Archive for January, 2007

How the folks in the finance industry got the idea of ?risk? wrong!

Wednesday, January 17th, 2007

In our previous article, How do you define risk?, we put forth our criticism on the way risk is measured by many in the financial service industry. Today, we will look at the underlying theory behind their measurement of risk. The recommended reading for today will be How the Finance Gurus Get Risk All Wrong.

As you may have noticed, ?risk? is often expressed as a nice and simple number in the world of finance. For example, in many stock research publications, the ?risk? of a stock may be defined in terms of a number called the beta. You may see risk jargons like standard deviation, the Sharpe ratio, variance, correlation, alpha, value at risk and so on. All these mathematical definitions of ?risk? give it a scientific feel, which seem to give us the impression that ?risk? can be measured and controlled. Unfortunately, in reality, these definitions and measurements of ?risk? are pseudo-science. The reason is because the underlying theory behind all of them is flawed in the first place.

What are the assumptions behind these conventional measures of ?risk?? They are all based on the assumption that price follows a statistic device known as the normal distribution. If a stock price follows a normal distribution, it means that at any given day, there is a 50% chance that it will go up and a 50% chance that it will go down by the same amount on average. In the long run, the vast majority of stocks? price will hover around its average, with a smaller percentage deviating from it. In other words, the behaviour of stocks? price will follow a bell curve like this (horizontal axis?stock price, vertical axis?probability of the price being at that level):

Bell curve

Is this a valid assumption?We doubt so. As you can see for yourself in the real market, prices often do not follow such behaviour?frequently, they move in trends and at times, exhibit extreme behaviour. As the article in the suggested reading (How the Finance Gurus Get Risk All Wrong) said,

The inapplicability of the bell curve has long been established, yet close to 100,000 MBA students a year in the U.S. alone are taught to use it to understand financial markets.

Thus, as contrarians, this is not the way we define risk.

Liquidity?Global Markets Face `Severe Correction,’ Faber Says

Tuesday, January 16th, 2007

Marc Faber, the legendary contrarian, predicted the 1987 stock market crash, had this to say. He singled out emerging markets for a correction, especially Russia, followed by China (see China is tightening liquidity) and India. In that correction, all asset markets will be affected.

What is the rationale behind Faber?s prediction?

First, we have to understand the concept of ?liquidity.? What is ?liquidity?? There are other meanings for the word ?liquidity?, but for the purpose of this article, we will stick to the quick and dirty definition of ?liquidity? being ?money? in the financial system. Now, how do we define what is the ?money? in liquidity? Traditionally, ?money? is just what it is?cash and deposits. But today, with the advances in finance, ?money? is no longer as easily and clearly defined as before. As a result, money substitutes are becoming proxies for money and playing a much more important role in global liquidity than before. Examples of money substitutes include credit (e.g. mortgage-backed securities) and derivatives.

Now, what has liquidity got to do with the asset markets?

As you may have noticed, stock markets around the world are in record high territories. What is driving the stock markets is liquidity?the sheer weight of money and money substitutes chasing after a limited supply of assets (bonds, stocks, art, etc), resulting in skyrocketing prices. Therefore, any crunch in liquidity will result in collapsing asset prices.

How is it possible for liquidity to be crunched?

The problem with liquidity is that most of the ?money? in it is made up of money substitutes, most notably derivatives. Today?s modern financial system is such that when the central bank ?creates? money, money substitutes get spawned multiple times. The outcome is a pyramid of ?money,? with hard cash at the apex and derivatives at the bottom. The financial assets between the apex and bottom include cash deposits (spawned and multiplied from hard cash through the fractional reserve banking system) and credit (e.g. securitised debt). In such a liquidity pyramid, the values of financial assets at the lower part of the pyramid are derived from and backed up by the financial assets above it. Since much more of global liquidity are composed of ?money? in the lower part of the pyramid, any contraction in the upper parts of the pyramid will result in a multiplied contraction in the lower parts. If the liquidity contraction is severe enough, asset prices will fall precipitously, which in turn may trigger even more contraction in liquidity. This is called a ?market crash.?

