Archive for December, 2007

Technical analysis & its ‘inverse’

Thursday, December 13th, 2007

Today, we will deviate from our usual discussion of macroeconomics and talk about tools for short-term trading- technical analysis. According to the Wikipedia, technical analysis is:

Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends.

Do we believe in technical analysis? As we commented before in Telstra?s share price vulnerable in the short-term,

Some analysts may scoff at technical analysis and place it in the same league as astrology. But for us, we prefer to be agnostic about it. The reason being, since there are so many traders in the market employing the use of technical analysis, it will become a self-fulfilling prophecy.

Whether you believe in technical analysis or not, you will do better to understand the root philosophy of technical analysis and thereby, be aware of its weaknesses, limitations and pitfalls.

First, what are the root assumptions of technical analysis? Technical analysis is based on the premise that:

  1. The price behaviours of the market/instrument exhibit repeatable patterns.
  2. The price reflects all known information about the market/instrument. That is, there is no need to study the fundamentals because the price has already reflected them.

Therefore, technical analysis uses statistical probability to take a stand on the likelihood of future price movements. In other words, it uses what happened in the past as a guide to what may happen in the future. For example, a technical analyst will base his/her trades on interpretation of patterns in the charts.

But this implies a major weakness of technical analysis- it is vulnerable to Black Swans. As you may recall in our earlier article, How the folks in the finance/economics industry became turkeys?Part 1: Parable of the turkey, a Black Swan event is

… one in which it is highly improbable
but has colossal impact.

By definition, a Black Swan event is close to impossible based on statistical probability. Therefore, it is something that is completely ‘unexpected’ by technical analysis. In other words, the Black Swan is the blind spot of technical analysis.

Interestingly, there is a rare breed of traders who uses what we call the ‘inverse’ of technical analysis. They seek to profit from statistically rare events (i.e. Black Swans). To be able to do so, they have to construct asymmetric payoff strategies. In view of this, our article series, How to profit from a stock market crash?, is an example of ‘inverse’ technical analysis (this phrase is our own invention- probably it is not used anywhere else).

Thus, by all means learn and use technical analysis if you intend to trade short term. But bear in mind, it has its own blind spot.

Is holding cash very risky?

Tuesday, December 11th, 2007

One of the myths that is often perpetuated in the mainstream world of finance and economics is that holding cash is considered ‘conservative.’ This is one of the myths that we wish to debunk today. In fact, in this current climate of world economic order, holding cash is very RISKY!

If this is the first time you are reading this, you may be completely surprised by this assertion because it completely goes against the grain of conventional wisdom. Therefore, what follows will only make sense if you first understand the fundamental reason for holding gold- read Why should you invest in gold? first before proceeding if you are unfamiliar with this topic.

As you have read the news recently, the current economic threat facing the US economy right now is deflation. Deflation, according to the Austrian School of economic thought, is defined as the contraction of money and credit. Conversely, inflation is defined as the expansion of money and credit. The popular mainstream notion of deflation, which is defined as falling of general price levels, is wrong and misleading. Thus, this is the most important concept that you have to get right before proceeding further- see Cause of inflation: Shanghai bubble case study.

Now, back to deflation in the US. Property prices is falling. The credit crunch is resulting in the rapid drying up of liquidity. Big financial institutions are facing massive asset write-downs (in terms of billions of dollars) due to the infamous sub-prime debacle. All these are merely symptoms of deflation (see Spectre of deflation). As we said before in Inflation or deflation first?,

Now, faced with the threat of a deflationary recession, what can the Fed do? Politically, it is impossible for them to allow a recession run its full course in order to clean up the prior excesses of the bubble. They will do anything and everything to ?prevent? another recession. The only way for them to do that is to do what they always did?pump even more liquidity into the economy (a.k.a ?print? money).

It is monetary inflation that causes the build up of mountainous bad debts and structural damage (through mal-investments) to the US economy. The inevitable monetary deflation that is running its course right now is threatening to tip the economy into an acute recession (perhaps even a depression). There is a sense of urgency in the Fed to ‘prevent’ a recession by propping up the solvency of the economy. The only way to do that is through monetary inflation (‘print’ money) i.e. ‘print’ its way out of unpayable amount of colossal debt. Each additional dollar that is ‘printed’ will degrade the quality of the US currency. The symptom of such currency degradation is price inflation.

