## Archive for June, 2010

### Should precise percentage of odds (of whether something will happen) be treated as nonsense?

Tuesday, June 29th, 2010

Recently, we saw an article that reported,

There is a 10 percent to 20 percent chance of BP being taken over,? said Gudmund Halle Isfeldt, an Oslo-based analyst at DnB NOR ASA, in an e-mailed note this week.

Whenever we read about analysts stating precise odds about whether certain event will happen (e.g. takeover, interest rates movement), we get very suspicious. How do they come up with such precise percentage? More importantly, are these kinds of precise numbers valid in the first place? If not, why?

To answer this question, let?s go back to the very basics.

Consider the odds of a dice showing up a ?1? on a throw. Obviously, the odds are 1/6. What if you do not know that the dice has 6 sides and instead, incorrectly think that there are only 5 sides on it? In that case, your computation of the odds (1/5) will be wrong. What if, you correctly understand that the dice has 6 sides but instead, do not know that the dice is loaded? In this case, your computation of the odds (1/6) is wrong because the dice is biased.

In both cases, there is a gap between how much you think you know and how much you actually know. The wider the gap, the more wrong your computation of the odds will be. As we quoted Nassim Nicholas Taleb in Failure to understand Black Swan leads to fallacious thinking,

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).

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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.

Whenever an analyst give such precise percentage for the odds of whether something will happen, he is implying that the gap between how much he actually know and how much he thinks he knows is very small. Perhaps it is true that he is really that knowledgeable. But it is very common for humans to underestimate the size of that gap when it comes to assessing themselves.

In the case of assessing the odds of a corporate takeover that has implications on national interests, perhaps something is happening secretly within the inner recesses of corporate and political machinery? Chances are, if the analyst is privy to the secret happenings, he will have to drastically change his assessment of the odds. If not, his assessment is like assessing the odds of a dice while not knowing it is loaded. When analysts show their confidence by giving such precise percentages, we can?t help but wonder whether he is falling into Ludic Fallacy (see How To Foolproof Yourself Against Salesmen & Media Bias).

For investors, they are at a disadvantage. You see, when assessing the odds of a dice throw, you can easily verify whether your assessment is correct or not (e.g. whether the dice is loaded) by repeating the throw many times and then use statistical analysis to check the results. But what about assessing whether BP will be taken over? Unfortunately, this event, if it happens, will only happen once. That means there?s no way you can verify the analyst?s number. For example, if the analyst said that there?s a 91.32 percent change that BP would be taken over and if that event did not happen, there?s no way you could prove that the analyst got the number very wrong. He could argue that it is due to sheer bad luck that it did not happen.

Thus, whenever analysts give such precise percentage of odds, ponder how big the gap is.

### Think Greece is bad? Look at China’s provinces

Sunday, June 27th, 2010

We all hear about how bad Greece?s national debt is. We hear about how the rest of the PIIGS countries are threatening to derail the Euro. Then there?s Japan, followed by UK. Also, most of the US states are like mini-Greece (see Inside the Dire Financial State of the States). Worse still, the US Federal Government itself is projected to face bankruptcy. You can see the who?s who list of potentially bankrupt major governments in our previous article- Next phase of GFC is when governments go bust.

But no one looks at China. Since it is the world?s greatest creditor nation, surely its fiscal position must be solid right?

No!

Firstly, China?s US\$2.4 trillion of reserves must not be mistaken as ?cash at bank? to be spent (see Is China allowed to use its US\$2.4 trillion reserve to spend its way out of any potential crisis?).

Secondly, many Chinese local government are heavily indebted too. According to Liu Jiayi, the head of China’s National Audit Office, some Chinese provinces have serious debt problems. As this news article reported,

Mr Liu said the ratio of debt to disposable revenues at some local governments was over 100pc and in the highest case it was 365pc.

He said the audited debts of 18 of China’s 22 provinces, together with 16 cities and 36 counties amounted to 2.79 trillion yuan (?279bn) in 2009.

Several observers believe the situation is far worse. The China Daily newspaper, which is run by the government, suggested that the total sum could add up to between 6 trillion and 11 trillion yuan (?590bn-?1.08 trillion).

Victor Shih, a professor at Northwestern University in the United States, believes the sum in 2009 was 11.4 trillion yuan, equivalent to 71pc of China’s nominal GDP.

Mr Shih has warned that local governments have also succeeded in rapidly funnelling large amounts of debt off their balance sheet and into public-private investment vehicles.

Mr Shih forecasted that by next year, China?s government debt will hit 96 percent of GDP as ?infrastructure projects continue to eat up cash and produce negligible returns.? According to him,

The worst case is a pretty large-scale financial crisis around 2012. The slowdown would last two years and maybe longer.

The good news is that the Chinese government is doing something about it today. But we doubt it will be painless. Fingers crossed on that one.

### When will silver prices explode?

Friday, June 25th, 2010

David Morgan of Silver Investor Report is a well-known expert on silver. Naturally, he is bullish on silver prices. But for many investors, after having seen silver prices languishing for so long, they feel like giving up.

As we wrote in our book, How to buy and invest in physical gold and silver bullion, there are many reasons why silver is a better choice than gold in terms of price speculation. This is because it is a hybrid between monetary and industrial metal. In terms of supply and demand fundamentals (in the context of industrial use), silver is much stronger than gold (because it has hardly any industrial use).

However, for whatever reason, silver prices are languishing for a very long time. But for David Morgan he has a theory of when silver prices will see its day of vindication. The theory goes like this:

1. Assuming that one day, people will lose faith in fiat money, gold will be hoarded by more and more of the masses.
2. Unfortunately, gold is relatively expensive and rare and that means the majority of the masses will miss out on getting some gold for themselves.
3. When that happens, they will notice that silver is dirt cheap relative to gold (since silver prices have been languishing for a very long time).
4. Therefore, they will surge towards getting silver.

