Was reading George Soros CEU lecture series during the weekend and would like to share his deep reflection on financial markets with all of you ( see below). You can watch the video or read the full transcript by clicking here.
“Let me state the two cardinal principles of my conceptual framework as it applies to the financial markets. First, market prices always distort the underlying fundamentals. The degree of distortion may range from the negligible to the significant. This is in direct contradiction to the efficient market hypothesis, which maintains that market prices accurately reflect all the available information.
Second, instead of playing a purely passive role in reflecting an underlying reality, financial markets also have an active role: they can affect the so-called fundamentals they are supposed to reflect. That is the point that behavioral economics is missing. It focuses only on one half of a reflexive process: the mispricing of financial assets; it does not concern itself with the impact of the mispricing on the so-called fundamentals.
There are various feedback mechanisms at work which may validate the mispricing of financial assets, at least for a while. This may give the impression that markets are often right, but the mechanism at work is very different from the one proposed by the prevailing paradigm. I claim that financial markets have ways of altering the fundamentals and that may bring about a closer correspondence between market prices and the underlying fundamentals. Contrast that with the efficient market hypothesis, which claims that markets always accurately reflect reality and automatically tend towards equilibrium. There are various pathways by which the mispricing of financial assets can affect the so-called fundamentals. The most widely travelled are those which involve the use of leverage—both debt and equity leveraging. These pathways deserve a lot more research.
My two propositions focus attention on the reflexive feedback loops that characterize financial markets. There are two kinds of feedback: negative and positive. Negative feedback is self-correcting; positive feedback is self-reinforcing. Thus, negative feedback sets up a tendency toward equilibrium, while positive feedback produces dynamic disequilibrium. Positive feedback loops are more interesting because they can cause big moves, both in market prices and in the underlying fundamentals. A positive feedback process that runs its full course is initially self reinforcing, but eventually it is liable to reach a climax or reversal point, after which it becomes self reinforcing in the opposite direction. But positive feedback processes do not necessarily run their full course; they may be aborted at any time by negative feedback.
I have developed a theory about boom-bust processes, or bubbles, along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. A boom-bust process is set in motion when a trend and a misconception positively reinforce each other. The process is liable to be tested by negative feedback along the way. If the trend is strong enough to survive the test, both the trend and the misconception will be further reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow, and more people loose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup said: we must continue dancing until the music stops. Eventually a point is reached when the trend is reversed; it then becomes self reinforcing in the opposite direction.
To go back to my original example, the conglomerate boom of the late 1960s: the underlying trend is represented by earnings per share, the expectations relating to that trend by stock prices. Conglomerates improved their earnings per share by acquiring other companies. Inflated expectations allowed them to improve their earnings performance, but eventually reality could not keep up with expectations. After a twilight period the price trend was reversed. All the problems that had been swept under the carpet surfaced, and earnings collapsed. As the president of one of the conglomerates, Ogden Corporation, told me at the time: I have no audience to play to.
Typically, bubbles have an asymmetric shape. The boom is long and drawn out: slow to start, it accelerates gradually until it flattens out during the twilight period. The bust is short and steep because it is reinforced by the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.
Bubbles that conform to this pattern go through distinct stages: inception; a period of acceleration, interrupted and reinforced by successful tests; a twilight period; and the reversal point or climax, followed by acceleration on the downside culminating in a financial crisis. The length and strength of each stage is unpredictable, but there is an internal logic to the sequence of stages. So the sequence is predictable—but even that can be terminated by government intervention or some other form of negative feedback.
…………………………………… ……………………..It will be useful to distinguish between near equilibrium conditions, which are characterized by random fluctuations, and far-from-equilibrium situations where a bubble predominates. Near equilibrium is characterized by humdrum, everyday events which are repetitive and lend themselves to statistical generalizations. Far-from-equilibrium conditions give rise to unique, historical events where outcomes are generally uncertain but have the capacity to disrupt the statistical generalizations based on everyday events. The rules that can guide decisions in near equilibrium conditions do not apply in far-from-equilibrium situations. The recent financial crisis is a case in point. ……………………………….
I have gained some new insights into far-from-equilibrium conditions during the recent financial crisis. As a participant I had to act under immense time pressure, and I could not gather all of the information that would have been available—and the same applied to the regulatory authorities in charge. That is how far-from-equilibrium situations can spin out of control. This is not confined to financial markets. I experienced it, for instance, during the collapse of the Soviet Union. The fact that the participant’s thinking is time-bound instead of timeless is left out of the account by rational expectations theory.
I was aware of the uncertainty associated with reflexivity, but even I was taken by surprise by the extent of the uncertainty in 2008. It cost me dearly. I got the general direction of the markets right, but I did not allow for the volatility. As a consequence, I took on positions that were too big to withstand the swings caused by volatility, and several times I was forced to reduce my positions at the wrong time in order to limit my risk. I would have done better if I had taken smaller positions and stuck with them. I learned the hard way that the range of uncertainty is also uncertain and at times it can become practically infinite. Uncertainty finds expression in volatility. Increased volatility requires a reduction in risk exposure. This leads to what Keynes calls increased liquidity preference. This is an additional factor in the forced liquidation of positions that characterize financial crises. When the crisis abates and the range of uncertainty is reduced, it leads to an almost automatic rebound in the stock market as the liquidity preference stops rising and eventually falls. That is another lesson I have learned recently.”
Monday, July 19, 2010
Tuesday, March 30, 2010
The power & perils of intuition
Below are excerpts from an interview of Daniel Kahneman and Gary Klein on the power & perils of intuition (Mckinsey Quarterly). You can read the full interview from here. I think the interview is as relevant for corporate personnel as it is for a stock researcher. Key points worth remembering are:
1. Don’t become overconfident: Look for information which does not support your thesis. If you’re starting with a hypothesis and planning to collect information to support the thesis, then you are doomed.
2. Learn the “The premortem technique”: It is a sneaky way to get people to do contrarian, devil’s advocate thinking without encountering resistance. Before a project starts, we should say, “We’re looking in a crystal ball, and this project has failed; it’s a fiasco. Now, everybody, take two minutes and write down all the reasons why you think the project failed.”. The logic is that instead of showing people that you are smart because you can come up with a good plan, you show you’re smart by thinking of insightful reasons why this project might go south. If you make it part of your corporate culture, then you create an interesting competition: “I want to come up with some possible problem that other people haven’t even thought of.” The whole dynamic changes from trying to avoid anything that might disrupt harmony to trying to surface potential problems.
3. Use “Checklists”: The checklist doesn’t guarantee that you won’t make errors when the situation is uncertain. But it may prevent you from being overconfident. The problem is that people don’t really like checklists; there’s resistance to them. So you have to turn them into a standard operating procedure—for example, at the stage of due diligence, when board members go through a checklist before they approve a decision. A checklist like that would be about process, not content. I don’t think you can have checklists and quality control all over the place, but in a few strategic environments, I think they are worth trying.
