Archive for December, 2007

To botch an economic forecast, rely on past experience

Monday, December 31st, 2007

Today, we have put together a collection of our articles in the Popular Topics section: Why are the majority so wrong at the same time and in the same ways? In line with this provocative question that is asked, we found an article by Peter L. Bernstein, a veteran financial consultant, economic historian, editor of the Economics & Portfolio Strategy newsletter and author of the investment classic, Against the Gods: The Remarkable Story of Risk. He wrote this article in the International Herald Tribune: To botch an economic forecast, rely on past experience,

A lot of people have been wrong about the markets and the economy in recent months. But how could so many people have been so wrong at the same time and in the same ways?

The question reminds me of the biggest and most embarrassing goof in my own career. This sad story happens to date back 50 years, to New Year’s Day of 1958.

In looking back, I can now see the source of my error: I was postcasting – extrapolating past experience instead of seeking change in future experience. The aftermath was embarrassing, but it taught me never to postcast again.

We agree wholeheartedly with Bernstein, as we mentioned before in our earlier article, Common mistakes in failing to see economic turning points:

Likewise, a common mistake that investors make is to look at the current situation as it is and project [extrapolate] what is current into the future [sometimes to the indefinite future!].

The conclusion of his article contains a paradoxical wisdom:

It has been said that good forecasters have a good sense of history. I suppose that is true. But the best lesson from the past is to forget it before it shoves you into trouble – and remember that surprises and ruptures surely lurk ahead.

Again, we agree wholeheartedly with Bernstein, as we mentioned before in our earlier article, Failure to understand Black Swan leads to fallacious thinking:

For this reason, that is why we delve more on the big picture and economic history and get mired less on minute statistics and detailed numbers. In technically philosophical terms, it means we are taking on a meta-view i.e. we are taking on a view of our view. At times, this means we have to expand our circle of understanding and venture outside of finance, investing and economics into fields such as psychology, politics and history. The broader our circle of wisdom and experience (that includes borrowed experience from a study of history), the less vulnerable we will be to being caught out like that turkey.

The root to the understanding of this paradox is this: It is not experiences (which include borrowed experiences from the study of history) that trip us. Rather, it is how we apply our experiences that lead us into fallacies.

Failure to understand Black Swan leads to fallacious thinking

Saturday, December 29th, 2007

As we talk to more and more people, we encounter a very frequent lack of understanding of Black Swans (for those who wants to learn more about Black Swans in detail, we recommend this book: The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb). As a result, many people have this erroneous belief that contrarians are predictors of gloom and doom. The more entrenched this lack of understanding (of Black Swans) is, the deeper the fallacy one will fall into. This lack of understanding will degrade the quality of one’s thinking, which can translate to severe financial loss when investing.

Today, we will again attack the stubborn entrenchment of this conception black hole.

First, let’s recall the parable of the turkey in our previous article, How the folks in the finance/economics industry became turkeys?Part 1: Parable of the turkey:

Let?s say you are a turkey. Ever since you were born, humans had always fed you, took care of you and ensured that you were healthy and fat. In all your long life of 1000 days, humans were always your friend. Therefore, you forecast that the next 1000 days will be like the average of the past 1000 days?great care under the hands of your human friends. Life has always been good and you see no reason for otherwise in the future…

Then on the 1001st day of your life, it was the eve of Thanksgiving Day. By Thanksgiving Day, you had became a meal for humans.

Sad story. But to that poor turkey, the eve of the Thanksgiving day is the day of the Black Swan event.

Again, what is a Black Swan event? A Black Swan event is one which is:

  1. Highly unlikely (i.e. very unlikely based on statistical probability)
  2. Colossal impact

For that turkey, being slaughtered on Thanksgiving Day eve is a Black Swan event because:

  1. Based on statistical probability, the chances of being slaughtered is ZERO
  2. The impact spells the end of everything for that turkey

For us, we can laugh at that turkey because our infinitely better wisdom and vastly greater experience tells us that a turkey being slaughtered on Thanksgiving Day eve is nothing new.

For this reason, that is why we delve more on the big picture and economic history and get mired less on minute statistics and detailed numbers. In technically philosophical terms, it means we are taking on a meta-view i.e. we are taking on a view of our view. At times, this means we have to expand our circle of understanding and venture outside of finance, investing and economics into fields such as psychology, politics and history. The broader our circle of wisdom and experience (that includes borrowed experience from a study of history), the less vulnerable we will be to being caught out like that turkey.

