Our dear readers, if you do not hear from us for the next couple of weeks, please be patient with us, for some of us will be away during this festive season. Therefore, our postings will be sparse during this period of time. But we will be back in full action some time after the 2nd week of January 2009.
Archive for December, 2008
We wish our readers a very Merry Christmas! Take a good rest, enjoy your holidays and recharge yourself for the coming 2009!
Also, if you are on Facebook, you may want to join our Facebook community here. It is a great place to interact, communicate, network, discuss and befriend other readers.
Back in How do you define risk?, we wrote,
In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is.
Also, as we wrote in Real economy suffers while financial markets stuff around with prices,
Right now, deflationary forces are acting on the economy while at the same time, central bankers and governments are attempting to inflate. Consequently, the result is extreme volatility in prices. Volatile prices hinder business calculations, which in turn hinder long-term planning.
Paradoxically, government interventions, for all their good intentions, are making the situation worse by introducing unintended consequences into the global financial system. For example, in the case for banks, Satyajit Das wrote in Fear & Loathing in Financial Products: Banks – The ?V?, ?U? or ?L?,
Risk models in banks are a function of market volatility. The low volatility regime of recent years reduced the amount of capital needed. Increased market volatility will increase the amount of capital needed. This may restrict the level of risk taking and therefore earnings potential.
Everything else being equal, the increase in the amount of capital needed implies a reduced availability and amount of credit to the real economy. This in turn will have an effect on economic activity.
We had just created a Facebook group called the Contrarian Investors’ Journal Community. This is a group for our growing community of readers to interact, communicate, network and befriend each other.
For those whose email addresses are in our emailing list and are not yet members of Facebook, an invitation to join this group had been sent. If you have received more than one invite, please accept our apologies because Facebook had been playing up on us with some unspecified errors.
For those who already have a Facebook account, please be part of our Facebook community by logging into Facebook and joining the group here.
Since the credit crisis first erupted 15 months ago, the problem was mainly confined to the financial side of the economy. Today, we are seeing signs of the crisis spreading to the real economy in far-flung countries like Australia. As Australian banks expected to sack staff reported,
Jobs are disappearing at the four major retail banks, and staff freezes have been ordered at investment banks and struggling fund management groups.
There are news reports that 10,000 banking jobs could go in the months ahead. While we will not be investigating the credibility of this number in this article, we will explore the concept of Game Theory using banking jobs as an example.
In essence, Game Theory is…
… a branch of applied mathematics that is used in the social sciences (most notably economics), biology, engineering, political science, international relations, computer science (mainly for artificial intelligence), and philosophy. Game theory attempts to mathematically capture behavior in strategic situations, in which an individual’s success in making choices depends on the choices of others.
In the banking jobs example, what if one of Australia’s major banks decide to cut staffs? What will be effect of this strategic decision on the other banks?
To put it simply, if XYZ bank restructures its business and cut, say 15% of its workforce, it will have a competitive advantage against the other banks in terms of costs. During hard economic times, people are tightening their belts and consumer spending will be down. Naturally, consumers will care less about product differentiations and care more on finding the cheapest bargains. Therefore, businesses that can lower their costs will have a price competitive advantage against their rivals. So, in this case, what will the rivals of XYZ banks do? They will follow XYZ’s lead of restructuring and cutting staffs.
That’s why in the months ahead, as the economy slows further, we will see waves of corporate restructures and staff cuts. Unfortunately, these actions by businesses will further depress the economy, which in turn will provoke the next wave of cost cuttings.
Today, we found this Dilbert comic strip here. It is the simplest explanation of CDO (see Collateral Debt Obligation?turning rotten meat into delicious beef steak) suitable for children.
Next year, the US government needs to borrow US$1.5 trillion to pay for its expenditure. Up till the end of November 2008, $4.16 trillions worth of spending programs were endorsed by the US government to bail out Wall Street and stimulate Main Street. There are rumours that the upcoming President Obama will sign in a trillion dollar economic stimulus package when he takes office next month.
Not too long ago, hundreds of millions of dollars were an unimaginable sum of money. After a while, the concept of million is replaced by the billion. Today, trillion supplanted the billion. How much money is a trillion dollars? Imagine you have a stack of US$1000. For that stack to reach $1 trillion, guess how high it has to go? The answer is: 109 kilometres! By comparison, the earth’s atmosphere is only 120 kilometres.
As we mentioned before in How is the US going to repay its national debt?, the US national debt stood at more than $4 trillion at the beginning of this year. With all these extra spending programs, bailouts, rescues and stimulus, it could easily more than double.
So, where is the US government going to get the money from? Will the Chinese, Japanese and Arabs be kind enough to lend them? Probably not, because the US government still owe these foreigners trillions of dollars of outstanding debt. Will they borrow from the American people? No, the American people are too deep in their own private debt to spare a dime. Will they tax the American people? No, because the US government want them to spend in order to ‘stimulate’ the economy. The only to do so is to shower them with even more money.
That leaves only one option- print money. The traditional way to do so is for the government to issue Treasury bonds to the Federal Reserve, which in turn conjures up the money from thin air to pay for them. But even then, at the rate at which the tide of financial destruction is going, the government cannot print fast enough. After all, there is a legal limit on the amount the Treasury Department can borrow. To break that limit, it has to seek the permission of Congress.