4. Avoid “Correlated errors”: There’s a classic experiment where you ask people to estimate how many coins there are in a transparent jar. When people do that independently, the accuracy of the judgment rises with the number of estimates, when they are averaged. But if people hear each other make estimates, the first one influences the second, which influences the third, and so on. That’s what I call a correlated error. Frankly, I’m surprised that when you have a reasonably well-informed group—say, they have read all the background materials—that it isn’t more common to begin by having everyone write their conclusions on a slip of paper. If you don’t do that, the discussion will create an enormous amount of conformity that reduces the quality of the judgment.
5. Postpone intuition as much as possible: Take the example of an acquisition. Ultimately, you are going to end up with a number—what the target company will cost you. If you get to specific numbers too early, you will anchor on those numbers, and they’ll get much more weight than they actually deserve. You do as much homework as possible beforehand so that the intuition is as informed as it can be.
1. Don’t become overconfident: Look for information which does not support your thesis. If you’re starting with a hypothesis and planning to collect information to support the thesis, then you are doomed.
2. Learn the “The premortem technique”: It is a sneaky way to get people to do contrarian, devil’s advocate thinking without encountering resistance. Before a project starts, we should say, “We’re looking in a crystal ball, and this project has failed; it’s a fiasco. Now, everybody, take two minutes and write down all the reasons why you think the project failed.”. The logic is that instead of showing people that you are smart because you can come up with a good plan, you show you’re smart by thinking of insightful reasons why this project might go south. If you make it part of your corporate culture, then you create an interesting competition: “I want to come up with some possible problem that other people haven’t even thought of.” The whole dynamic changes from trying to avoid anything that might disrupt harmony to trying to surface potential problems.
3. Use “Checklists”: The checklist doesn’t guarantee that you won’t make errors when the situation is uncertain. But it may prevent you from being overconfident. The problem is that people don’t really like checklists; there’s resistance to them. So you have to turn them into a standard operating procedure—for example, at the stage of due diligence, when board members go through a checklist before they approve a decision. A checklist like that would be about process, not content. I don’t think you can have checklists and quality control all over the place, but in a few strategic environments, I think they are worth trying.
4. Avoid “Correlated errors”: There’s a classic experiment where you ask people to estimate how many coins there are in a transparent jar. When people do that independently, the accuracy of the judgment rises with the number of estimates, when they are averaged. But if people hear each other make estimates, the first one influences the second, which influences the third, and so on. That’s what I call a correlated error. Frankly, I’m surprised that when you have a reasonably well-informed group—say, they have read all the background materials—that it isn’t more common to begin by having everyone write their conclusions on a slip of paper. If you don’t do that, the discussion will create an enormous amount of conformity that reduces the quality of the judgment.
5. Postpone intuition as much as possible: Take the example of an acquisition. Ultimately, you are going to end up with a number—what the target company will cost you. If you get to specific numbers too early, you will anchor on those numbers, and they’ll get much more weight than they actually deserve. You do as much homework as possible beforehand so that the intuition is as informed as it can be.
Sunday, March 28, 2010
Identifying Speculative Manias and Financial Crises
Edward Chancellor’s (GMO) latest white paper, “China’s Red Flags”, is a must read. Edward highlights 10 common characteristic of past manias and financial crises and then points to China’s current vulnerability. Top ten aspects of great bubbles over the past three centuries are:
1. Great investment debacles generally start out with a compelling growth story.
2. A blind faith in the competence of the authorities is another typical feature of a classic mania.
3. A general increase in investment is another leading indicator of financial distress.
4. Great booms are invariably accompanied by a surge in corruption.
5. Strong growth in the money supply is another robust leading indicator of financial fragility.
6. Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts.
7. Crises generally follow a period of rampant credit growth.
8. Moral hazard is another common feature of great speculative manias.
9. A rising stock of debt is not the only cause for concern. The economist Hyman Minsky observed that during periods of prosperity, financial structures become precarious.
10. Dodgy loans are generally secured against collateral, most commonly real estate. Thus, a combination of strong credit growth and rapidly rising property prices are a reliable leading indicator of very painful busts.
“In summary, researchers find that rapid credit growth is the most important leading indicator of financial instability. The presence of an asset price bubble is the second most reliable crisis indicator. Low interest rates and strong money growth are also good warning signs. Real estate busts often produce severe and long-lasting economic downturns, while investment booms may result in a misallocation of capital. Classic manias have often been accompanied by a compelling growth story and an uncritical faith in the competence of the authorities. They are exacerbated by moral hazard and accompanied by rampant corruption.”
1. Great investment debacles generally start out with a compelling growth story.
2. A blind faith in the competence of the authorities is another typical feature of a classic mania.
3. A general increase in investment is another leading indicator of financial distress.
4. Great booms are invariably accompanied by a surge in corruption.
5. Strong growth in the money supply is another robust leading indicator of financial fragility.
6. Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts.
7. Crises generally follow a period of rampant credit growth.
8. Moral hazard is another common feature of great speculative manias.
9. A rising stock of debt is not the only cause for concern. The economist Hyman Minsky observed that during periods of prosperity, financial structures become precarious.
10. Dodgy loans are generally secured against collateral, most commonly real estate. Thus, a combination of strong credit growth and rapidly rising property prices are a reliable leading indicator of very painful busts.
“In summary, researchers find that rapid credit growth is the most important leading indicator of financial instability. The presence of an asset price bubble is the second most reliable crisis indicator. Low interest rates and strong money growth are also good warning signs. Real estate busts often produce severe and long-lasting economic downturns, while investment booms may result in a misallocation of capital. Classic manias have often been accompanied by a compelling growth story and an uncritical faith in the competence of the authorities. They are exacerbated by moral hazard and accompanied by rampant corruption.”
Sunday, December 06, 2009
Growth- Is it good or bad for markets?
"Even in such a time of madness as the late twenties, a great many men on Wall Street remained quite sane. But they also remained very quiet. The sense of responsibility in the financial community for the community as a whole is not small. It is nearly nil. Perhaps this is inherent. In a community where the primary concern is making money, one of the necessary rules is to live and let live. To speak out against madness may be to ruin those who have succumb to it. So the wise in Wall Street are nearly always silent. The foolish thus have the field to themselves.”-John K Galbraith
“It follows that once the investor pays a substantial amount for the growth factor, he is inevitably assuming certain kinds of risks; viz., that the growth will be less than he anticipates, that over the long pull he will have paid too much for what he gets, that for a considerate period the market will value the stock less optimistically than he does.”- Benjamin Graham and David Dodd
India’s 3Q09 GDP growth came in at 7.9%, better than expectation. Growth in good, but it comes at a price. Monetary tightening is a certainty, sooner rather than later, which puts upward pressure on rupee (look out for export oriented companies!) and downward pressure on markets. However it is highly unlikely that the EM rally will fizzle out soon. As developed world continue to slug through subpar growth (loose monetary and fiscal conditions will continue to remain benign in developed market) and as EM growth profile improves, EM asset class will continue to do well led by low rates globally, the dollar carry trade will be alive & kicking and even the EM central banks will be more constrained in raising rates. Global investors will be willing to pay more for any growth visibility and will look for returns and growth in Asia. The biggest risk to the aforesaid scenario, both on an absolute and a relative basis, will be if growth in the US or more broadly, OECD surprises on the upside, and monetary and quantitative tightening is faster than currently envisaged. Thus, it is very important to know and analyse what we are asking for.
