, aha! within those swirls I've discovered a lower-level A and B, and between these two, anyway, there is a simple straight line. But when you make another zoom, you find it isn't so.

This truth pressed itself upon me recently when, for the sake of a quick paycheck, I agree to write a brief essay on "Accounting for Software Licenses." Can't be too complicated, right? So ... how does one account for software licenses?

Turns out there are swirls. First, do we want to talk about the accounting of the leesor or the lessee? From the point of view of the lessee, the payments it has to make on a regular basis (yearly? quarterly?) are treated, one might naturally suspect, as a liability on its balance sheet.

But maybe not. Is this a "capital lease" or an "operating lease"? If the former, then in general the lease is a liability for the borrower, and an asset for the lender. If it is an operating lease, though, it can be kept off-balance sheet which (many biz management types seem to think) is re-assuring to actual and potential investors. Are they right? Is it really re-assuring, or does the rational expectations theory rightly presume that the market sees through mere formalities?

Never mind all those squiggles and squirrels! What about the lessor's POV? Can't we at least achieve some clarity, some sort of straight line, there? No. Have I mentioned that reality is fractal?

In general, how a lessor treats a productive asset that it has lent out for the use of another will depend on whether the asset is classified as "direct financing" or as a "multiple-element arrangement." (There is a grey zone in between those two possibilities, and further swirls, but for my brief essay I ignored that zone.)

If a financing company buys software for me and lends it to me, and if that is the only thing it does -- if it doesn't promise any upgrades or trouble-shooting services, and it doesn't deliver same -- if in the words of one authority the lessor "has no involvement with the software that is inconsistent with being a lender" -- in that case, the lease is a loan, and my lease payments are a matter of paying off that loan. The accounting proceeds accordingly, with a "Lease Receivable" item on the vendor/lendor's balance sheet.

But if it does promise and deliver upgrades and the like, then this lease contract is a "mutliple-element arrangement," more akin to a sale than to a loan. It becomes necessary to distinguish and value the different elements of the deal. This is true, too, of the loan of tangible equipment (you might lease me a backhoe with servicing promises). But distinguishing the separate elements in a software contract is apparently especially tricky, and auditors will require vendor-specific objective evidence (VSOE) of the value of the different components.

Zoom in further, and try to grapple with what VSOE means, and what are the consequences when VSOE can't be produced, and you get yet further Mandelbrotian swirls within swirls.

And there is the additional complication that software often comes embedded in hardware -- the "appliance" model. So the question of distinguishing among the elements of the arrangement may include the complexity of distinguishing the valuing of the dance and the dancer.

Nobody Knows Nuttin' : Latest Proof

Now, with the benefit of hindsight, we can understand some of the volatility of the world's stock exchanges in recent days.

The US markets were closed for M.L. King's birthday on Monday, but the rest of the world's exchanges took steep dives. Then when the markets in the US re-opened on Tuesday morning, they started sharply lower, regaining some of the lost ground as the day went on. On Tuesday, again, sharp loss in the morning, this time with a firm rally in the afternoon -- regaining more than had been lost -- ending the day above Friday's close.

What was going on? There was no dearth of explanations. It involved bond insurers, liquidity problems, jobs statistics, reactions to developments in the US presidential campaign. Phases of the moon and the death of Heath Ledger were only rarely invoked as explanations, but were on standby.

Meanwhile, though, in Paris, officials of that country's second largest bank, an institution that has been around since the era when Paris was briefly run by the communards, were desperately trying to close out the positions of a rogue trader who had lost about 5 billion euros of their money.

The timing and the scale both look right for this to be cause and effect. The Société Générale employee, Jerome Kerviel, had been making huge unauthorized and very speculative trades, and had evaded the bank's risk-management controls by hacking its computer system. Its an old story, though it seldom happens on this scale. Trader hopes to cover his initial losses by doubling down. Heck, if I just lost $100 on a coin toss, I should bet $200 next time, shouldn't I? I could win my money back and still book a gain. If I lose again, so my losses are $300, I can always bet $400 on the third try. Lose again, bet $800. Sooner or later, I've got to win.

Well, no. There is no law of probability that guarantees that even a talented hacker can dig himself out of such a [w]hole. The losing streak can continue until your bankroll is gone.

In this case, it continued until he tried something fancier than usual in his hacking, and raised red flags. Bank officials questioned him throughout the day Saturday.

Monday ... well, you know the rest. Extreme volatility on all those non-US markets. The bank made no official statement on the matter until yesterday, Thursday.

Still, the incident proves that markets are hard to fool. You can fool some of the traders some of the time, and your bank bosses for a long time, but world markets figure it out and start to mark prices down accordingly.

This is why nobody knows nuttin. Even the brightest of us is just a single neuron within the brain which is the world financial market as a whole.