Archive for January, 2007

Prepare for asset repricing, warns Trichet

Wednesday, January 31st, 2007

In this news article, Trichet, the president of the European Union central bank warned that that instability of global financial markets can lead to ?re-pricing? of assets. He said that:

There is now such creativity of new and very sophisticated financial instruments . . . that we don’t know fully where the risks are locatedā€¦ We are trying to understand what is going on?but it is a big, big challenge.

As we mentioned in Spectre of deflation, the majority of global liquidity is made up of derivatives which is estimated to be valued at US$450 trillion. However, world GDP is estimated to be only US$46.66 trillion?only one-tenth the size of the value of derivatives!

With such massive quantity of derivatives sloshing around the global financial market, there is very little wonder that no one, not even governments or central banks can fully understand what is going on. Thus, opinions on derivatives are highly polarized?some think they are beneficial because they reduce risks by spreading it, whereas others see that they are currently too dangerous because they encouraged too much leverage and risk taking behaviour. Whichever the truth is, we believe that with all these absurdities in the financial world, it is more likely that risks are underestimated than overestimated.

Now is the time to reduce both debt and leverage. Start hedging.

Is trend following trading risky?

Tuesday, January 30th, 2007

In a nutshell, Trend Following is a trading strategy that buys (or technically speaking, go ?long?) when prices are in an uptrend and short sell (or technically speaking, go ?short?) when prices are in a downtrend. Unlike other trading and investing strategies, trend following only look at one thing for its buy or sell decisions: price. Also, trend following does not try to anticipate price movements or foresee long-term fundamental outlook?it merely reacts to price behaviour.

Does trend following works? Michael Covel, in his book, Trend Following?How Great Traders Make Millions in Up or Down Markets made a thorough case for this trading strategy. We suggest you read his book if you are interested in the idea of trend following.

However, there are some in the finance industry who claim that trend following is very ?risky.? The underlying reason for such a claim is based in the fact that trend following exhibits very volatile returns. Is there any flaw behind such a claim?

First, how is volatility measured? Standard deviation is most often used for measuring volatility. The calculation of standard deviation requires the statistical mean as one of its input. Here lies the weakness for the claim that trend following is ?risky??the underlying assumption behind standard deviation is that prices follow a normal distribution As we said before in How the folks in the finance industry got the idea of ?risk? wrong!, this assumption is generally not true in practice. Price often moves in trends, and the incidence of extreme movements (e.g. 1987 stock market crash) shows that normal distribution is an invalid assumption. Therefore, according to the assumption of normal distribution, meltdowns like 1929 and 1987 are so rare that they occur once every billions of years (we are not sure of whether it is billions or millions, but you get the idea). Thus, if you believe in trend following, you cannot believe in the idea that volatility that is defined by standard deviation is ?risk.?

One more thing: since most of the financial industry uses the faulty normal distribution example as the basis for measuring ?risk,? we cannot help but feel that perhaps much of the financial risks in the world are being wrongly appraised. If that is the case, the next fat-tail event will indeed draw many nasty surprises.

Could the fall in oil prices be due to geopolitics?

Monday, January 29th, 2007

In our previous article, What if the Israelis strike Iran?, we mentioned that it was ?interesting to note the Saudis? nonchalance about the recent falls in oil prices.? Today, we saw this article, How the Saudis plan to put oil squeeze on Iran, from the mainstream news media.

Given that any military strikes against Iran will result in extremely serious consequences, using the suppression of oil prices as an economic tool to deal with Iran is the most sensible option. Iranian President Mahmoud Ahmadinejad is in a very vulnerable position?his regime lacks economic credibility and hence, it is very much possible for him to be ousted from power because of it. Falling oil revenues, which are detrimental to Iran?s economy, will probably make this possibility even more likely.

We certainly hope this best-case scenario will ensue. Since President Mahmoud Ahmadinejad (an extremist within his Shia Islam religion) has the destruction of Israel as part of his ?theology,? we see that he is beyond rationality and reason. Thus, as long as he remains in power, Israel will be in a lose-lose situation?when faced with an irrational enemy who is on the way to acquire destructive weapons against you, your remaining options are pretty much limited!

Myth of asset-driven growth

Sunday, January 28th, 2007

One of the dangerous myths that we often hear about is the mainstream idea of ?asset-driven? growth. As we mentioned before in The Bubble Economy, ?economists trained in the Austrian School of economic thought, such kind of growth is unsustainable. Furthermore, they believe that the severity of the following eventual bursting of the bubble is related to the preceding inflation of the bubble.?