Dr. John Hussman writes in his latest article to investors about Reckless Myopia and says that in his estimate, there is still close to an 80% probability (Bayes' Rule) that a second market plunge and economic downturn will unfold during the coming year. Also, Gluskin Sheff chief economist David Rosenberg noted last week, “Even if the recession is over, the historical record shows that downturns induced by asset deflation and credit contraction are different than a garden-variety recession induced by Fed tightening and excessive manufacturing inventories since the former typically induce a secular shift in behavior and attitudes towards debt, asset allocation, savings, discretionary spending and homeownership. The latter fades more quickly.”
Thus, the gloom and doom scenario, in OECD, as outlined by Hussman, David Rosenberg, Roubini, et al, ( through various articles) looks to be good for EM market asset class, as was discussed above.
Other important points from Hussman article worth exploring, “I should have assumed that Wall Street's tendency toward reckless myopia – ingrained over the past decade – would return at the first sign of even temporary stability. The eagerness of investors to chase prevailing trends, and their unwillingness to concern themselves with predictable longer-term risks, drove a successive series of speculative advances and crashes during the past decade – the dot-com bubble, the tech bubble, the mortgage bubble, the private-equity bubble, and the commodities bubble. And here we are again………Whether or not I have focused too much on probable “second-wave” credit risks is something we will find out in the quarters ahead – my record of economic analysis is strong enough that a “miss” on that front would be an outlier. What I do think is that over the past decade, investors (including people who hold themselves out as investment professionals) have become far more susceptible to reckless myopia than I would have liked to believe. They have become speculators up to the point of disaster…………Frankly, I've come to believe that the markets are no longer reliable or sound discounting mechanisms. The repeated cycle of bubbles and predictable crashes over the recent decade makes that clear. Rather, investors appear to respond to emerging risks no more than about three months ahead of time. Worse, far too many analysts and strategists appear to discount the future only in the most pedestrian way, by taking year-ahead earnings estimates at face value, and mindlessly applying some arbitrary and historically inconsistent multiple to them. This is utterly different from true discounting – which does not rely on multiples, but instead carefully traces out the likely path of future revenues, profit margins, cash flows and earnings over time, and explicitly discounts expected payouts and probable terminal values back at an appropriate rate of return. That's what we actually do here. Talking in terms of multiples can make the process easier to explain, and can be a reasonable approach to the market as a whole if earnings are normalized properly, but ultimately, an investment security is a claim to a long-term stream of cash flows. It is not simply a blind multiple to the latest analyst estimate. Fortunately, the evidence suggests that the long-term returns to a careful discounting approach tend to be strong even if investors repeatedly behave in speculative and short-sighted ways. This is because long-term returns are fully determined by the stream of cash flows actually received by investors over time, and because inappropriate valuations ultimately tend to mean-revert. In the face of speculative noise, the long-term returns from a proper discounting approach may not capture as much speculative return as might be possible, but over time, many of those speculative swings tend to wash out anyway.”
The dollar carry trade route is pumping up the stock, real estate and commodity markets all over the world. Also, the money being printed by various central banks all over the world to ensure that the value of their currency doesn't shoot up too much against the dollar (example-Swiss, China, HK, et al) is also at some level getting diverted for speculation purposes. A fascinating article on the aforementioned two points can be read from here.
Happy Reading!!
“It follows that once the investor pays a substantial amount for the growth factor, he is inevitably assuming certain kinds of risks; viz., that the growth will be less than he anticipates, that over the long pull he will have paid too much for what he gets, that for a considerate period the market will value the stock less optimistically than he does.”- Benjamin Graham and David Dodd
India’s 3Q09 GDP growth came in at 7.9%, better than expectation. Growth in good, but it comes at a price. Monetary tightening is a certainty, sooner rather than later, which puts upward pressure on rupee (look out for export oriented companies!) and downward pressure on markets. However it is highly unlikely that the EM rally will fizzle out soon. As developed world continue to slug through subpar growth (loose monetary and fiscal conditions will continue to remain benign in developed market) and as EM growth profile improves, EM asset class will continue to do well led by low rates globally, the dollar carry trade will be alive & kicking and even the EM central banks will be more constrained in raising rates. Global investors will be willing to pay more for any growth visibility and will look for returns and growth in Asia. The biggest risk to the aforesaid scenario, both on an absolute and a relative basis, will be if growth in the US or more broadly, OECD surprises on the upside, and monetary and quantitative tightening is faster than currently envisaged. Thus, it is very important to know and analyse what we are asking for.
Dr. John Hussman writes in his latest article to investors about Reckless Myopia and says that in his estimate, there is still close to an 80% probability (Bayes' Rule) that a second market plunge and economic downturn will unfold during the coming year. Also, Gluskin Sheff chief economist David Rosenberg noted last week, “Even if the recession is over, the historical record shows that downturns induced by asset deflation and credit contraction are different than a garden-variety recession induced by Fed tightening and excessive manufacturing inventories since the former typically induce a secular shift in behavior and attitudes towards debt, asset allocation, savings, discretionary spending and homeownership. The latter fades more quickly.”
Thus, the gloom and doom scenario, in OECD, as outlined by Hussman, David Rosenberg, Roubini, et al, ( through various articles) looks to be good for EM market asset class, as was discussed above.
Other important points from Hussman article worth exploring, “I should have assumed that Wall Street's tendency toward reckless myopia – ingrained over the past decade – would return at the first sign of even temporary stability. The eagerness of investors to chase prevailing trends, and their unwillingness to concern themselves with predictable longer-term risks, drove a successive series of speculative advances and crashes during the past decade – the dot-com bubble, the tech bubble, the mortgage bubble, the private-equity bubble, and the commodities bubble. And here we are again………Whether or not I have focused too much on probable “second-wave” credit risks is something we will find out in the quarters ahead – my record of economic analysis is strong enough that a “miss” on that front would be an outlier. What I do think is that over the past decade, investors (including people who hold themselves out as investment professionals) have become far more susceptible to reckless myopia than I would have liked to believe. They have become speculators up to the point of disaster…………Frankly, I've come to believe that the markets are no longer reliable or sound discounting mechanisms. The repeated cycle of bubbles and predictable crashes over the recent decade makes that clear. Rather, investors appear to respond to emerging risks no more than about three months ahead of time. Worse, far too many analysts and strategists appear to discount the future only in the most pedestrian way, by taking year-ahead earnings estimates at face value, and mindlessly applying some arbitrary and historically inconsistent multiple to them. This is utterly different from true discounting – which does not rely on multiples, but instead carefully traces out the likely path of future revenues, profit margins, cash flows and earnings over time, and explicitly discounts expected payouts and probable terminal values back at an appropriate rate of return. That's what we actually do here. Talking in terms of multiples can make the process easier to explain, and can be a reasonable approach to the market as a whole if earnings are normalized properly, but ultimately, an investment security is a claim to a long-term stream of cash flows. It is not simply a blind multiple to the latest analyst estimate. Fortunately, the evidence suggests that the long-term returns to a careful discounting approach tend to be strong even if investors repeatedly behave in speculative and short-sighted ways. This is because long-term returns are fully determined by the stream of cash flows actually received by investors over time, and because inappropriate valuations ultimately tend to mean-revert. In the face of speculative noise, the long-term returns from a proper discounting approach may not capture as much speculative return as might be possible, but over time, many of those speculative swings tend to wash out anyway.”