Next, why is it that people get caught out by Black Swans?

Let us quote page 140-141 of The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb:

Epistemic arrogance bears a double effect: we overestimate what we know, and underestimate uncertainty, by compressing the range of possible uncertain states (i.e. by reduce the space of the unknown).

I remind the reader that I am not testing how much people know, but assessing the difference between what people actually know and how much they think they know.

What do disasters such as the sub-prime crisis, probable collapse of Centro, collapse of Basis fund have in common? The common defense we hear is, “We didn’t expect it!” Those ‘experts’ often use technically sounding words like “six-sigma” to describe such unexpected events. In reality, they were just like the turkey: they think they know a lot when in reality, they know very little. That is, as what Taleb said, “compressing the range of possible uncertain states.” As a result, they were caught out by the unknown unknowns, just like the turkey. That is why economic and financial experts’ forecasts are often unreliable- in their models, the unknown unknowns do not exist and their forecasts depend on the non-existence of the unknown unknowns to be accurate. But in real life, unknown unknowns often appears unexpectedly, which serve to expose how much these experts do not know.

Now, back to some people’s erroneous belief that we are predictors of gloom and doom.

First, as contrarians, we are not in the business of prediction. Rather, we prepare for Black Swans. To give yourself an idea why such preparation is important, ask yourself this question: Why do parachutists pack a second reserve parachute? Since the statistical probability of a parachute failure is extremely low, does that mean we should completely ignore such a possibility (of the primary parachute not opening)? Therefore, those people who fallaciously believe that preparing for Black Swans is ‘predicting’ is like believing that the parachutist who packs a reserve parachute is ‘predicting’ that his/her primary parachute will fail. Here, as you may notice, we explore the possibilities of how things may go wrong, which is far from ‘predicting’ that things will go wrong. By doing that, we are pushing the boundaries of the unknown unknowns further and further away. The unknown unknowns are where Black Swans occurs. Also, it is not possible to explore all possibilities. Therefore, we concentrate on those that are going to have colossal impact.

To end it all, remember this: there is a difference between prediction and preparing (and even profiting) from Black Swans.

See how a mortgage CDO work

Friday, December 28th, 2007

Previously, in Collateral Debt Obligation?turning rotten meat into delicious beef steak, we explained how CDOs work. For those who are more  visually inclined (as oppose to ‘literary inclined’), we recommend this Flash demonstration from the Wall Street Journal that shows how CDOs work.

Recipe for hyperinflation

Wednesday, December 26th, 2007

In our previous article, Are we heading for a deflationary type of recession?, we explained the argument of those who believe that the current credit crisis in the US will lead to deflation of money and credit. The manifestation of such a deflation will be falling asset and consumer prices. Examples of such deflation are the Great Depression of the 1930s and the Japanese recession of the 1990s.

Today, we will explore the possibility of the inflationary scenario. Examples of such a scenario are the hyperinflation of Weimar Germany of the 1920s and Zimbabwe today. We assume that you have read our previous article, Are we heading for a deflationary type of recession? for today’s article.

Given that under today’s fiat money regime, central banks have the sole authority to create money out of thin air. Such authority entails vast power. To illustrate this point further, imagine you are the only person in town who has the authority to create money out of any piece of paper with your own signature. Wouldn’t this make you a pretty powerful person in town? With such power, you can acquire anything you wish at the expense of others. Likewise, the paper money that we have today is exactly such money. Look at any piece of paper money today and you will find the words of a government decree (e.g. “This Australian note is legal tender throughout Australia and its Territories”) and perhaps a signature or two.

Therefore, some kinds of ‘rules’ are necessary to fetter and curb such vast power. Without these ‘rules,’ it is impossible to maintain the integrity of money. If money loses its integrity, the financial system and economy will break down and we will be reduced to primitive bartering. The ancient Chinese knew about the necessity of ‘rules’ when they experimented with fiat paper money about a thousand years ago (see Ancient Chinese fiat paper money). During the Song Dynasty (960-1279), they had self-expiring fiat money in an attempt to prevent inflation.

Now, look at the current scheme of arrangement as described in our earlier article, Are we heading for a deflationary type of recession?:

  1. The creation of fiduciary money (credit) lies in the power of the banking system through the granting of credit. Today, with the proliferation of non-bank financial institutions and financial ‘innovations,’ the central bank is not able to control the supply of fiduciary money.
  2. The central bank sets the target price of money (interest rate), which influences the quantity of standard money (base money). As we said before in How does a central bank ?set? interest rates?, setting the target price of money involves open market operations. Injecting or draining base money from the financial system involves buying and selling government bonds and entering into repurchase agreement (repos). For those who are interested, this document from the Reserve Bank of Australia explains how money market operations work.