The rest of the world is not off the hook either. As we said before in How does the US export inflation?, as the US debase their currency, other nations have to follow suit. Thus, every national currencies are in a race to the bottom.

So, can you see why holding cash is risky? The current world economic order is setting itself to a path of synchronized currencies depreciation. The purchasing power of cash will fall and continue to fall i.e. price inflation will rise and continue to rise. Your superannuation, pension and retirement fund may grow in nominal terms, but in the end, the risk of losing significant value through price inflation is high.

The signs are there: synchronized cutting of interest rates (‘print’ money), bail-outs, more cutting of interest rates, more bail-outs, rescue packages, bank deposit guarantee (remember Northern Rock?), e.t.c. All these things (monetary inflation) are happening in the midst of price inflation.

We have said it before many times, and we are going to repeat ourselves again: the only way to protect yourself against currency debasements is to accumulate gold, which has a history of functioning as money stretching back to early human civilization.

Bush’s mortgage relief plan- who pays?

Saturday, December 8th, 2007

Recall that Is the worst over yet?, we mentioned about looming wave of housing defaults in the US. Hence,

… there are going to be more adjustable rate mortgages in the US that will have their mortgage rates reset in the coming months. That is, a lot more home loan borrowers will find that their mortgage rates will revert from the ?honey moon? rate to the standard rate. Therefore, more people are going to find that their mortgage expense will shoot up suddenly. When this happens, we can expect the rate of foreclosures and home loan debt defaults going to rise in the US.

But now, as you would probably have heard by now, President Bush has a plan to preempt the escalation of this crisis. In Bush offers homeowners 5-year rate freeze, it reported that

US President George Bush today offered new steps to help homeowners facing steep increases in their mortgage payments, an effort to prevent the US housing crisis sending the broader economy into a recession.

Look at how the stock market reacted in respond to Bush’s plan- it surged almost 200 points upwards on Thursday. Isn’t this wonderful?

Well, no.

There is no such thing as a free lunch. The question is, who is going to pay the bill for the mortgage reset relief? As you may recall in Collateral Debt Obligation?turning rotten meat into delicious beef steak,

After you ?buy? the home loan ?product,? your regular loan repayments are aggregated together with other borrowers? repayments into a tap of cash flow. This cash flow is then sliced into pieces of ?investment? products.

So, no matter how wonderful Bush’s plan may be, someone, somewhere, has to foot the bill. Who are the ones to do so? We can think of two groups of people:

  1. ‘Investors’ of CDO products – If the cash flow from borrowers has to be reduced to help them tide over their un-payable mortgage repayments, then those ‘investors’ of CDO products will have to accept reduced yields on their ‘investments.’ This would mean that the value of their ‘investments’ would have to be crimped significantly to accommodate the crimped yields. Since the values of these ‘investments’ will exist in someone’s balance sheet as an ‘asset,’ then this means there will be further asset write downs.The question is, who are those ‘investors’ of CDO products? They could be you and I!! What??

    Well, almost all of us have superannuations, 401k, insurance policies, bank accounts, etc. How do we know whether our superannuation/401k funds, insurance companies, banks, etc have any kind of direct or indirect exposures to those toxic CDOs? Well, they can assure us all they want regarding their levels of exposure to those CDOs, but can they really be absolutely sure? They can account for their direct exposures (if any) to CDOs, but what about their unknown indirect exposures through their relationships to other financial institutions, funds, businesses, derivative position, etc?

    Mind you, a lot of us are foreigners to the US. For example, some of us could be pensioners in Australia footing the bill of Bush’s plan.

  2. American tax-payers – Bush could tax the American people to pay for his plan. But this will be politically impossible because in a democracy, the mob always want something for nothing. The next best alternative will be through stealth tax- ‘printing’ of money (see How to secretly rob the people with monetary inflation?). This way, the American people will pay through price inflation. That is, they will pay through the further loss of their dollar’s purchasing power.

Between these two groups of people, who do you think will be the chosen one to foot the bill? We doubt it will be the first group because of the risk of further inflammation of the credit crisis. Therefore, the more likely choice will be the second group, which is more convenient for the US government. And it is most likely the second group will pay by stealth (i.e. further debasement of currency through the ‘printing’ of money).

Sure, the stock market may react by rising further. But it will be for the wrong reason.

Will the Chinese really tighten?