How does asset price bubble cause economic ?growth??

The rationale behind the mainstream thinking of such growth goes like this: When asset prices are artificially inflated by loose monetary policies (inflation of money supply and credit), asset owners feel wealthier. When they feel wealthier, they increase their consumer spending, which result in businesses expanding their production due to their perception of increased demand by the consumers. This will lead to expanding production, which in turn lead to increase in hiring and business investments, which in turn increase employment and productive capacity of the economy respectively.

But we have grave reservations on this kind of economic growth?there are serious flaws that will doom it to the eventual detriment of the economy.

As asset price growth outpaces income growth by an ever-increasing margin, increasing issue of credit (i.e. the flip side of taking up of debt) is required to bridge the gap between the asset price and income. What is most often overlooked is that the uptake of debt, which is required for asset-driven growth, has to be serviced. There are two kinds of debt?investment debt and consumption debt. Investment debts are being used for investments that will generally add value to the economy by increasing its productive capacity. Thus investment debts are self-servicing loans?they will generate the necessary economic returns to make repayments possible. The problem with asset-driven growth is that much of the debts are consumption debts. Since such debts are acquired for consumption, they do not add value to the economy because they do not increase its productive capacity. As such, asset-driven growth magnifies the consumption debts of the economy, which will have to be serviced in the future. By deferring the burden of debt servicing to the indefinite future, it can only mean that the nation?s wealth will shrink in the future. Hence, asset prices cannot rise in perpetuality. Eventually, the weight of future debt servicing burdens dooms the bubble to collapse under its own weight. In Japan, when the asset prices bubble burst in the late 1980s, the financial health of banks, corporations and households were seriously damaged. What followed was a deflationary spiral that plunged Japan into recession for the next two decades.

Mark our words: nations who plunge recklessly into heavy debts are postponing their economic rot to their future generations!

Discerning a stock market bubble

Thursday, January 25th, 2007

In our previous article, Speculative fervour in the Chinese stock market, we mentioned that we were ?dismayed to see the amount of speculative fervour and volatility in the Chinese stock market? and that there were ?stories after stories of stock market ?success? and how ?investors? achieved wealth through share ?investment.??

Yesterday, from someone we know in Shanghai, we learnt that the Chinese stock market mania seems to be getting worse.

Retirees are lining up in long queues all over Shanghai?s banks. What can they be queuing up for? We learnt that many of them are withdrawing a significant part of their savings to ?invest? in managed funds, which is the latest investment fad. Many of these retirees do not even know what a managed fund is. When asked which managed fund they want to invest in, they replied, ?I don?t know. I want to invest in whichever is good.? With rampaging inflation, many of these retirees want to preserve the purchasing power of their savings. Upon seeing that scores of people are making easy money in the stock market, they want to join in the party too.

This is a classic sign of a stock market bubble. When you see people who are usually very financially conservative (and have a good reason to be) being overcome by greed, it?s time to exit the market.

What to do with US$ raised from dumped US Treasuries?

Wednesday, January 24th, 2007

Recently, in Bloomberg, we saw this news: OPEC Dumps $10.1 Billion of Treasuries as Oil Tumbles. In our previous article, Awash with cash?what to do with it?, we asked this question: What would these countries [mainly China and Middle Eastern oil-producing nation] buy to replace their US dollars [of which a significant proportion are parked in US Treasuries]?

This is significant.

While this news is hardly surprising, it serves as an indication of what is likely to be a long-term trend. What would those OPEC nations buy to replace the proceeds of their sale of US Treasuries?

We do not really know the answer. But if we are them, we will steer clear away from stocks, bonds and real estates. Other than investment expenditure, if we still need to find a place to park our surplus US dollars, the most logical place, in our opinion, will be to buy gold. This is what we will do if we are them. But we are not them.

Spectre of deflation

Tuesday, January 23rd, 2007

For too long, money around the world had (and still is) been too cheap. There are all kinds of asset booms around the world, from Shanghai properties to US bonds. Stocks around the world are hitting record highs, with the consequent emergence of private equity booms and hedge fund crazes. Along with that, we have all kinds of grotesque imbalances?record consumer debt, negative savings rates and massive current account deficits in the US, Britain and Australia (with the corresponding massive current account surpluses in China and the oil-producing countries).Such good times can never end right? Many financial analysts predicted that 2007 will be another year of abundant returns in the Australian stock market as the sheer weight of more local superannuation ?investments? and Chinese and Middle-Eastern money heads towards the Aussie financial markets to find a home (see More Chinese and Middle Eastern money heading Down Under: recipe for inflation?). Maybe those analysts are right. But don?t you see the absurdities? Nowadays, it seems that the path to great wealth is to be good at shuffling money in the financial markets?speculation, trading, acquisition, borrowing and charging fees for gambling other people?s money. To lubricate all these wealth ?creation? activities, central banks around the world are running the money printing press at top speed in order to conjure up the necessary liquidity grease to be injected into the financial system.