The dollar carry trade route is pumping up the stock, real estate and commodity markets all over the world. Also, the money being printed by various central banks all over the world to ensure that the value of their currency doesn't shoot up too much against the dollar (example-Swiss, China, HK, et al) is also at some level getting diverted for speculation purposes. A fascinating article on the aforementioned two points can be read from here.
Happy Reading!!
Monday, November 23, 2009
The “inside” view and the “outside” view
“The human brain is incapable of conceptualizing something vastly different from what it is today. But the big-money ideas are those where the changes are far beyond what you can conceive today. The closer you can get to conceiving those types of changes and the higher the probability they might happen, the more likely you are to find big winners.” - Lisa Rapuano, Matador Capital Management, Value Investor Insight– September 28, 2005.
Bill Miller’s 3Q commentary is a must read. Miller highlights Michael Mauboussin’s new book, Think Twice, to explain the concept of “inside” view and “outside” view in investing. The inside view considers a problem by focusing on the specific task and by using information that is close at hand. The outside view asks if there are similar situations that can provide a statistical basis for making a decision. The outside view wants to know if others have faced comparable problems, and if so, what happened. It’s an unnatural way to think because it forces people to set aside the information they have gathered.
Says Miller, “……Think Twice, the opening chapter tells the story of Big Brown, the super looking colt who’d won such impressive victories in the Kentucky Derby and the Preakness, the first two legs of racing’s Triple Crown. This is a story with a lesson that directly relates to investing, and to understanding the kind of recovery that appears to be getting underway in the U.S. economy. After winning all 5 of his starts by a combined total of almost 40 lengths, Big Brown was a 3-10 favorite to win the Belmont Stakes and become the first horse in 30 years to win the Triple Crown. Those odds indicated the “wisdom of crowds” putting a 77% probability on Big Brown’s winning the race and making horse racing history. Part of that was right: he did make horse racing history — by being the only horse to win the first two legs of the Triple Crown and finish last in the Belmont. That so many were so sure of Big Brown’s success was due to a common analytical error that manifests itself in investing as well as horse racing. That error is the neglect of base rates. Psychologists call it the “inside” view, in contrast to the “outside” view. In the case of Big Brown, taking the outside view would be to see how many horses in the past had won the first two legs of the Triple Crown and then went on to win the third. The inside view focused on Big Brown, his history, the competition he faced, the tracks he ran on and their condition, his time between races, and so on.
The outside view revealed that 29 horses had won the first two races of the Triple Crown in the 130 years it had been run, with 11 of those horses going on to win the third race. Parsing the data a little more finely showed a remarkable divergence in winning percentages. Before 1950, 8 of the 9 horses that had a shot at the Triple Crown won it. After 1950, only 3 of 20 were successful. Moreover, when Big Brown’s speed ratings were compared to the most recent 6 Triple Crown contenders (and not just to his competition in the race), he was the slowest by a wide margin. If those who were betting on the Belmont had used the outside view instead of the inside view, no one would have believed what everyone did believe, that Big Brown had a nearly 80% chance to win the Belmont.
Investors are faced with these sorts of problems constantly: if I put my money in bonds now, what rate of return should I expect over the next 5 or 10 years? What is the outlook for stocks over the next 12 months? What are the chances of a significant rise in inflation over the next few years? What kind of economic recovery will we have? Should I fire my active money manager and replace him with a passive index product? What are the chances we have a “double-dip” recession? And on and on. Faced with these sorts of questions, most people default to the inside view, and then augment its flaws with the usual assortment of behavioral biases long known to psychologists: they anchor on the most recent experience, they assume instances are representative of deeper patterns, they give more weight to vivid examples or dramatic outcomes, they place twice the weight on a dollar lost as on a dollar gained, etc. The financial crisis that is now abating has created a near perfect environment for the admixture of all of the above, and that is perhaps why what Nobel winning economist Ken Arrow called the “clouds of vagueness” seem particularly thick and forbidding just now. Taking the outside view on some of the issues facing investors won’t make an inherently unknowable future predictable, but it can improve the odds of getting things right, or getting fewer things wrong.”
An intriguing post in Moneycontrol board is worth a read and re-read, “If your money doubles every five years, the compounded return that you are earning on your investment is somewhere close to 15%. Similarly, if it is doubling in every four years, the compounded return is in the vicinity of 19%. Have you ever wondered how long it will take to double your money if the interest rate is as low as 0.01%? Well, you don’t have to do the math. We will save you the effort and let you know that it will take all of 6,932 years! Yes, you’ve read that right. It will take a mammoth 6,932 years to double your money if you are earning a return of 0.01%.While this may seem like a joke to you, people invested in the US money market instruments currently are earning just that, a paltry return of 0.01%. Bill Gross, who runs the world’s biggest bond fund at PIMCO, believes that it is the measly return in the US that is driving investors towards higher yielding asset classes like gold and emerging markets. But can the US Fed continue maintaining short term interest rates at such low levels, especially given the fact that the specter of bubbles is being raised in most high yielding asset classes? Indeed, says Bill Gross. According to him, Fed’s foremost worry is the recovery of the US economy. Unless the US economy recovers and its employment scenario improves dramatically, Fed will continue to hold interest rates close to zero, asset bubbles or no asset bubbles. Gross is also of the opinion that once China starts letting its currency appreciate, which it would in about six months time, asset prices might come down and hence, the US Fed should not be hasty in its decision to tighten monetary policies and put the fledgling recovery under further pressure.”
If you want to read the Chinese argument on not letting the Yuan appreciate this year and why it will allow the currency to appreciate next year, read the latest Economist article here. “…….Beijing rejects the accusation that its exchange-rate policy has given it an unfair advantage. It is true that other emerging-market currencies have risen sharply this year, but this ignores the full picture. Last year China held its currency steady against the dollar throughout the global financial crisis, while others tumbled. Since the start of 2008, the yuan has actually risen against every currency except the yen……….Nevertheless, in the long run, a stronger yuan would benefit China’s economy—and the world’s—by helping shift growth from investment and exports towards consumption. It would boost consumers’ purchasing power and squeeze corporate profits, which have accounted for most of the increase in China’s excessive domestic saving in recent years. China will probably allow the yuan to start rising again early next year. This will not be the result of foreign lobbying—indeed, China is more likely to change its policy if foreign policymakers shut up. But by early next year China’s exports should be growing again, its year-on-year GDP growth could be close to 10%, and its inflation rate will have turned positive. The arguments in favour of revaluation will then loom much larger.”
