Archive for February, 2008

New Popular Topic page: What is inflation and deflation?

Saturday, February 16th, 2008

We have added another guide in the Popular Topics section: What is inflation and deflation?.

Rising price of money through the demise of ‘shadow’ banking system

Thursday, February 14th, 2008

Recently, as we all know, Commonwealth Bank was censured for raising mortgage rates independently of the Reserve Bank of Australia (RBA) and raising them for more than the RBA’s rise of 0.25 percent in cash rate. The reason given was that credit conditions had ‘tightened’ and thus, raising its cost of funding. In another instance, we saw this mainstream media article, Business confidence hits 6-year low: NAB:

Australian business confidence slumped to a six-year low in January, hurt by sharp falls in global equity markets and tightening credit conditions, even as actual sales and employment remained healthy in the month.

As we can see, there is a trend of money getting more expensive. This trend affects both business and consumer confidence because Australia (along with the rest of the English-speaking nations) as a whole, is mired in huge amount of debt. Worse still, why is money getting more expensive than what was officially ‘set’ by the RBA?

To understand this question, we have to understand what the ‘shadow’ banking system is. Traditionally, the purpose of the banking system is to act as an intermediary between those with surplus capital and those who needs capital- one saves, bank lends, the other borrow. But as we said before in Collateral Debt Obligation?turning rotten meat into delicious beef steak, thanks to the ascent 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. As the loan travels down the chain from the lender to the ultimate owner, intermediaries along the way collect fees and charges. Thus, lenders make profits the moment they make a loan. After that, they pass the risk of bad debt down the chain like a hot potato.

Securitisation has grown to the point of having a life of its own outside the banking system, thus becoming a ‘shadow’ banking system. It has become like this: one ‘invest,’ complex web of intermediaries take cuts and mash and re-mash the ‘invested’ money, and finally the other borrows. Such a scheme of arrangement was so lucrative that even banks began to join in the racket by sourcing their money from the ‘shadow’ banking system (see What is SIV?). Thus, the global banking system, in conjunction with the ‘shadow’ banking system becomes a colossal credit machine, spewing out vast amount of money to be lent. Eventually, the global economy becomes accustomed to such cheap money in the same way drug addicts are accustomed to cheap drugs. Obviously, huge amount of bad debts will accrue if too much money becomes too cheap for too long.

One faithful day, the world awakens to the sub-prime problem. Suddenly, money is not that cheap any more. The ‘shadow’ banking system turned out to be the emperor with no clothes. Banks that source their money from the ‘shadow’ banking system suddenly find that they face big losses. They eyed each other suspiciously, wondering whether who among their peers have more hidden losses to confess. The world has awakened to the fact that that much amount of money should not be that cheap for that long.

What can central bankers do? They do not control the ‘shadow’ banking system, for their sphere of influence lies in the banking system. That is how Australia’s RAMS get into trouble. Their source of funds came from the discredited ‘shadow’ banking system.

What will happen next? Imagine a gambler who won big initially through a string of good luck. With his newfound wealth, he became careless with his money. One day, he made one big losing bet and lost most of his wealth. Suddenly, he has to live life very frugally- more frugal than when before he became a gambler. If the credit crisis continues to gnaw and bite at the global financial system, then money will be forced to become more expensive in the same way the gambler was forced to be more frugal.

The danger is, this can develop into a vicious cycle. As money becomes more expensive, individuals and businesses that are addicted to cheap money find themselves in trouble. Bad debts accumulate in the financial system. That makes money more expensive. Then more find themselves in trouble.

How does this affect Australia? As we can see, Australians love their debt too much. From the large current account deficit (see Understanding the Balance of Payments), much of Australia’s debts are sourced from overseas. With the demise of the global ‘shadow’ banking system, the price of money in Australia has to rise too.

How useful is a stock’s price target?