Thursday, December 6th, 2007

Today, we saw this news article, China Plans `Tight’ Monetary Policy Next Year to Cool Economy,

China plans to shift to a “tight” monetary policy in 2008, signaling the government may raise interest rates further and allow quicker currency appreciation as the economy heads for its fastest expansion in 12 years.

Do the Chinese authorities have the will to really tighten their monetary policy? This is not the first time they say they will be doing that. Furthermore, they have been ‘tightening’ monetary policy for quite a long while already, with no success (see What makes monetary policy ?loose? or ?tight??). They had tried many things, from price fixing, price controls and decrees and yet met with no success as price inflation is still running red hot. The only effective way to tighten monetary policy is to let the yuan appreciate significantly. But if they do so, the risk is that they may accidentally lose control, turning a slowdown of the economy into a rout (deflation).

Is the Chinese financial system really that much healthier than the US financial system? Well, we can be sure that there are heaps of bad debts around in China. When the monetary tide recede, we can see which companies and businesses have been swimming naked.

Common mistakes in failing to see economic turning points

Tuesday, December 4th, 2007

In our previous article, Why some believe a crash is imminent, we discussed the contradictions between the US stock market and the economic fundamentals. In other words, we believe that we are at a turning point in the economic cycle that is not yet recognised by the stock market. However, as contrarians, we expect the majority of market participants to disagree with us. But bear this in mind: at turning points, an investor is either a contrarian or a victim. The difference between the two is the quality of their thinking.

What are the common mistakes of those who fail to see turning points?

Adopting turkey thinking
Recall that in our earlier article, Parable of the turkey, that poor turkey extrapolates the good life it had into the indefinite future and became a victim during Thanksgiving day. Likewise, a common mistake that investors make is to look at the current situation as it is and project what is current into the future. Looking back into history, we can see that the majority failed to anticipate the Great Depression. As we said before in The Great Crash of 1929,

Contrary to popular belief, the Great Crash of 1929 was not completely without any warning. As early as November 15 1925, Alexander D. Noyes, a highly respected financial editor of the New York Times, warned in a very long article that the ?speculative mania? of the 1920s was not unlike previous bubbles and that stock prices could not rise forever. Long before the Great Crash, the contrarians of the day were already sounding the alarm.

The only fault of the contrarians is that some of them were far too early. The lesson for us, as contrarians, is that it is foolish to make any forecast, especially with regards to price and timing. Instead of predicting, we highlight the possibilities of what may happen. Again, many critics of contrarians fail to understand the difference between the two.

Failure to see the connections
The global economy is made up of highly complex connections of systems within systems. Therefore, it is more appropriate to see the global economy as a network rather than just a disparate collection of entities. The nature of the network is that any changes on one part of the network can have unpredictable side-effects on the entire network itself. Furthermore, the nature of networks is such that it exihibits behaviours that arises from self-reinforcing and stabilising feedbacks. That’s why sometimes markets move in cycles and sometimes market revert to the mean.Though there may be disagreements and differences in opinion on the workings and the side-effects of a network, it is a colossal mistake to see the global economy as just a collection of incongruent units. Thus, one of the most common mistakes investors make is to look at one part of the network and assume that it is immune to whatever is happening to the other side of the network.

With that in mind, what are the questions to ask? For example,

  1. What are the effects of the Fed’s normalising of interest rates from 1% to 5.25% from 2002 to 2005?
  2. How will the slowdown of property asset price appreciation affect the solvency of consumer debts?
  3. How does the sub-prime crisis affect the financial system of the US?
  4. How will the credit crunch affect the operations of businesses?
  5. When will the solvency of consumer debts affect consumer spending?
  6. Will falling profitability of businesses result in self-reinforcing feedback effect on consumer solvency?
  7. What are the connections between the credit crunch and financial solvencies of funds and businesses in far away China and Australia?
  8. How much will consumer spendings in the US affect the Chinese economy?
  9. If the Chinese economy slow-downs, how will it affect the resource industry in Australia?
  10. How vulnerable is the Australian economy on the resource boom?
  11. If the vast majority of the world’s assets are deonominated in US dollars, what are the implications of a loss in confidence in the US dollar?
  12. … many many more questions…

If you have been with us for quite a while, you will notice that we are always trying to work out these connections in the ‘network.’