Thus, as long as the central bank can influence the increase in liquidity into the financial system, asset prices will rise. If for whatever reason, liquidity contract severely enough, asset prices will collapse.

The question is, are we now ripe for a contraction in liquidity?

Analysing recent falls in oil prices?real vs investment demand

Saturday, January 13th, 2007

In November last year, we explained our opinions on the future of oil prices (see Is oil going to be more expensive?). Recently, oil prices had been falling very rapidly to even below US$53. Were we wrong?

Before we answer this question, we have to understand the distinction between the real and financial side of the economy. The real side where you find the physical market for goods, services and labour. The financial side is where you find the flow of financial capital, assets and payments. For example, the stock, debt and derivatives markets are part of the financial side of the economy. As Ross Gittins said in his article, Two sides to the story of nation’s rising prosperity, as the financial side grows in importance, it balloons and crowds out the real side. In Australia, with hundreds of millions more of superannuation money seeking to find a home, we can expect the financial service industry to grow even more, which means the financial side of the economy will rise in further prominence in the future.

Now, let?s go back to oil. What makes up the demand for oil? There are basically two types of demand for oil: (1) The physical demand where the real side of the economy uses for its everyday needs and (2) The investment demand where the financial side of the economy shifts the money here and there from one asset class to the other. We need to ask ourselves the following question: Has the physical demand for oil changed? Will it change in the long run?

From the International Energy Agency (IEA), we can see that world oil supply exceeds world oil demand by just around a couple of millions of barrels per day (or around 2.5% of demand). From the US Department of Energy (DOE), we learnt that,

In the AEO2006 reference case, the combined production capacity of members of the Organization of the Petroleum Exporting Countries (OPEC) does not increase as much as previously projected, and consequently world oil supplies are assumed to remain tight. The United States and emerging Asia?notably, China? are expected to lead the increase in demand for world oil supplies, keeping pressure on prices though 2030.

World oil demand is expected to increase to around 120 million barrels per day in 2025, from 84.5 million in 2006, with developing nations (notably China) capturing a mounting slice of the increase. World oil supply is expected to barely keep up (assuming that Peak Oil is not true) with the demand.

These forecasts are based on a fundamental economic assumption: ceteris paribus, which means ?everything else being equal.? But as we know in real life, things rarely happen nicely according to plan. Unexpected surprises often do happen. The biggest wild card is the geopolitical situation in the Middle East. Would the Israelis or the Americans strike Iran, resulting in Iranian retaliation by disrupting the global flow of oil? Will the US succeed in creating a viable state in Iraq or will Iraq descend into chaos, thus removing a major oil-producing nation from the equation? Would war break out in the Middle East again, destroying and damaging oil infrastructures in the region?

As we can see, the fundamentals of oil are still intact. Therefore, from what we can see, such a rapid drop in oil prices is mainly due to the change in investment demand?asset managers (we prefer to see them as ?money shufflers?) shifting their preferences from one asset class to another.

Some of the reasons given by the financial media to ?explain? the recent falls in oil prices are nonsense. For example, they blamed the warmer than expected weather in North America for the price fall. In reality, oil demand is primarily driven by transportation needs, not by winter heating needs.

One more thing: as oil prices fell because of the fall in investment demand, guess what will happen to the real demand for oil?

Zimbabwean inflation hits 1,281%

Friday, January 12th, 2007

Today, we saw this article Zimbabwean inflation hits 1,281%. This is an example of what can happen to fiat currencies. See Cause of inflation: Shanghai bubble case study and How to secretly rob the people with monetary inflation?.

Introducing options as insurance

Friday, January 12th, 2007

In our previous article (How not to use options), we mentioned about options. Today, for those of you who are uninitiated to the world of options, we will give you a quick introduction. For more in-depth information about options, we recommend the books in the ?Derivatives? section in Recommended Books.

First, let us have a brief introduction on options. When you buy a call option of a stock, you are purchasing the right (but not the obligation) to buy the stock at a specific price (the exercise price in the option?s contract) on and before the option?s expiry date. Correspondingly, when you buy a put option, you are purchasing the right to sell the stock at the exercise price. Technically, when you buy a call (put) option, you are said to be entering a long call (put) option position, or simply ?long? a call (put) option.