Is there a way to break tradition? In this recent Wall Street Journal article, it reported that the…
… Federal Reserve is considering issuing its own debt for the first time, a move that would give the central bank additional flexibility as it tries to stabilize rocky financial markets.
It isn’t known whether these preliminary discussions will result in a formal proposal or Fed action. One hurdle: The Federal Reserve Act doesn’t explicitly permit the Fed to issue notes beyond currency.
Just exploring the idea underscores many challenges the ongoing problems are creating for the Fed, as well as the lengths to which the central bank is going to come up with new ideas.
So, they are thinking of new ‘ideas’ to change the rules of the game in the middle of the session? Remember what we wrote in Recipe for hyperinflation:
One thing we have to be clear. Assuming that the ?rules? are strictly adhered to, there will only be one outcome for the current credit crisis: deflation.
Since the current structure of ?rules? will be too restrictive in such a war against deflation, there will be popular momentum towards the bending and rolling back of these ?rules.? If they press on relentlessly till the final end, there can only be one outcome: the US dollar will be joining the long list of failed fiat paper money in the annals of human civilization.
We quoted Marc Faber at Is the Warren Buffett way dead?:
Above I tried to show the existing connectivity between global liquidity (coming from the US current account deficit), asset markets, and currency movements. To navigate successfully between all these volatile and often unpredictable market movements you need to be a genius.
As we explained before in Real economy suffers while financial markets stuff around with prices, volatile movement in prices in the context of market movements will have tangible impacts on the real economy. One of the market movements is currency flow. Over the past few months, there had been a flight towards the US dollar, which in turn had a flight towards the Japanese yen through the reversal of the yen carry trade (we first mentioned the carry trade in Another source of potential financial crisis?reversal of yen carry trade). These currency movements resulted in a rising US dollar relative to all the other major currencies (except the yen) and the rise of the yen relative to the US dollar. Indeed, over the past 3 months, the US dollar had depreciated around 17% against the yen.
The rapidly rising yen is wrecking havoc on the Japanese export sector, which in turn has a serious effect on the Japanese economy. For example, as this news article from the Asahi Shimbun reported, Toyota budgeted a yen exchange rate of around 100 yen to 1 US dollar for the second half of this fiscal year to March next year. But for every 1 yen that appreciated against the US dollar, Toyota loses 400 billion yen of income per year. This unexpected appreciation of the yen is a setback for Toyota. Other Japanese export companies are finding themselves in the same predicament.
Japan was finally climbing out of the 18 long years of economic stagnation when the GFC struck. Now, they are falling back into the hole again. Looks like the Japanese are in the same boat as the Chinese with regards to their export sector.
In fundamental analysis of stocks, one of the most important numbers is the book value. Basically, book value is calculated by total assets minus intangible assets (patents, goodwill) and liabilities. Roughly speaking, it is the value you get if you liquidate the company.
But in times of debt deflation, how reliable is book value?
Remember, as we said before in Will deflation win?, such a deflation
… is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on.
When that happens, there is widespread liquidation of assets in the economy. Furthermore, buyers tend to be few as cash tend to be hoarded. In such an environment, it will be extremely difficult to realise the book value of a company if it has to be liquidated.
Therefore, when analysing a company’s balance sheet, be very sceptical of the carrying value of its assets, especially the very large and illiquid ones (e.g. buildings, plants). In times of deflation, the actual realisable value can be very far below the stated value. Therefore, the book value can be a very hollow number.
Very often, you may hear the more experienced investors saying things like this
I’ve been investing for the past x number of years. In my experience,
- … it is such a time of maximum fear and panic that an investor makes a killing.
- … markets eventually recover soon.
- … investments in stocks/property/whatever has never disappoint in the long term.
- … blah blah blah
Therefore, accept what I just told you because I have more experience then you.
Today, we will not be arguing over the correctness of the points (1) to (4) that follow the phrase “In my experience.” These points in themselves may or may not be true. But this phrase (that precedes the points) is a very dangerous one. Why? This is because it has the potential to cause you to fall into a mental pitfall. It is often invoked to stop the less experienced investors from thinking and to bulldoze their arguments.
Other variations of this phrase may include:
- According to research, over the past x number of years,
- Warren Buffett has been investing successfully for the past 4 decades,
What is wrong with this phrase? It is a form of mental pitfall called Lazy Induction. As we wrote in Mental pitfall: Lazy Induction,
The trouble starts when the sample that we used for our observations is drawn from our own personal bias. Then, from the observations of the biased sample, we make generalisations based on our flawed observations.
For example, if you invest in the Australian stock market over the last 20 years, you will do very well despite the recession of the early 1990s. Some ‘wise’ heads will use this experience as a basis to extrapolate into stock investments in general. Will the next 20 years yield the same result? We wouldn’t go into that for this article.
But consider this: what if you invest in the Japanese stock market over the last 20 years? Well, in that case, your investment performance will be a disaster.
The point is, no matter how experienced a ‘wise’ head is, his experience is still confined to either (1) a specific market or (2) a slice of time in history. That is, all the experience that a ‘wise’ head has is still limited in the bigger scheme of things. Therefore, to stop thinking and extrapolate blindly from this limited perspective into the general is a dangerous trap to base one’s investment decisions on.