Wednesday, February 13th, 2008

If you have access to any brokerage research, you will often notice that brokerage analysts often have ‘price targets’ for stocks. Usually, these price targets have a one-year time frame. In essence, price targets are just brokerage analysts’ predictions (or more accurately, guesses) of stock prices in one year’s time.

In reality, how useful are price targets?

Bias, vested interests and incentives
A brokerage company makes its money by providing brokerage services (that is obvious isn’t it?). That is, the more you trade, the more they make money from you. Therefore, you should never expect brokerage analysts’ price targets to serve your best interests. This is not to say that they deliberately acts contrary to your interests, but the power of incentives can easily sway the sub-conscious thinking of any human. For this reason, you will notice:

  1. Buy recommendations are more likely than sell recommendations because the former is applicable to everyone while the latter is only applicable to those who already own the stocks. Therefore, the former is more likely to generate more trades, and thus, more profits for the business. In the same way, hold recommendations are relatively rarer.
  2. Have you notice that brokerage analysts’ price target tend to follow the views of the crowd? Notice that crowd opinions tend to change easily with every whims of fancy.

Precision vs accuracy
You may notice that price targets tend to be highly precise (e.g. $3.67). Again, as we mentioned in Confusion between precision & accuracy, just because a number is precise does not necessarily mean it is accurate. Analysts often use complex mathematical models to calculate the ‘intrinsic’ value of a stock. As this book, How to Pick Stocks Like Warren Buffett (commented in our Recommended Books section) says,

By relying on so many variables to predict stock-price performance (sales, market share, interest rates, currency rates, operating costs, shares outstanding, options, earnings per share, and the public’s prevailing mood over stocks), analysts unwittingly expose themselves to the chain link of errors. As their models grow more complicated and detailed, the rate of failure increases.

This is akin to the situation that we described in Myth of diversification as safety?Part 2: nature of risk,

Therefore, risk is something that you cannot simplistically reduce to a precise number obtained from a mathematical model. As we said before in How do you define risk?, risk has to be defined in terms of the ?soundness of the underlying economic and financial state.?

In the same way, the value of a business cannot be easily be reduced into a precise number using a mathematical model.

Real-world vs models
A business exists in the real world where Black Swans and unknown unknowns happen, where entrepreneurs make decisions that changes the status quo. As we said before in See like an entrepreneur… how will Telstra be like in 2010?,

We believe the reason is in the difference between the thinking of analysts and entrepreneurs. Analysts, by definition of their job description, look at businesses through the eyes of the status quo. Yes, they may engage in the forecast of future earnings of a business, but their forecasts are usually made by extrapolating from the status quo or some other derivations from it. Entrepreneurs, on the other hand, look at businesses from the eyes of what can possibly be in the future. As such, what others see as ?impossible? is an opportunity for entrepreneurs to force the camel through the eye of the needle.

In other words, there are far too many dimensions in the complex real world that can never be captured in models. In fact, we would go as far as to say that no matter how complex a model is, it can never match the complexity of the real world. In that case, how should investors look at a stock? The very best investors look at a stock from the vantage point of a business owner. A business has its subtleties, nuances, relationships, personalities, culture, politics, environment and so on. These are impossible to be reduced into a model.

Flexible and elastic
Price target models have one major weak point: by simply tweaking the parameters and assumptions of a model, one can tweak the end result (price target) produced by it. This means that price targets can be flexibly and elastically adjusted to fit according to the bias, incentives and interests of whoever produces the stock research. But in the real world that a business resides in, problems and issues cannot be tweaked and assumed away.

Finally, in conclusion, there is no escaping of the fact that the best investors are the ones who understands business. This is because, ultimately, everything you invest in is ultimately a business or related to a business. Therefore, it pays to cultivate your own sense of business.

Is economics a science or an art?

Tuesday, February 12th, 2008

Recently, we found this article, Bad Debt: $100 Billion, $400 Billion, Who’s Counting?,

These are not good days for the dominant “who could have known?” school of economics. First, they missed the housing bubble.

Fortunately, the media do not hold economists responsible for their failures.