Another interesting article in Economist asks the recurrent question-- central banks are wrong to keep rates low, or markets are wrong to expect recovery? “LIKE a truck rolling downhill, the rally in risky assets is proving hard to stop. Good economic news causes share prices to rise because it indicates the recovery is robust; bad economic news also causes prices to rise because it signals that central banks will keep interest rates near zero. Those low interest rates have probably been the main driver of the rally, encouraging investors to put their cash to work in search of higher returns. But other factors have been at play. Forecasts for corporate profits have been revised steadily upwards as analysts anticipate the benefits of economic recovery…Instead, the main threat to the rally seems likely to be disappointing growth, at least in the developed world…..At some point, the central dilemma at the heart of this rally will have to be resolved. Low interest rates seem like good news for investors. But why are central banks holding rates so low? Either they are correct in assessing that the economy is still fragile, in which case corporate profits will ultimately disappoint. Or they are underestimating the strength of the recovery, in which case inflationary pressures will start to emerge (and bond yields will rise sharply). Markets will have a tricky time navigating between this Scylla and Charybdis in 2010.”
George Cooper, author of ‘The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy’ interview in DnaIndia can be read from here. Coopers says that Central banks are not genuinely independent. They are in effect slaves to the developments in the markets. “Central banks say they must ignore asset prices and change in asset prices. If that is correct, why do they act when asset prices fall? They didn’t know that they were wrong to start with — they can’t know when the prices fall. The practical aspect as to why they do it is effectively the same answer as the previous question. They respond to falling asset prices because that leads to contracting credit, contracting economic activity, higher unemployment and intense political pressure. So central banks are acting, or trying, to continuously push credit into economies for political reasons. But of course the result of that if they are successful, they push the economy to get over-indebted, which is exactly what they shouldn’t be doing. It’s essentially a war between politics and good central banking……….. What I am saying is that we have now become so indebted in the West, that were we to try to pay off the debt in the conventional manner, the degree of economic contraction would be so severe that we would find ourselves in a situation like the 1930s, the Great Depression. The alternative is that we go into something like that 1970s, when we technically monetised the debt away to create inflation. Both of those scenarios are very bad. But the 1970s scenario is less bad than the 1930s. What concerns me, however, is that if we are going through that option, it is very important that we recognise the mistakes that led up to it. We must reform the system so we do not make the same mistakes again. And that’s basically why I wrote the book. My concern is that we are going into the endgame of monetising the debt without ever admitting to ourselves that’s how we got into the problem in the first place. So we will repeat the mistake again.”
Other good articles worth exploring are:
What if a Recovery Is All in Your Head?-Robert Shiller
The Phantom Menace-Paul Krugman
Tuesday, November 10, 2009
Liquidity- its benefits and pitfalls
Excess liquidity, its benefits and pitfalls, continue to remain at the centre-stage of debate amongst most intellectual illuminati, especially in the field of economics and finance. Below are highlighted two articles on the topic, one from Paul McCulley of PIMCO and other from Ruchir Sharma of Morgan Stanley. Happy Reading!
Paul McCulley’s (PIMCO) latest article is a must read. It will immediately struck a cord with those grounded in deep fundamental analysis. Mr. McCulley highlights the contradiction between what equity markets is currently discounting (V-shaped recovery) and treasury bond markets (U or W-shaped recovery) and explains that, although seemingly irrational, the tie that binds them is the Fed’s policy of "exceptionally low levels of the Federal funds rate for an extended period." Mr. McCulley also highlights that markets can stray quite far from "fundamentally justified" values if Fed maintains it current ultra-loose policies for an extended period and, ironically, the strongest case for risk assets holding their ground is that the big-V doesn't unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed.
Says Mr. MaCulley, “But, you retort, this can't go on forever – at some point, risk assets will have to capitulate to reality if the big-V does not unfold, no? Yes, but it is not quite as simple as that. Without the big-V, Treasuries will tend to bull flatten, soothed by rational expectations of an extended period of the Fed funds rate pinched against zero. In turn, such a path for Treasuries would provide valuation support for risk assets. How so? All risk asset prices are analytically the Net Present Value of expected growth in cash flows, discounted by the appropriate-duration risk-free rate plus a risk premium. Thus, expectations of a friendly-for-longer Fed policy would be supportive of risk assets, as they (1) tend to pull down long-duration risk-free rates, while also (2) pulling down the market-required risk premium (which moves inversely with investors' animal-spirited risk appetite, which moves inversely with fears of Fed tightening). To be sure, this fundamental valuation framework – known as the Gordon Model – also implies that in real terms, the positive P/E effect of low long-term risk-free rates is moderated to the extent that the non-big-V scenario also implies lower growth in real profits. There are no free lunches. But since real long-term Treasury rates trade in real time, while "new-normalized" real growth rates are uncertain, subject to animal-spirited conjecture, friendly real long-term interest rates will tend to dominate the formulation of P/Es. Thus, ironically, the biggest intermediate-term risk for risk assets is not that the big-V doesn't unfold, but that it does, inciting the Fed to bring the extended period of a near-zero policy rate to a close. But again, you retort, doesn't that imply that in the absence of the big-V, risk asset prices could levitate into bubble valuation space? Yes, it does mean that. And that is a very, very uncomfortable proposition for those grounded in fundamental analysis, as I am.”
Ruchir Sharma’s latest article in ET is worth pondering over as he talks how excess liquidity heading towards unproductive assets could derail the current market momentum. How? Mr. Sharma points out the significant increase in commodity price and explains that prices are unusual high at this stage of the economic cycle given that the underlying demand and supply fundamentals are still so weak. Thus, if Oil and other commodities (especially food items) continue their relentless march upwards led by liquidity rather than fundamentals, then we could see the Central Bankers tightening before current market expectation, which could be negative for equity markets. The aforesaid point once again reminds us that there is no point in chasing risky assets from current valuation levels.
Other key points from McCulley’s article that’s worth noting are:
• Thus, as we look forward, a huge amount of humility is warranted in projecting asset returns on the basis of tight bands around what "fundamentals" suggest constitute fair value. Yes, there is no substitute for fundamental analysis; it remains at the core of investment management. But asset values can stray far, very far, away from their putative "fair" levels, much, much further than was the case during the middle-aged years of the Great Moderation. The efficient market hypothesis may not be dead, but it is most assuredly in retreat.