Such scheme of arrangements is just a tiny fraction of ‘rules’ that ‘govern’ the vast power associated with the authority to create money. Now, imagine that those above-mentioned ‘rules’ are being relaxed such that the government can order the central bank to bail out everyone and every business that is financially insolvent by giving them freshly printed money. Overnight, this will solve the problem of bad debts and we will not have any credit crisis to worry about. Everyone will be happy right?


Take the example of Japan in the 1990s. As this article from the Ludwig von Mises institute said,

If banks held 100% reserves, this would not sound the death knell. But for a fractional-reserve system, it’s institutional death. Only the central bank can prevent total collapse. It must act as a lender-of-last resort. Yet, when the credit expansion of the boom has been particularly extreme, making good on all bad loans with monetary inflation is something the central bank dare not do for fear of hyperinflation.

The current [1995] level of bad debt in Japanese banks is estimated to be between 50 and 80 trillion yen, which translates to a 30 to 50% increase in the narrow money stock. The Bank of Japan simply cannot bail out the system with this level of monetary inflation.

The main point is, once those ‘rules’ are rolled-back to give the government more power and authority with regards to their monopoly on money, the slippery road towards the ultimate loss of confidence in the integrity of money begins. A very fine example is Zimbabwe. With an autocratic despot in power, such loss of confidence is manifested in the form of hyperinflation.

Now, the question for us as investors is this: are we moving towards such a scenario?

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. But alas, we live in a democracy where the mob rules. As we said before in A painful cleansing or pain avoidance at all cost?,

Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.

There is no way any politician can sell the message that America needs a severe recession (or even a depression) to cleanse the economy from the gross excesses, imbalances, blunders and mal-investments. Thus, it is very likely that they will have to fight deflation till the very bitter end, till the last drop of blood from their last soldier. 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. Since the rest of the world’s currencies are as fiat as the US dollar and are based on the US dollar standard (see How does the US export inflation?), you can be sure the result will be ugly for the global financial system.

Therefore, watch what the US government is doing with the monetary ‘rules’ in its attempt to fight deflation. And hold gold as you watch them. Remember what we said before in Have we escaped from the dangers of inflation?,

One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.

Are we heading for a deflationary type of recession?

Tuesday, December 25th, 2007

If you have been with us for quite a long while, you will know that we believe we may be heading towards an inflationary type of recession (i.e. ‘stagflation’ e.g. Zimbabwe’s current hyper-inflation)- see Supplying never-ending drugs till stagflation. But there are some contrarians who believe that we are heading towards deflation (e.g. Great Depression).

Today, we will explain their position, though that does not necessarily mean we are justifying such a view.

Remember, back in 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?, we said

Today, we live in a time of fractional reserve banking system. Put it simply, if you deposit $100 into a bank account, the bank is going to lend out a large proportion of your $100 and keep the rest as reserves, in case you decide to withdraw some of your money as cash. The proportion that the bank is going to keep as reserves is the reserve ratio. Let?s say the reserve ratio is 10%. After depositing $100, the bank is going to keep $10 and lend out $90. The $90 that someone borrowed from the bank will again be deposited, resulting in $81 being lent out and $9 keep as reserve. At this point time, how much money has you original $100 multiplied into? In terms of the amount of bank deposits, there are now $100 + $90 + $81 = $271 of ?money? in the financial system. This can go on and on, until the quantity of money swell to the theoretical limit of $1000 (based on reserve ratio of 10%).

In this example, the original $100 is known as the “base money.” In the Austrian School of economic thought, “base money” is called the “standard money.” The $900 worth of money, according to the Austrian School terminology, is known as the “fiduciary money.” In common terms, that is called “credit” (which is “debt” from the viewpoint of the counter-party).

What happens, for whatever reason, there are bad debts? In that case, the value of credit has to be written off, resulting in the cascading contraction of fiduciary money in the economy (see How money & credit can shrink for more details) i.e. deflation.

Now, recall that in What makes monetary policy ?loose? or ?tight??, we said that,

… the central bank cannot control the demand for money and credit. It can supply whatever amount of them that it wants, but it cannot force business and people to desire them. Put it simply, you can lead a horse to the water, but you cannot force it to drink.