But we smell danger.

It is a danger in which many in the finance industry failed to fully appreciate?deflation. Such complacency is beyond our belief. In the 1990s, Japan experienced it, with dire consequences for their economy. At least, the ordinary Japanese had their savings to fall back on. For many Americans, with their negative savings rate, what can they fall back on? Have they not learned from the mistakes of others in the past?

Before we delve further into the topic of deflation, let us clear some misconceptions about it. Inflation is popularly misunderstood as the general rising of prices. As a result, deflation is also commonly misunderstood as the general falling of prices. But such concepts of inflation and deflation are merely the effects of a root cause. We suggest you read our previous article, Cause of inflation: Shanghai bubble case study for the background understanding of the true nature of inflation and deflation. Henceforth, we will now define deflation as the contraction of liquidity (money and money substitutes) relative to the available goods and services in the economic system.

In our previous article, Liquidity?Global Markets Face `Severe Correction,? Faber Says, we asked the thought-provoking question: Are we now ripe for a contraction in liquidity? Given the colossal leverage in the global financial system, if there is going to be a severe and sustained contraction in the amount of liquidity, the effect will be a downward deflationary spiral in asset prices, which can lead to deflation in the real side of the economy.

Why is it so?

One thing many people fail to understand is that values of financial assets can vanish as easily as they are created in the first place. It is a fallacy to believe that just because money has to move somewhere from one asset class to another, the overall valuation in the financial system cannot contract. The very fact that all the money in the world cannot buy up all capitalisation is proof of that fact. This leads us to the next question: how do financial assets derive their value?

As we mentioned in The Bubble Economy, we have to understand the principle of imputed valuation. Suppose you have a house which you bought for $100,000. What happens if one day, your neighbour decide to sell his house (which is similar to yours) for $120,000? When that happens, your house would have to be re-valued upwards to $120,000 even though you had done absolutely nothing. The same goes for stocks. All it needs for a stock to increase in value is for a pair of buyer and seller to transact at a higher price. As long as the other shareholders do absolutely nothing, that higher price will be imputed into the values of the rest of the stocks. Thus, when asset values rise, all it takes is a handful of them to trade at higher prices in order for the rest to be re-valued upwards. If assets can ?increase? in value that way, it can ?decrease? in value that way too.

What is more worrying is that assets of such imputed values are used as collaterals for further borrowing, which becomes the borrower?s liability. The borrower?s liability then becomes the lender?s asset, which in turn is being used as collateral for the next round of borrowing. Conceptually, this is how the liquidity pyramid (mentioned in Liquidity?Global Markets Face `Severe Correction,? Faber Says) is made up of. As you can see by now, if the original assets? imputed values crash (which can happen easily), it will have a cascading effect on all the other assets? values further down the chain. If this chain-effect spirals out of control, it will result in the wiping out of vast financial wealth (this is how global liquidity contracts). The outcome is a gigantic deflation of epic proportion.

Since the majority of the world?s liquidity is made up of derivatives (which obviously derive its value from another financial asset) valued at hundreds of trillions of dollars, we shudder to think what will happen if that derivative bubble burst. There is a reason why Warren Buffet calls them ?financial weapons of mass destruction.?

What can the Federal Reserve do if this happens? Should it let the bubble burst in order for a resulting depression to clean up the colossal excess? Or should it print copious amount of money for the financial system to remain solvent, thus resulting in hyperinflation?

What if the Israelis strike Iran?

Monday, January 22nd, 2007

Today, we will look at a Middle-Eastern geopolitical scenario that we believe can possibly happen?an Israeli strike on Iran. However, the likelihood of it is impossible to quantify. Nevertheless, it is our firm conviction that investors will do better to be prepared for it (even though it may be an arguably improbable event) than completely ignore it because its effects will have a massive impact on their portfolio.