Being off by 300 percent might be considered a serious problem in other lines of work, but apparently not for economists.

The last sentence is indeed humorous. It is an example of highly precise but inaccurate forecast (see Confusion between precision & accuracy). Thanks to such great flops, economics is often called the “dismal science.” But our question for today is this: Is economics ever a science in the first place? Should it even be ‘scientific’ in the first place?

This question was controversial even in the 1930s. As we quoted Wilhelm R?pk from his 1936 Austrian School classic in our previous article, Why is the market so easily tossed and turned by dribs and drabs of data?,

It was indeed an ingenious idea to apply the principle of nautical astronomy to economic forecasting, but there was one fatal flaw…

Mainstream economists tend to apply the scientific method into the study of economics, using abstract mathematical theories and unrealistic models. In addition, it is being overrun with statistics, to the extreme point of replacing “deductive reasoning entirely by their empirical and statistical method” (see Why is the market so easily tossed and turned by dribs and drabs of data?).

At the heart of what makes us contrarians is our philosophy from the Austrian School of economic thought. At the base of this school of economic thought is praxeology, which is the study of human behaviour. Ludwig von Mises, in Chapter 16 of his economic treatise, Human Action: A Treatise on Economics, wrote that,

The problems of prices and costs have been treated also with mathematical methods. There have even been economists who held that the only appropriate method of dealing with economic problems is the mathematical method and who derided the logical economists [the Austrian School economists] as ?literary? economists.

If this antagonism between the logical and the mathematical economists were merely a disagreement concerning the most adequate procedure to be applied in the study of economics, it would be superfluous to pay attention to it. The better method would prove its preeminence by bringing about better results. It may also be that different varieties of procedure are necessary for the solution of different problems and that for some of them one method is more useful than the other.

However, this is not a dispute about heuristic questions, but a controversy concerning the foundations of economics. The mathematical method must be rejected not only on account of its barrenness. It is an entirely vicious method, starting from false assumptions and leading to fallacious inferences. Its syllogisms are not only sterile; they divert the mind from the study of the real problems and distort the relations between the various phenomena.

The ideas and procedures of the mathematical economists are not uniform. There are three main currents of thought which must be dealt with separately.

The first variety is represented by the statisticians who aim at discovering economic laws from the study of economic experience. They aim to transform economics into a ?quantitative? science. Their program is condensed in the motto of the Econometric Society: Science is measurement.¬† The fundamental error implied in this reasoning has been shown above…

The second field treated by mathematical economists is that of the relation of prices and costs. In dealing with these problems the mathematical economists disregard the operation of the market process and moreover pretend to abstract from the use of money inherent in all economic calculations.

At this point, we hope we have not bore you with dense philosophy. So, we will stop here. But as you can see by now, we see economics more as an ‘art’ rather than a ‘science’ because we do not believe that economics is a subject that lends itself to a ‘scientific’ study.

Will China slow down from 2009?

Monday, February 11th, 2008

Yesterday, we talked to a retiree from China. From what we heard from him, it seemed that he felt that the Chinese economy is not doing too well recently. When we asked why, he could not really point a finger at the reason. But after some probing, it looked that the wobbly stock market was the cause of the turn in sentiment. When the conversation turned to property, we learned that young Chinese are burdened with crushing debt too. In Shanghai, an apartment that is located conveniently near the city can cost around 1 million yuan. A young Chinese couple with a modest combined salary of say, 120,000 yuan a year and a deposit of say, 300,000 yuan from their parents have to borrow around 700,000 yuan. From the anecdotal hearsay, it looks to us that like Australia, China is vulnerable to debt deflation too. Further hearsay tells us that the Chinese banking and financial system is relatively opaque and there are probably a lot of hushed up bad debts piling up. There are also widespread popular expectations that the Chinese economy will slow down after the Olympics.