• And the envelope between those two modes of theorizing is the fact that the future is inherently uncertain. That might not sound like a profound assertion, and it isn't. We all intuitively know that. But the efficient market hypothesis conveniently assumes away that reality, in what is technically called the "ergodic axiom" – that past and current relationships between variables are reliable predictors of future relationships between variables. This assumption holds in astronomy, which is why astronomers can forecast with incredible accuracy when the next lunar eclipse will unfold. This assumption also holds in calculating the risk of any given hand in a defined card game – there are 52 cards in the deck and it is quite possible to calculate with great precision the odds of winning the game, such as Blackjack or Poker. That doesn't mean that you can know with precision whether you will win, simply that you can forecast the odds of any given player winning, given the cards in their hands and other players' hands, in the context of what cards are left in the deck. Indeed, I find it amusing when television shows broadcasting such games flash up the odds of any player winning after each card is dealt. There is risk, but not uncertainty – we know there are 52 cards in the game and we know what constitutes a winning hand. The ergodic axiom holds. In investment markets, however, the ergodic axiom doesn't hold, even though it is implicitly assumed in the efficient market hypothesis (but ironically, not in the legal disclaimers of all investment presentations, which state that past results are not necessarily indicative of future results!). In investment markets, genuine uncertainty exists: We can't assume that we know how many cards will be in the future deck or what will constitute a winning hand. That's not risk, but rather uncertainty.
• And how do we deal with it? "Certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur. How then are these highly significant daily, even hourly, revaluations of existing investments carried out in practice? In practice, we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention – though it does not, of course, work out so simply – lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not really mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalize our behavior by arguing that to a man in a state of ignorance; errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads us to absurdities. We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematically expectation. In point of fact, all sorts of considerations enter into market valuations which are in no way relevant to the prospective yield.
• Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention. For if there exist organized investment markets and if we can rely on maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence. Thus investment becomes reasonably 'safe' for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are 'fixed' for the community are thus made 'liquid' for the individual." Those few paragraphs, my friends, are the foundation of modern behavioral economics and finance. Human beings, including investment managers, face both risk and uncertainty, and deal with uncertainty by resorting to conventions, notably that yesterday is the best predictor of today, and that today is the best predictor of tomorrow. George Soros calls it reflexivity.
• But when that comforting convention is overwhelmed by a new reality, all hell breaks loose. Uncertainty can no longer be simply assumed away. And when that happens, human beings tend to disengage, eschewing investment in favor of building up cash reserves. And if this proclivity becomes both widespread and profound, we find ourselves in Keynes' Liquidity Trap – there is plenty of money around, but risk-averse investors, infected with uncertainty, refuse to "put it to work" – on either Wall Street or Main Street. Such was the case a year ago, following the fateful decision to let Lehman Brothers fall into a watery grave.
• We here at PIMCO think it will, but only in a muted way, not a big-V way. We also recognize, however, that markets can stray quite far from "fundamentally justified" values, if there is a strong belief in a friendly convention, one with staying power. And right now, that convention is a strong belief in a very friendly Fed for an extended period. Thus, the strongest case for risk assets holding their ground is, ironically, that the big-V doesn't unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed. Simply put, big-V'ers should be wary of what they wish for. U'ers, meanwhile, must be mindful of just how bubbly risk asset valuations can get, as long as non-big-V data unfold, keeping the Fed friendly. But that's no reason, in our view, to chase risk assets from currently lofty valuations. To the contrary, the time has come to begin paring exposure to risk assets, and if their prices continue to rise, paring at an accelerated pace.
Other key points from Mr. Sharma’s article that’s worth noting are:
• Oil and agricultural commodity prices typically tend to rise sharply during the late stages of an expansion when supply becomes tight following strong demand for many years. Commodity bulls spin the story that prices are rising due to relatively better growth prospects of China and other commodity-consuming emerging economies. Hard numbers just don’t back that claim: inventories for many commodities from aluminium to zinc are at multi-decade highs. Massive inflows of financial capital are propelling commodity prices higher as investors and speculators buy the asset class to just make an anti-dollar play or because cheap money has their speculative juices flowing.
• The US dollar and commodity prices have shared a very high degree of inverse correlation ever since the Fed started easing monetary policy in the second half of 2007 when global economic activity was at its peak as was the associated oil demand. The price of oil at that time was trading at around $70 a barrel. Oil prices then doubled between August 2007 and June 2008 due largely to speculation and the resultant monetary tightening by several central banks in developing economies arguably contributed to the global recession last year. It is incredible that oil and many other commodity prices are now trading well above the average price that prevailed during the 2003-07 economic boom even though demand is yet to recover. Global spare capacity is currently running at 8% and in the past, oil prices have only risen when spare capacity was below 5%. Indeed, world oil demand is set to contract in 2009 for the first time since 1983.
• A commodity price rally during the initial stages of the economic recovery was not in the script of policymakers. Food and energy prices — the biggest contributors to inflation in many countries — usually remain relatively low so early in an economic upturn. Central banks then do not have to worry about inflation until the recovery is well entrenched.
• During previous expansion phases in the US dating back to 1970, the stock market on an average rose 30% six months after hitting a bottom while commodity prices were more or less flat over that period. This time around, prices of metals and oil have risen by almost the same magnitude as the already outsized 50% jump in the US stock market from its March lows.
• Nearly $35 billion has flown into commodity Exchange Traded Funds or ETFs that are a popular way for investors to gain exposure to commodities. The number of commodity ETFs outstanding has surged to 12 million securities compared to just three million in February this year. Speculative turnover in the commodity markets is also huge. Estimates put the daily trading volume of futures contracts in the energy space at a staggering 15 times underlying demand. The norm, just five years ago, for trading volumes of various commodities was four to five times actual demand.
• It is remarkable to see how emboldened speculators in commodities have become all over again just a year after the rout they faced when the bubble burst. ‘Echo bubbles’ are hardly uncommon in history. In several instances bubbles in the same asset class have resurfaced shortly after the original boom-bust cycle as it takes a long time for an idea to die and easy money conditions created to deal with the slump often end up reflating the same old notion. However, echo bubbles typically tend to be of a lesser magnitude as the original bubble. While both policymakers and market participants are slow to learn lessons from their previous mistakes, they do not completely forget the painful consequences of the previous boom-bust experience, suggesting the current run up in commodity prices will not be anywhere as large as the move seen during the 2003-07 bubble phase. In addition, any surge in commodities has to be self-limiting.
• If the easy money-driven economic recovery rolls on in its present form then oil prices will soon be back at close to $100 a barrel. Such a price shock will be too much for the global economy to handle; oil close to $100 a barrel will have the same debilitating effect on consumer balance sheets as oil at $150 a barrel had last year. Consumer incomes in many economies have shrunk from when oil traded close to $150 a barrel; at $80 a barrel now, oil is already draining away more resources from consumer wallets than at most points in history and offsetting much of benefit from the stimulus plans. Food and energy account for one-third of the consumer basket in developing countries and with prices of various agricultural commodities from vegetables to sugar also joining the commodity party, inflation worries are surfacing rather prematurely in the economic recovery cycle.
• The concerted and vigorous actions of policymakers across the world to revive the global economy are now doing more to reflate asset prices rather than lift economic growth. The realisation that easy money alone cannot create economic growth and the adverse consequences of just pumping liquidity into the system are likely to dawn upon investors and policymakers alike in the months ahead.