It is interesting to note that ING, one of the world?s largest investment banks, had came up with an internal report to analyse the possibility and effects of this scenario. It is certainly even more interesting to note that they had come up with a possible timeframe (February to March 2007) for such an extraordinary event. For the sake of today?s discussion, we will assume that the report is genuine. We encourage you to read this report with an open mind. Please note that ING is not predicting that this scenario will happen?rather, they are saying that this scenario is possible and that should it happen, what the impact on the financial markets will be.

As we said in How the folks in the finance industry got the idea of ?risk? wrong!, this is an example of a ?fat-tail? scenario in which by definition of the normal distribution curve assumption (which we sees it to be an academic assumption that does not fully reflect reality), is so highly improbable that it borders towards the realm of impossibility. Hence, we believe that this scenario is a risk that is not fully appreciated and ?priced in? by the financial markets. Thus, there are some in the financial industry who have the mind-set that since it is impossible to quantify the probability of such a scenario, it should be ignored.

As contrarian investors, we believe that it is unwise to adopt such a mind-set. Firstly, though the probability of an Israeli strike is impossible to quantify, its impact on our investments will be extremely severe. Since the financial markets will be taken by surprise by such an event, we can be assured that it will trigger a massive shift of capital from one asset class to another. (No prize for guessing which asset class we prefer!) Thus, a high impact but low probability event is something which should not be completely ignored. Secondly, though we cannot do everything to hedge every aspect of our lives if such a scenario eventuates, we certainly can do something now to hedge ourselves in terms of our investments. Doing something now is certainly better than doing absolutely nothing.

Assuming that a military strike is being seriously considered, what is the most logical course of actions to take?

Definitely, military training is the first step. Indeed, there are rumours of it in this news report. Secondly, preparation for Iranian retaliation will have to undertaken. Already, there are unusually significant US navel and marines deployment in the region. The recent deployment of 20,000 more US troops in Iraq may perhaps be not what it seems. Thirdly, oil will have to be stockpiled because there is no doubt that oil supplies will be disrupted. The recent fall in oil prices in response to reports of rising oil inventories may be the result of such accumulation. Lastly, it is certainly interesting to note the Saudis? nonchalance about the recent falls in oil prices?they declined to agree on another OPEC oil production cut to prop up the price of oil. We do know that the Iranian economy is not in good shape and they have heavy reliance on oil revenues. The Saudis (who are Sunni Muslims) have the motivation to undermine the Iranians (who are Shias Muslims), who looks to be taking steps towards dominating the Middle East.

Are we implying that there will be military action? Again, we stress that we don?t know the answer. We believe it is possible. But we would not want to place our heads on the chopping board by making geopolitical predictions.

Is an Israeli strike on Iran so improbable and ?mad? that only those who belong to the conspiracy theorists fringe groups will even bother to consider it?

To answer this question, we have to consider this: As investors, since we may often see things through an economic prism, we can make the mistake of seeing certain actions as ?irrational? when it is completely rational in the context of the overall big picture. In this case, even though an Israeli military strike on Iran is ?crazy? in our eyes, it may be perfectly rational in the context of national survival. The Israelis may see that since the Iranian nuclear issue is such a serious threat to their national survival, if the world economy has to be damned to eliminate this threat, so be it!

In conclusion, our advice is: Be prepared.

China paradise for stock speculators

Friday, January 19th, 2007

In our previous article, Speculative fervour in the Chinese stock market and Caution: new high in Shanghai Stock Exchange Composite Index, we cautioned about the risks we perceived in the Chinese stock market.

Today, this article in the mainstream financial media caught our eye. It ended up with:

Bold foreign investors, meanwhile, may stay on for the ride: they have done well enough out of it so far. But sooner or later, those who kid themselves that buying shares in Chinese companies is the same thing as buying into China’s growth story are likely to face a rude awakening.

We couldn?t agree more! See our article How to join in the growth of China?.

?Top metals analysts bullish on bullion??Impending bubble?

Thursday, January 18th, 2007

Today, this article, Top metals analysts bullish on bullion, caught our eye.

It looks to us that the crowd are soon becoming fixated with gold again. When that happens, we can be sure another short-term bubble will emerge again?it will be once more history repeating itself (see The story of gold). Again, we would like to repeat our reason for wanting to buy gold: What should be your real reason for buying gold?.

So, are we bullish on gold?

The truth is, we are not bullish on gold?rather, we are bearish on fiat currencies. This is the difference between the crowd and us. Since there is no good reason to be bullish on gold, the crowd who buy it can easily change their minds and dump gold. On the other hand, since we have good reasons to be bearish on fiat currencies, we will remain steadfast and hang on to our gold, perhaps buying even more when the crowd dump it to us.