The interesting thing about options is that you can also ?create? them for sale. When you sell a call option of a stock, you may be obliged to sell the stock at a specific price if the buyer of the option chooses to exercise his/her right to buy from you. Correspondingly, when you sell a put option, you may be obliged to purchase the stock from the buyer of the option. Technically, when you sell a call (put) option, you are said to be entering a short call (put) option position, or simply ?short? a call (put) option.

When you initiate an option purchase or sale, you are said to ?open? an option position. To ?close? an option position, you enter an opposite option transaction?sell back the purchased option or purchase back the sold option.

A good way to understand options is to see them as akin to insurance. When you enter a long call (put) option position, you are in effect purchasing ?insurance? against the rise (fall) of the underlying stock price. When you enter a short call (put) option position, you are in effect underwriting ?insurance? for the rise (fall) of the underlying stock price. So, option trading is a game of probability?the same way insurance companies are in the business of pricing probability of events for profit. Therefore, as in the insurance business, the option trader has to accurately ascertain the price of probabilities accurately in order to profit.

A brief history of money and its breakdown- Part 2

Wednesday, January 10th, 2007

In today?s topic, we will continue from the previous topic, A brief history of money and its breakdown- Part 1 by touching on the gradual breakdown of the monetary system from two centuries ago till now. Today, the world?s money is totally fiat (money that enjoys legal tender status through the authority of the government instead of through the choice of the free market). Again, the recommended reading for today is Murray Rothbard?s What Has Government Done to Our Money? As Rothbard said in that book:

To understand the current monetary chaos, it is necessary to trace briefly the international monetary developments of the twentieth century, and to see how each set of unsound inflationist interventions has collapsed of its own inherent problems, only to set the stage for another round of interventions. The twentieth century history of the world monetary order can be divided into nine phases.

In the first phase, lasting from 1815 to 1914, the Western world was on a classical gold standard. Each national ?currency? was just a definition of a weight of gold. For example, the ?dollar? was defined as 1/20 of an ounce of gold. Each national currency was redeemable for gold on its pre-defined weight. Thus, if a nation were to recklessly inflate the supply of its money, it would run into danger of having its gold drained from its treasury. At this point, we must stress that gold was not any arbitrary choice by the government. Rather, it was the choice of the free market over the course of centuries as the best money. Thus, at that time, the world had a uniform money medium, which as Rothbard said, ?facilitated freedom of trade, investment, and travel throughout that trading and monetary area, with the consequent growth of specialization and the international division of labour.? Furthermore, such an international gold standard put a rein on government inflating the money supply as well as helped kept the balance of payment of each nation in equilibrium. Though it was not perfect, it ?provided us with by far the best monetary order the world has ever known, an order which worked, which kept business cycles from getting out of hand, and which enabled the development of free international trade, exchange, and investment.?

Next, the First World War arrived. Under the confusion of a wide-scale war, each warring government (except the United States) came off the gold standard and printed money to fund the prohibitive cost of waging war, which would not be possible under the gold standard. Thus, national currencies were devalued and fell in relative value to gold and the US dollar.

After the First World War, the most logical step would be to return to the gold standard at a redefined weight of gold for each national currency. However, British insistence at maintaining the unrealistic pre-war definition (due to national pride) led to their economic malaise. Instead of rectifying the folly of their ways, they induced and coerced foreign governments into the same mistakes at the Genoa Conference of 1922. This resulted in a gold exchange standard whereby (1) the US remained in the gold standard, (2) the British remained in a pseudo-gold standard and ?US-dollar standard,? and (3) the rest on the ?pound standard.? The outcome was a ridiculous pyramid of US dollars on gold, pounds on dollars and the other European currencies on pound. By 1931, as expected, the absurd gold exchange standard collapsed.