Turning away hearsay to official assessment, Chinese Premier Wen Jiabao warned that 2008 will be a most difficult year and said that

There are uncertainties in international circumstances and the economic environment, and there are new difficulties and contradictions in the domestic economy.

Back in December last year, as we mentioned in Will the Chinese really tighten?, China had already announced plans for a ‘tight’ monetary policy in 2008. Even turning further back to March last year, in China to pull the plug?, we quoted Premier Wen Jiabao saying that the Chinese economy is “unstable, unbalanced, uncoordinated and unsustainable.” We speculated that

… we can expect significant policy changes in China that will shift focus from the economy to the environment and social stability. This means the Chinese government will take steps to slow economic growth significantly in order for the non-economic aspects of the nation to catch up and for the economy to catch a breather.

Also, it is open knowledge that China is planning a broad industry and power shutdown for the Beijing Olympics, which is certain to slow the economy significantly.

Turning away from official assessments to economic theory, we argued in Can China really ?de-couple? from a US recession? that China will not be able ‘de-couple’ from a recession in the US.

Dear readers, do you see what we are trying to mean? Make no mistake about this: the Chinese economy will slow down appreciably for the Olympics. We believe it will not be just a quick and temporary once-off slowdown- rather it will be a time for the Chinese economy to take a breather and cool down significantly, both by the design of the Chinese government and the effects of a US recession. The giddy and euphoric economic growth of 2007 will not be so ecstatic in 2008 and beyond (but not forever, we guess- but touch wood, if China fall into total social breakdown, then all bets are off… again, touch wood).

The question is: will this slowdown descend into an unexpected rout (i.e. a hard landing)? We do not really know, but we suspect it is a possibility that cannot be ignored (see Can China really ?de-couple? from a US recession?). But whatever the outcome of the Chinese slowdown, Australia will be affected greatly for the worse. With such high debt levels (see Aussie household debt not as bad as it seems?), the results will probably be ugly.

Be warned. Now is not the time to go further into debt. Personally, we are preparing for the coming lean years.

Mental pitfall: Recency Bias

Sunday, February 10th, 2008

Today, we will continue with the series on common mental pitfalls that can lead to fallacious reasoning (see Common mental pitfalls that leads you astray for a compilation of this series of articles). The topic we will cover today is Recency Bias. In this mental pitfall, we tend to attach more importance to the more recent events than the less recent ones. As a result of this bias, our judgement becomes clouded and we overestimate risks from the more recent events at the expense of other just as real risks.

The best explanation of this mental pitfall would be through an example. Less than 3 years ago, there was a lot of chatter and fear about how a bird flu pandemic may affect the world, and by extension, the global economy. Many investors were fretting about how such a Black Swan event will affect their portfolio.

Now, look at today.

The stock market chatter is now about the US recession and its impact on the global economy. Bird flu (and we can add SARS and terrorism into the list as well) is largely forgotten. But we have to ask ourselves this question: Have the threat of bird flu receded since then? No, we can argue that the threat has risen (or at least remain unchanged). Therefore, it will be illogical to place more importance on the US recession than bird flu on the implication to our portfolio.

Of course, we are not advocating that we all become paranoid and fearful about bird flu (and SARS, terrorism, earthquakes, cyclones, etc). Instead, our perception of these risks should still remain balanced and free of bias.

Message to Daily Reckoning Australia

Sunday, February 10th, 2008

We know the guys at DRA is reading this. It is not our intention to start a war (or something like that). Our hope is that by bringing this out to the open, there is a way for dialogue. Our offer is still open: if there is a way for us to contribute positively to DRA, we will be interested. But please do not label us as ‘spammer’ and treat us as such.

P.S. See Dispute with Daily Reckoning Australia and Discern what they do, not what they preach- Daily Reckoning Australia case study.