Under-girding this process, we need a strong theoretical framework to help us build a model of the complex environment that we are in. If you use a flawed theoretical framework, then your model will be flawed. If your model is flawed, then your understanding will be flawed. If your understanding is flawed, your conclusions will be flawed.

Failure to understand the nature of Black Swans
Back in How to take advantage of an impending crash- Part 2: understanding a subtlety, we said that,

If someone asks us, ?Is the market going to go up or is it going to come down?? a simple and direct answer of ?Up? or ?Down? will be too simplistic to reveal a subtlety.

This implies two things:

  1. In today?s market, the probability of the market going up is higher than the probability of it coming down. Hence, it is rightly called a bull market.
  2. But should it come down (which is unlikely), it can collapse at extremely great speed and magnitude.

Hence, the stronger and longer this uptrend continues, the greater in magnitude and speed (as in volatility, not timing) the Great Crash III will be. Hence, the coming Great Crash III is a Black Swan event?an improbable but colossal impact event.

The importance of a particular event is the likelihood of it multiplied by its consequences. Black Swan events are events that are (1) highly unlikely and (2) colossal impact/consequences. One common mistake investors (and many professionals) make is to look at the former and forget about the latter i.e. ignore highly unlikely but impactful events.

Therefore, when contrarians are preparing for a crash, it does not necessary mean that they are predicting doom and gloom. Rather, they see the vulnerability of Black Swans and prepare for them.

Failure to see underlying causes
Look for underlying causes behind seemingly unrelated events. Try looking deeper than what is apparent and obvious and ask questions. Those who fail to see the turning points did not ‘join the dots’ together.

For example, in Why some believe a crash is imminent, we did mention about the apparent contradictions between rising stock prices and bad economic news. What is the connection? The answer to this question can be found at Zimbabwe: Best Performing Stock Market in 2007?.

That’s why we are very insistent on building up a strong foundation of theoretical framework. As we said before, faulty models lead to faulty understanding.


Do not get caught out at turning points. Be aware of the signs and be prepared.

Why some believe a crash is imminent

Sunday, December 2nd, 2007

In this week alone, after hearing hints that the Federal Reserve will be cutting interest rates, the Dow Jones index shot up several hundred points. In two days alone, it rose more than 500 points, which had not happened before for many years. Back in October, in Drugged up stock market, we remarked that

Ever since Ben Bernanke cut interest rates, the US stock market had been surging, even hitting another record high.

To an outside observer who is only allowed to look at the stock market in isolation, his/her conclusion must be that the economy must be booming. After all, as we said before in Drugged up stock market,

… the stock market is an early indicator of the health of the economy. It is very much like the radar of an aeroplane, telling the pilot what dangers are ahead. In fact, the stock market is such a sensitive indicator that its alarms of economic slowdowns often turns out unfounded.

But when that outside observer looks at the US economy, he/she will see a completely different picture. Bad news after bad news on the US economy has been piling up. Even mainstream news media has been chattering recession in the US (see Mainstream chatter about recession in the US). The credit crunch is getting worse (see Tightening noose around business?s neck). US Treasury bond prices have been rising (i.e. long term interest rates has been falling).

Meanwhile, despite economists downgrading their forecasts for global growth in 2008 (due to the economic malaise in the US), the general belief is that China and India will save the rest of the world. As contrarians, we are very sceptical of this belief (see Is Chinese growth ?de-coupled? from the US economy? and Contradictions in the red hot Chinese economy).

This is a very surreal situation. How is it possible to have,

  1. Bear market for the economy (which is fundamentally bad).
  2. Bear market for the credit market (which will worsen the already bad economic fundamentals).
  3. Bull market for Treasury bonds (which tells us that the bond market believes that it the economic fundamentals will be bad)

… and have a bull market for stocks (which tells us that the stock market believes that the economic fundamentals will be very good) at the same time?

Isn’t this a strange contradiction? It is very obvious that something have to give way eventually. Chances are, the stock market will have to give way to the economy, credit market and bond market. When that happens, it is called a “crash.” This is why there is a lot of volatility and skittishness in the stock market. And by the way, just prior to the Great Crash of 1929, there was a lot of volatility in the stock market too (see The Great Crash of 1929).

So, how should we understand this anomaly? For those who are struggling to comprehend this strange situation, we will provide the perspectives for you to see what on earth is going on.

Meanwhile, for the adventurous, here are some of our thoughts on how to profit from a possible stock market crash.