At this point in time, it was back to the post-war chaos of fiat currencies again. The US went off the gold standard partially?US dollars were only redeemable to foreign governments and central banks at a re-defined rate of 1/35 of an ounce. International trade and investment were at a standstill and ensuing economic conflict was said to be one of the leading causes of World War Two.

After World War Two, the United States led the way to a new monetary system?the Bretton Woods system. In this system, the US remained in a partial gold standard?US dollars were redeemable for gold by foreign governments. Other countries pyramid their currencies on top of the US dollars. Initially, the US dollar was undervalued and European currencies were overvalued. However, as time went by, with the US inflating their supply of dollars, their gold was increasingly being redeemed by European governments. Soon, it became harder and harder for the US to maintain the free market value of gold at $35.

By 1968, there was a crisis in confidence in the US dollars. The US then decided to abandon maintaining the US dollar at $35 in the free market. From then on, the US decided to ignore the gold free market and maintain the inter-government gold peg at $35. As expected, the free market value of gold soared above $35.

In August 15 1971, the US severed the last link between gold and the dollar. As a result, from then on, the world?s monetary system became totally fiat.

In December 1971, the Smithsonian Agreement was introduced to create some order by maintaining fixed exchange rates among currencies and without any gold backing. With the US continuing to inflate their dollars, fixed exchange rates were untenable. Finally, the agreement collapsed in February 1973.

Finally, that is what we have today?freely fluctuating fiat currencies. As Rothbard said,

Since the U.S. went completely off gold in August 1971 and established the Friedmanite fluctuating fiat system in March 1973, the United States and the world have suffered the most intense and most sustained bout of peacetime inflation in the history of the world. It should be clear by now that this is scarcely a coincidence.

A brief history of money and its breakdown- Part 1

Monday, January 8th, 2007

Today, for this part, we will give a brief introduction on the history of money. For the next part, we will then look at how the monetary system had (and are still today) broken down. For a more in-depth coverage of this topic, we recommend Murray Rothbard?s excellent book: What Has Government Done to Our Money?, which is just only 58 pages?a quick read over the weekend. This background knowledge is highly useful for understanding the value of gold (and the corresponding absurdities of the fiat monetary system that we now have) with regards to today?s monetary system.In the beginning of history, mankind simply used barter for economic exchange. Obviously, barter is problematic because it requires a coincidence of wants. Even if coincidence of wants exists, they require costs to search for them. Also, for some goods (e.g. a live cow), there is no way to divide them for exchanges with more than one counter-parties. Thus, barter is highly restrictive.

The next stage of monetary development is indirect exchange. For this, if you have A and wants C, you exchange A for B and then exchange B for C. Though this way may look inefficient at first glance, it actually works because B may be a more highly sought-after good than A. Therefore, it makes sense to acquire B first as the intermediate step towards acquiring C.

At this third stage of monetary development, a highly marketable good will eventually emerge as the most sought-after intermediate good for the purpose of exchange with other goods. This intermediate good functions as money as we know it. Obviously, such an intermediate good must have characteristics of portability, divisibility, durability and sufficiently rare (but not too rare). Historically, goods like tobacco, cattle, grain, cooper and tea had functioned as money. But over the course of centuries, gold and silver, for whatever reason, were eventually selected by most civilisations as money?gold for larger exchanges and silver for smaller exchanges. That is why we must not make the mistake of following the market?s error by seeing gold and silver as industrial commodities (see Is gold a commodity?).

Crowding at the exits

Sunday, January 7th, 2007

Recently, we had done anecdotal verbal surveys and observations among the people we know. We notice these curious trends:

  1. More and more people (i.e. retail private investors) are trading the stock markets on the side. Leveraged derivatives, like Contract-For-Difference (CFD) are increasingly being used.
  2. More and more people believe that a big crash will happen one day.