Paul McCulley’s (PIMCO) latest article is a must read. It will immediately struck a cord with those grounded in deep fundamental analysis. Mr. McCulley highlights the contradiction between what equity markets is currently discounting (V-shaped recovery) and treasury bond markets (U or W-shaped recovery) and explains that, although seemingly irrational, the tie that binds them is the Fed’s policy of "exceptionally low levels of the Federal funds rate for an extended period." Mr. McCulley also highlights that markets can stray quite far from "fundamentally justified" values if Fed maintains it current ultra-loose policies for an extended period and, ironically, the strongest case for risk assets holding their ground is that the big-V doesn't unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed.
Says Mr. MaCulley, “But, you retort, this can't go on forever – at some point, risk assets will have to capitulate to reality if the big-V does not unfold, no? Yes, but it is not quite as simple as that. Without the big-V, Treasuries will tend to bull flatten, soothed by rational expectations of an extended period of the Fed funds rate pinched against zero. In turn, such a path for Treasuries would provide valuation support for risk assets. How so? All risk asset prices are analytically the Net Present Value of expected growth in cash flows, discounted by the appropriate-duration risk-free rate plus a risk premium. Thus, expectations of a friendly-for-longer Fed policy would be supportive of risk assets, as they (1) tend to pull down long-duration risk-free rates, while also (2) pulling down the market-required risk premium (which moves inversely with investors' animal-spirited risk appetite, which moves inversely with fears of Fed tightening). To be sure, this fundamental valuation framework – known as the Gordon Model – also implies that in real terms, the positive P/E effect of low long-term risk-free rates is moderated to the extent that the non-big-V scenario also implies lower growth in real profits. There are no free lunches. But since real long-term Treasury rates trade in real time, while "new-normalized" real growth rates are uncertain, subject to animal-spirited conjecture, friendly real long-term interest rates will tend to dominate the formulation of P/Es. Thus, ironically, the biggest intermediate-term risk for risk assets is not that the big-V doesn't unfold, but that it does, inciting the Fed to bring the extended period of a near-zero policy rate to a close. But again, you retort, doesn't that imply that in the absence of the big-V, risk asset prices could levitate into bubble valuation space? Yes, it does mean that. And that is a very, very uncomfortable proposition for those grounded in fundamental analysis, as I am.”
Ruchir Sharma’s latest article in ET is worth pondering over as he talks how excess liquidity heading towards unproductive assets could derail the current market momentum. How? Mr. Sharma points out the significant increase in commodity price and explains that prices are unusual high at this stage of the economic cycle given that the underlying demand and supply fundamentals are still so weak. Thus, if Oil and other commodities (especially food items) continue their relentless march upwards led by liquidity rather than fundamentals, then we could see the Central Bankers tightening before current market expectation, which could be negative for equity markets. The aforesaid point once again reminds us that there is no point in chasing risky assets from current valuation levels.
Other key points from McCulley’s article that’s worth noting are:
• Thus, as we look forward, a huge amount of humility is warranted in projecting asset returns on the basis of tight bands around what "fundamentals" suggest constitute fair value. Yes, there is no substitute for fundamental analysis; it remains at the core of investment management. But asset values can stray far, very far, away from their putative "fair" levels, much, much further than was the case during the middle-aged years of the Great Moderation. The efficient market hypothesis may not be dead, but it is most assuredly in retreat.
• And the envelope between those two modes of theorizing is the fact that the future is inherently uncertain. That might not sound like a profound assertion, and it isn't. We all intuitively know that. But the efficient market hypothesis conveniently assumes away that reality, in what is technically called the "ergodic axiom" – that past and current relationships between variables are reliable predictors of future relationships between variables. This assumption holds in astronomy, which is why astronomers can forecast with incredible accuracy when the next lunar eclipse will unfold. This assumption also holds in calculating the risk of any given hand in a defined card game – there are 52 cards in the deck and it is quite possible to calculate with great precision the odds of winning the game, such as Blackjack or Poker. That doesn't mean that you can know with precision whether you will win, simply that you can forecast the odds of any given player winning, given the cards in their hands and other players' hands, in the context of what cards are left in the deck. Indeed, I find it amusing when television shows broadcasting such games flash up the odds of any player winning after each card is dealt. There is risk, but not uncertainty – we know there are 52 cards in the game and we know what constitutes a winning hand. The ergodic axiom holds. In investment markets, however, the ergodic axiom doesn't hold, even though it is implicitly assumed in the efficient market hypothesis (but ironically, not in the legal disclaimers of all investment presentations, which state that past results are not necessarily indicative of future results!). In investment markets, genuine uncertainty exists: We can't assume that we know how many cards will be in the future deck or what will constitute a winning hand. That's not risk, but rather uncertainty.
• And how do we deal with it? "Certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur. How then are these highly significant daily, even hourly, revaluations of existing investments carried out in practice? In practice, we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention – though it does not, of course, work out so simply – lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not really mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalize our behavior by arguing that to a man in a state of ignorance; errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads us to absurdities. We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematically expectation. In point of fact, all sorts of considerations enter into market valuations which are in no way relevant to the prospective yield.
• Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention. For if there exist organized investment markets and if we can rely on maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence. Thus investment becomes reasonably 'safe' for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are 'fixed' for the community are thus made 'liquid' for the individual." Those few paragraphs, my friends, are the foundation of modern behavioral economics and finance. Human beings, including investment managers, face both risk and uncertainty, and deal with uncertainty by resorting to conventions, notably that yesterday is the best predictor of today, and that today is the best predictor of tomorrow. George Soros calls it reflexivity.
• But when that comforting convention is overwhelmed by a new reality, all hell breaks loose. Uncertainty can no longer be simply assumed away. And when that happens, human beings tend to disengage, eschewing investment in favor of building up cash reserves. And if this proclivity becomes both widespread and profound, we find ourselves in Keynes' Liquidity Trap – there is plenty of money around, but risk-averse investors, infected with uncertainty, refuse to "put it to work" – on either Wall Street or Main Street. Such was the case a year ago, following the fateful decision to let Lehman Brothers fall into a watery grave.
• We here at PIMCO think it will, but only in a muted way, not a big-V way. We also recognize, however, that markets can stray quite far from "fundamentally justified" values, if there is a strong belief in a friendly convention, one with staying power. And right now, that convention is a strong belief in a very friendly Fed for an extended period. Thus, the strongest case for risk assets holding their ground is, ironically, that the big-V doesn't unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed. Simply put, big-V'ers should be wary of what they wish for. U'ers, meanwhile, must be mindful of just how bubbly risk asset valuations can get, as long as non-big-V data unfold, keeping the Fed friendly. But that's no reason, in our view, to chase risk assets from currently lofty valuations. To the contrary, the time has come to begin paring exposure to risk assets, and if their prices continue to rise, paring at an accelerated pace.