Discern what they do, not what they preach- Daily Reckoning Australia case study

Saturday, February 9th, 2008

One of the most important ‘soft’ skills of successful investors is the ability to discern whether there is any contradiction between the actions and stated or implied philosophy of an entity (e.g. business, organisation, government, etc). Obviously, as the old adage says, actions speak louder than words. If the contradiction occurs in a human, then there is a very stinging word for such a person: hypocrite. For long-term investors, when it comes to analysing a business, it is important to discern whether such a contradiction exists. No business (in the context of a free market) can exist in the long haul while bearing a tension of mismatch between its actions and underlying philosophy. Such mismatch engenders feelings of distrust which can only grow if it is not rectified.

We will now give you an example of such a contradiction from our most recent experience with Daily Reckoning Australia (DRA). Please note that DRA is pretty independent from its parent organisation Agora Financial. Therefore, not want to lump all of them together, which may be unfair.

First, what is the underlying philosophy of DRA? If you go to their web site, you can see words like “libertarian” and “free-wheeling.” Like us, they adhere to the Austrian School of economic thought. Basically, the Austrian School in a libertarian movement believes in the free market, and non-intervention (note: not anarchy) of government. But as you can see from our experience with them (see Dispute with Daily Reckoning Australia), this is just where our similarities end. In reality, although they proclaim liberty and non-intervention, they practice censorship and draconian control. It is similar to the situation that we described in Analysing Web 2.0 businesses: Shoutwire vs Digg case study about Shoutwire,

  1. Their staffs perform the role of the police and arbiter. We see a significant weak point in such business policy. Firstly, staff members are people who have their own personal bias, prejudice, predisposition and perspective. This implies that any news that can make it to the voting gallery are already ?censored?. That is why some people think that Shoutwire has an ?agenda??their very policy of ?management? (in the name of quality) doomed their stories to possess a slant.
  2. Such ?management? (censorship) implies that subjective judgements of their staffs will inevitably override some of the collective viewpoints of the community. This defeats the entire purpose of having community-based news in the first place.

For example, they accused us of ‘spamming.’ But their readers thanked us and complimented us for our comment contributions. Who is right? The answer depends on whom you ask. If you believe in totalitarianism, then DRA is right. If you believe in liberty, then the free market is right. Clearly, you can see what DRA believes in through their actions. The problem is that on one hand, they preach liberty. Yet on the other hand, they practice control.

We understand that in every web-based publishing business, there is a need to control spams. There is a libertarian way to solve this problem and a totalitarian way to do so. For us, this experience with DRA (see Dispute with Daily Reckoning Australia) made us think about the best way to solve this problem. We decide to solve the problem from a free-market perspective (see Installed a new comment feature: comment rating)- we let the community (i.e. free market) censure those whom they do not like. Of course, this system works best if contributors are not anonymous. As a side note, all our comments contributions in DRA are never anonymous. If our intention is to spam, then it does not make sense to do it on our own name.

Had DRA approached the problem from the free-market perspective, it will benefit everyone. For us, if the free market despises our comment contribution in DRA’s web site, we will get instant feedback about it and think of ways to take the better route. But if the free market loves our contribution, then it benefits because everyone is given access to quality content. DRA would benefit too because such a system tells them what their customers want.

But alas, Daily Reckoning Australia (DRA) chooses the totalitarian way, which contradicts their underlying philosophy. How is it possible to trust them?

Simplified commenting system

Saturday, February 9th, 2008

We have received feedbacks that our previous commenting system was hard to use. To contribute a comment, you have to enter a code from a graphical image. The problem is, it is very difficult to work out what are the letters and numbers in the graphical image.

Therefore, we have removed this feature in our commenting system and install a more transparent anti-spam-bot comment feature. We hope it will make life easier for you. Enjoy!

Installed a new comment feature: comment rating

Saturday, February 9th, 2008

We have installed a new comment feature called SezWho. It is a

… distributed context, rating and reputation service for blogs, forums, wikis and other social sites.

With this feature, you can rate each others’ comment contribution. Also, each person who comments will have a score rating. For contributors, you can carry your reputation across sites that uses SezWho.

Enjoy! It’s all yours!