To put it simply, under the current arrangement of global banking and finance, central banks cannot control the supply of money and credit directly. They supply or withdraw whatever amount of base money given its current state of demand by setting the target price of money (interest rates). Then through the banking system, credit is dispersed and created throughout the economy.

In times of recessionary deflation, when bad debts are abounding and there is great economic pessimism, the demand for credit (fiduciary money) will collapse. In such a time, borrowers will be unable to borrow money and lenders will be unable or unwilling to lend. Consequently, the banking system’s demand for base money (standard money) can potentially collapse as well. As a result, the quantity of base money can follow in the contraction (or at the very least, unable to expand). Whether base money will expand or contract is immaterial for today’s discussion. What is material is that central bankers cannot control (but can influence) the quantity of fiduciary money (credit) in the economy. This is especially true for today, where there is proliferation of non-bank financial institutions and financial ‘innovations’ that lies outside the mandate and control of central banks.

Thus, this is the root reason for contrarians who argue that the deflation of money (primarily fiduciary money) is unstoppable (because central bankers are in no position to stop the implosion of bad debts). Since it is outside the mandate of central banks to print money and force it down the throat of the economy, central banks cannot create inflation in such a situation. Japan, which experienced 16 years of extremely stubborn deflation since the early 1990s, is an object lesson for the deflation argument.

So, what are the arguments for inflationary scenario? Keep in tune!

Merry Christmas!

Monday, December 24th, 2007

We would like to wish all our readers a very merry and happy Christmas!

Red-hot Chinese property market getting the blues?

Sunday, December 23rd, 2007

Today, we saw this article,

 Market shows sign of flagging but analysts say it will escape disaster

One of those property ‘investors’ was quoted in the article, saying

‘The investment doesn’t make sense if property prices stop rising,’ said Mr Wang, 34 and the father of a 3-year-old, who spent most of his savings buying the apartment.

But most analyst and the so-called ‘experts’ are sanguine about the possibility of a crash in Chinese real estate.

As we mentioned before in Is China about to crash? last month, this first sign of asset price deflation in China could be a precursor of something more painful to come.

Outlook 2008

Wednesday, December 19th, 2007

Back in January this year, we said that the US dollar would be the one to watch out for in 2007 (see One potential trouble-maker to watch out for in 2007). Indeed, 2007 is the year that we see the rapid fall of the US dollar and the rise of gold. Just as we explained last year in What can we expect in a US dollar decline?, a sustained decline in the US dollar will let loose the demon of price inflation. This is what is happening right now in the US. At the same time, we are seeing a serious deflation of housing asset prices and liquidity contraction due to the rise of bad debts (i.e. the implosion of the infamous sub-prime loans).

Right now, there are two opposing macro themes at work- as we can see by the fact that central bankers are fighting on two fronts simultaneously, namely monetary deflation and price inflation. Thus, as 2007 draws to a close, we will refrain from any prediction in our outlook for 2008. However, we would like to highlight some possible risks:

  1. Further corrections in the global stock markets We had explained our reasons for this in Marc Faber on why further correction is coming?Part 2. The credit crunch is one of the manifestations of the liquidity contraction in that article.
  2. Global price inflation Central bankers will want to pre-empt any liquidity contraction as much as they can. The only way to do that is to debase the currency further. The manifestation of such is being elaborated in Is holding cash very risky?.
  3. Debt deflation Currently, Australia’s total private debt is around 160% of GDP, which is at a unprecedented level even exceeding the Great Depression (when it was just 80% of GDP). Australia’s economic propsperity is financed by debt. However, it is such high levels of debt that can accentuated the inevitable bust. One outcome, will be as explained in Can Australia?s deflating property bubble deflate even further?.
  4. Will Australia escapes the effects of a recession in the US? See Is Chinese growth ?de-coupled? from the US economy? and China at turning point?.

What should equity investors focus on in 2008?

At this point in time, it is unclear which front (deflation or inflation) central bankers will be victorious on. Currently, there are signs of both- asset price deflation in the US and UK and food and energy price inflation i.e. stagflation. Investors should hedge their bets both ways.

First, avoid businesses that are too dependent on debt. In light of the global bear market in credit, such businesses can be easily caught with their pants down. Businesses that have strong cash position should be favoured. In times of deflation, the real (as oppose to nominal) value of cash increases. Also, look for businesses that have strong pricing power as well- that would be handy in times of price inflation.

Finally, we favour hedging of financial well-being with gold. More explanations on Why should you invest in gold?. For those who know what they are doing, they may want to consider gold mining companies- but be aware of the potential pitfalls as explained in Can Australia?s mining boom turn into bust?.