Other key points from Mr. Sharma’s article that’s worth noting are:
• Oil and agricultural commodity prices typically tend to rise sharply during the late stages of an expansion when supply becomes tight following strong demand for many years. Commodity bulls spin the story that prices are rising due to relatively better growth prospects of China and other commodity-consuming emerging economies. Hard numbers just don’t back that claim: inventories for many commodities from aluminium to zinc are at multi-decade highs. Massive inflows of financial capital are propelling commodity prices higher as investors and speculators buy the asset class to just make an anti-dollar play or because cheap money has their speculative juices flowing.
• The US dollar and commodity prices have shared a very high degree of inverse correlation ever since the Fed started easing monetary policy in the second half of 2007 when global economic activity was at its peak as was the associated oil demand. The price of oil at that time was trading at around $70 a barrel. Oil prices then doubled between August 2007 and June 2008 due largely to speculation and the resultant monetary tightening by several central banks in developing economies arguably contributed to the global recession last year. It is incredible that oil and many other commodity prices are now trading well above the average price that prevailed during the 2003-07 economic boom even though demand is yet to recover. Global spare capacity is currently running at 8% and in the past, oil prices have only risen when spare capacity was below 5%. Indeed, world oil demand is set to contract in 2009 for the first time since 1983.
• A commodity price rally during the initial stages of the economic recovery was not in the script of policymakers. Food and energy prices — the biggest contributors to inflation in many countries — usually remain relatively low so early in an economic upturn. Central banks then do not have to worry about inflation until the recovery is well entrenched.
• During previous expansion phases in the US dating back to 1970, the stock market on an average rose 30% six months after hitting a bottom while commodity prices were more or less flat over that period. This time around, prices of metals and oil have risen by almost the same magnitude as the already outsized 50% jump in the US stock market from its March lows.
• Nearly $35 billion has flown into commodity Exchange Traded Funds or ETFs that are a popular way for investors to gain exposure to commodities. The number of commodity ETFs outstanding has surged to 12 million securities compared to just three million in February this year. Speculative turnover in the commodity markets is also huge. Estimates put the daily trading volume of futures contracts in the energy space at a staggering 15 times underlying demand. The norm, just five years ago, for trading volumes of various commodities was four to five times actual demand.
• It is remarkable to see how emboldened speculators in commodities have become all over again just a year after the rout they faced when the bubble burst. ‘Echo bubbles’ are hardly uncommon in history. In several instances bubbles in the same asset class have resurfaced shortly after the original boom-bust cycle as it takes a long time for an idea to die and easy money conditions created to deal with the slump often end up reflating the same old notion. However, echo bubbles typically tend to be of a lesser magnitude as the original bubble. While both policymakers and market participants are slow to learn lessons from their previous mistakes, they do not completely forget the painful consequences of the previous boom-bust experience, suggesting the current run up in commodity prices will not be anywhere as large as the move seen during the 2003-07 bubble phase. In addition, any surge in commodities has to be self-limiting.
• If the easy money-driven economic recovery rolls on in its present form then oil prices will soon be back at close to $100 a barrel. Such a price shock will be too much for the global economy to handle; oil close to $100 a barrel will have the same debilitating effect on consumer balance sheets as oil at $150 a barrel had last year. Consumer incomes in many economies have shrunk from when oil traded close to $150 a barrel; at $80 a barrel now, oil is already draining away more resources from consumer wallets than at most points in history and offsetting much of benefit from the stimulus plans. Food and energy account for one-third of the consumer basket in developing countries and with prices of various agricultural commodities from vegetables to sugar also joining the commodity party, inflation worries are surfacing rather prematurely in the economic recovery cycle.
• The concerted and vigorous actions of policymakers across the world to revive the global economy are now doing more to reflate asset prices rather than lift economic growth. The realisation that easy money alone cannot create economic growth and the adverse consequences of just pumping liquidity into the system are likely to dawn upon investors and policymakers alike in the months ahead.
Tuesday, November 03, 2009
Mother of all Carry Trades Faces an Inevitable Bust
In a must read article in FT Dr. Nouriel Roubini explains how the combined effect of the Fed policy of a zero Fed funds rate (through carry trade) + quantitative easing + massive purchase of long-term debt instruments is fuelling the current market rally. But when will the bubble burst?
Dr. Roubini explains, “if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments. Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed. This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.”
V. Anantha Nageswaran writes on the same topic in his weekly article in Mint today. Says Nageswaran, “That might become the more pressing objective of the two goals that the US would be pursuing in the coming years: asset price reflation and preserving its hegemonic status in global affairs. Unfortunately, both cannot be pursued simultaneously at all times, although that would be preferable. Now, after a few trillion dollars of last year’s losses have been clawed back in the asset markets in the last seven months, the US can and would likely switch priorities. The persistence of the gold price above $1,000 per ounce and in excess of its high earlier in the year would be unwelcome at the US Federal Reserve board. Hence, some increase in risk aversion, stability to slight recovery in the dollar and reduction in the bond yield might be the Fed’s prescription for the hour. Whether financial markets would deliver on this combination remains to be seen. Well, if the Fed could deliver a 60% rise in US stocks at a time when nearly three million jobs were lost, it could make this happen too—provided, of course, that this is its immediate goal.”
As per Mr. Nageswaran article, Fed should bring in some increase in risk aversion + stability to slight recovery in the dollar + reduction in the bond yield. If this happens then as per Dr. Roubini a stampede could occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts will trigger a co-ordinated collapse of all those risky assets. Macro investors should keenly monitor this issue as this could impact their returns substantially.
However, for all those in the bottoms-up camp, the great guru (Warren Buffett) advice should be of utmost importance during volatile times, “Price is what you pay, value is what you get” + “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” + “We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely.”
Happy Reading!!
Dr. Roubini explains, “if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments. Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed. This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.”
V. Anantha Nageswaran writes on the same topic in his weekly article in Mint today. Says Nageswaran, “That might become the more pressing objective of the two goals that the US would be pursuing in the coming years: asset price reflation and preserving its hegemonic status in global affairs. Unfortunately, both cannot be pursued simultaneously at all times, although that would be preferable. Now, after a few trillion dollars of last year’s losses have been clawed back in the asset markets in the last seven months, the US can and would likely switch priorities. The persistence of the gold price above $1,000 per ounce and in excess of its high earlier in the year would be unwelcome at the US Federal Reserve board. Hence, some increase in risk aversion, stability to slight recovery in the dollar and reduction in the bond yield might be the Fed’s prescription for the hour. Whether financial markets would deliver on this combination remains to be seen. Well, if the Fed could deliver a 60% rise in US stocks at a time when nearly three million jobs were lost, it could make this happen too—provided, of course, that this is its immediate goal.”
As per Mr. Nageswaran article, Fed should bring in some increase in risk aversion + stability to slight recovery in the dollar + reduction in the bond yield. If this happens then as per Dr. Roubini a stampede could occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts will trigger a co-ordinated collapse of all those risky assets. Macro investors should keenly monitor this issue as this could impact their returns substantially.
However, for all those in the bottoms-up camp, the great guru (Warren Buffett) advice should be of utmost importance during volatile times, “Price is what you pay, value is what you get” + “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” + “We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely.”
Happy Reading!!
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