For the first trend, that may explain the increase in volatility among the stock market, which in our opinion often does not exhibit the most rational of all behaviour. We believe one of the reasons is because of the widespread use of technical analysis. One popular idea among technical analysis is the concept of a ?support level,? whereby stock prices are expected to ?rest? on and rebound from. Traders often place their ?stop-losses? on the support level, which is the price level that they will sell their stocks in order to cut their losses. As the stock price rests on some traders? stop-loss levels, it triggered their stop-loss sales of their stocks. Such sales put downward pressure on the stock price, which may result in other stop-loss levels to be breached, which in turn triggered even more stop-loss sales. The outcome is a very steep and rapid fall in stocks prices. This outcome is an example of irrational and volatile market behaviour that is increasing in frequency. With easy availability of (1) leveraged instruments like CFDs, (2) instantaneous communications via the Internet and (3) automation of trading via computers at the hands of the common people (who are not trained to think like true investors), this effect becomes magnified even more.

For the second trend, it may be the consequence of the fact that the common people are beginning to understand and see the absurdities, excesses and greed in the financial systems. Unfortunately, even among those who believe that a crash is inevitable, they still have a substantial portion of the wealth in the stock market, either voluntarily through their side trading, or involuntarily through their superannuation. For some of these side traders, they may believe that it is all right as long as you know ?when? to get out of the stock market.

This is the scary part.

If you sincerely believe that a crash is inevitable, you have to understand these facts:

  1. You cannot know ?when? to get out. Crashes always take the majority by surprise. Otherwise, the majority would have gotten out long ago, which means it cannot be called a crash in the first place.
  2. By the time you know it is time to get out, chances are, everyone else does too.

What is the implication? The first trend, along with these facts implies that when a crash happens, it will be so extremely rapid that vast amount of paper wealth will vanish in seconds as the gigantic herd heads for the crowded exits simultaneously. Your chances of surviving a crash with your wealth intact is pretty much zero. Even scarier, since the vast majority of people have much of their accumulated wealth in the stock market through their superannuation, a crash will affect this vast majority, which is an unprecedented scale in all of human history.

Please bear in mind that we are not predicting a massive crash in the days ahead. We are highlighting the important point that if you sincerely believe that a crash is inevitable, the time to get out is NOW, which is the most rational thing to do. The ideas of (1) an inevitable crash and (2) staying in the stock market while the party is still on, are mutually incompatible. On the other hand, if this is not your belief, then you can pretty much ignore everything this article has to say.

China is tightening liquidity

Sunday, January 7th, 2007

Today, this article caught our eye: China Raises Bank Reserve Requirement to Cool Lending (Update3). China is tightening liquidity in its financial system and the implication is that sooner or later, if the tightening trend continues, the stock bubble merrymaking will eventually ends (see Caution: new high in Shanghai Stock Exchange Composite Index). It may not lead to a crash, but at the least, the upward momentum will have to end.

Good news! Gold fell by more than 3% overnight!

Saturday, January 6th, 2007

This morning, we were pleasantly surprised to see that gold prices (along with the other metal commodities) plunged overnight in New York. It was just a few days ago when gold prices was north of US$640 and it is suddenly US$605 today. We checked out the financial media and found those dubious ?reasons? for the plunge:

  1. The US$ surged after a better than expected jobs data (which ?means? the Fed is more likely to raise interest rates, which in turn is bullish on the US$).
  2. Oil prices fell due to warmer than expected weather in North America.
  3. Profit taking ahead of the weekend.
  4. Funds hate uncertainty?so they pull the sell trigger and ask questions later.
  5. Tightening of money supply in China and India, led to a stronger US$ (the US$ and gold price has a so-called inverse relationship).
  6. French President Chirac urged a growth-oriented Euro policy, which is bullish for the US$.
  7. ?Investors? were nervous because the energy market was being beaten up badly.

As we said before in How much should we listen to the financial media?, the financial media have to always come up with ?reasons? to explain the market?s behaviour. At times, there can be no particular rationale behind such developments simply because those are characteristics of mindless herd behaviour.

For us, what if the gold price falls further in the next wave of panic selling? If that happens, we welcome that as another opportune time to further increase our hoard of this undervalued treasure. Indeed, we do thank those hedge fund managers for selling us gold and silver at such giveaway prices. Meanwhile, for us as investors, we do well to remind ourselves of the fundamental reason for holding them so that we would not be unduly perturbed by short-term price volatility.