Is this sub-prime or solvency crisis?

Monday, December 17th, 2007

Today, news hit the Australian market of a very highly likely collapse of Centro Properties Group, one of the largest and most well-known Australian property trust. The result was a bloodbath in the stock market. As we read the mainstream news media, we caught hold of this article, Centro on the brink as shares collapse in the Sydney Morning Herald:

Centro Properties Group has become the biggest local victim of the US sub-prime mortgage crisis after higher funding costs forced it to downgrade of its distribution guidance, causing its shares to plunge by more than 70 per cent.

Pay attention to the phrase “US sub-prime mortgage crisis” in the above paragraph.

Sometimes, the problem with the mainstream media is that they often reduce their readers’ understanding of what is really going on in the financial market. As a result, we get to hear nonsense like this: “Oh, investment x is a fundamentally solid investment because it does not have sub-prime exposure.” People has come to believe that the sub-prime crisis is the source and root of the problem.


The root of this crisis is bad debts. Back in March this year, we mentioned in Marc Faber on why further correction is coming?Part 1,

Next, how is liquidity created? Traditionally, the money that is ?printed? by the central bank is the source of liquidity. But today, through the fractional reserve banking system (see 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy? on how money and credit is created by the banks), the central bank is no longer in total control of liquidity because the creation of money and money substitutes is no longer in its hands. This situation has gone to the point whereby money substitutes (e.g. derivatives, securitised loans) supplanted the ?original? money created by the central bank as the vast bulk of global liquidity (see Prepare for asset repricing, warns Trichet on the extent of this supplantation).

The problem is that much of the economic boom that we enjoy over the past several years are financed by the explosion of credit (which is debt on the opposite side of the balance sheet). There is such a colossal amount of debt created and scattered throughout the globe that it does not take a genius to see that massive amount of bad debts have to accumulate and build up in the global financial system. Eventually, all bad debts will be exposed as what they truly are.

Hence, the sub-prime crisis is just a symptom and focal point of this systemic rot. In essence, the big picture is not merely about sub-prime mortgage debt. It is about the mass-solvency of the global financial system.

What is SIV?

Sunday, December 16th, 2007

Today, if you read the financial media, you will often come across a bewildering series of alphabet soup associated with the infamous credit and sub-prime crisis: CDO, SIV, ABCP, LIBOR, MBS, ABS etc.  Although they sound very technical and mysterious to the uninitiated, the essence of their meanings is actually very simple. Today, we will unravel yet another one of these alphabet soups: SIV. Before you continue reading this article, it would be good if you can revise your understanding of the securitisation process (see How to dump risk to consumers: securitisation) and CDO (see Collateral Debt Obligation?turning rotten meat into delicious beef steak).

Recall that back in How to dump risk to consumers: securitisation, we mentioned that

With the recent financial ?innovation? of debt securitisation, lenders can now aggregate their loans, and through dicing, slicing, splicing and divesting, repackage it into an ?investment? product… These ?investment? products are then sold to retail investors (i.e. consumers) directly and indirectly (through their retirement funds).

Now, imagine that you are a lending. After lending your money to a mortgagee borrower, your loan to the mortgagee borrower becomes an asset in your balance sheet (and a liability in the mortgagee borrower’s ‘balance sheet’). Thus a link is formed between you as a lender and the mortgagee borrower as a borrower. As we said before in Collateral Debt Obligation?turning rotten meat into delicious beef steak,

 Today, through the financial ?innovation? of securitisation, the link between lenders and borrowers were broken. It has developed to the point whereby the one who is lending you the money is not the one who has to bear the loss or clean up the mess when you default on the loan.

So, how can this link be broken between the lender and the borrower? Here comes the Structured Investment Vehicle (SIV) which is a type of “conduit.” Basically, a SIV is a fund that buys those mortgage assets from the lender. By doing this, the lender can offload these mortgage assets from its balance sheet.

The next question is: where does the SIV get its money from?

As it turns out, the SIV get its money through borrowing short-term in the credit market by issuing commercial paper. Since the mortgage asset is a long term debt, the SIV basically borrows money in the short-term to finance the purchase long term mortgage assets. The difference between the short-term and long-term interest rates makes up the profit of the SIV.

The recent deterioration in the credit market is severely disrupting the SIV funds because of the high cost of obtaining short-term funding. As a result, many of the lenders have to buy back the mortgage assets from the SIV, resulting re-loading those mortgage asset into its balance sheet.