Given that silver prices are at a far lower base than gold, it doesn?t take much for silver prices to rise in absolute terms in order for it to rise a lot in percentage terms.

That?s when David Morgan believes that we will see silver prices soar. Will that day come? We don?t know, but this is a very good Black Swan trade to get into. If you want to speculate in silver prices, just make sure that the ?silver? that you hold are not empty promises.

### Subscribe and get “How To Lie With Statistics”

Wednesday, June 23rd, 2010

Recently, we read a very good 1954 classic, How To Lie With Statistics by Darrell Huff. Those who subscribe to our emailing list will receive FREE access to this book. To subscribe to our emailing list, submit your details on the Subscription box to the right of this page. If you are already subscribed, you will receive an email from us by Thursday on how to access that book.

From the review of this book at Amazon.com,

“There is terror in numbers,” writes Darrell Huff in How to Lie with Statistics. And nowhere does this terror translate to blind acceptance of authority more than in the slippery world of averages, correlations, graphs, and trends. Huff sought to break through “the daze that follows the collision of statistics with the human mind” with this slim volume, first published in 1954. The book remains relevant as a wake-up call for people unaccustomed to examining the endless flow of numbers pouring from Wall Street, Madison Avenue, and everywhere else someone has an axe to grind, a point to prove, or a product to sell. “The secret language of statistics, so appealing in a fact-minded culture, is employed to sensationalize, inflate, confuse, and oversimplify,” warns Huff.

Although many of the examples used in the book are charmingly dated, the cautions are timeless. Statistics are rife with opportunities for misuse, from “gee-whiz graphs” that add nonexistent drama to trends, to “results” detached from their method and meaning, to statistics’ ultimate bugaboo–faulty cause-and-effect reasoning. Huff’s tone is tolerant and amused, but no-nonsense. Like a lecturing father, he expects you to learn something useful from the book, and start applying it every day. Never be a sucker again, he cries!

Even if you can’t find a source of demonstrable bias, allow yourself some degree of skepticism about the results as long as there is a possibility of bias somewhere. There always is.

Read How to Lie with Statistics. Whether you encounter statistics at work, at school, or in advertising, you’ll remember its simple lessons. Don’t be terrorized by numbers, Huff implores. “The fact is that, despite its mathematical base, statistics is as much an art as it is a science.”

### Trend followers alert: gold breakout!

Sunday, June 20th, 2010

For those of you who are into a trading technique called “trend following” (or “momentum trading”), you will want to know that gold prices had broken out of its trading range last Friday at around US\$1256. For those who are unacquainted to trading, trend following traders are always on the lookout for prices that “break out” of a trading range in search for a trend to ride on.

The tricky issue for Australian traders is that though gold prices had hit a record high in US dollar terms, it is still below the record high in Australian dollar terms (in the first quarter of 2009).

Our? friends from Market Club has more detailed explanation on the charts here.

Meanwhile, for those who are into stock-picking, it is time to compile a list of stocks that you want to buy. We will talk more about it in the coming articles.

### Hidden weak foundations covered by high tide of debt

Thursday, June 17th, 2010

Today, we read this interesting article, Nothing can save Spain,

"Greece is not Spain", has been how European politicians have been trying to reassure the markets. Once analysts had a closer look at the Spanish figures they concluded that this was indeed true ? Spain?s troubles are much worse.

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In fact, before the crisis struck the Spanish were seen as Europe?s model citizens. Public debt was low, the economy grew rapidly, and in 2007 the government could still report a healthy budget surplus of 1.9 per cent of GDP. There was no sign of grave economic mismanagement, let alone on a scale comparable to the Greek basket case.

So what turned the Spanish miracle into an economy on the abyss? How can a country be regarded as a role model one day and almost a failed state the next?

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But whereas in Greece the lower interest rates were taken as an opportunity to incur greater public deficits, in Spain it was the private sector which accepted the invitation to go deeper into debt.

One sector in particular benefited from this injection of cheap cash thanks to the euro: real estate. For many years, Spanish house prices only knew one way, and that was up. Between 1998 and 2007, property prices increased by about 10 per cent per year on average.

When the global financial crisis struck, the bubble burst. Since 2008, Spanish house prices have declined 15 per cent and there is no end in sight to the correction. Some real estate experts are predicting further falls of up to 35 per cent.

Suddenly, the weak foundations of Spain?s economy are exposed, especially its over-reliance on debt coupled with low productivity.

Consequently, the pristine clean Spanish public debt turned into deficit as unemployment rate soared to 20% and bad debts plagued the banking system.

Note that we highlighted the word ?suddenly? in the final paragraph.

The key to remember is that the economy looked rosy until something suddenly gave way. The high tide of debt kept the weak foundations hidden under the water. Finally, when the debt tide receded, the weak foundations were exposed. With the weak foundations in full view, the financial market reacted in horror accordingly.

Spain?s situation reminds us very much of Australia. As the Reserve Bank of Australia (RBA) governor hinted in a speech last week,

Markets can happily tolerate something for an extended period without much reaction, then suddenly react very strongly as some trigger brings the issue into clearer focus.

Again, we highlighted the word "suddenly.? As we wrote in Serious vulnerability in the Australian banking system, there is a serious weak underbelly in the Australian economy. All we need is a trigger for all eyes to be on its weak foundation (see Will there be an AUD currency crisis?).

However, many pundits in the mainstream media are still putting on Turkey Thinking (see our book, How To Foolproof Yourself Against Salesmen & Media Bias for more information on Turkey Thinking).

### Marc Faber: Short the AUD

Wednesday, June 16th, 2010

In case you’ve missed it, this is what Marc Faber said in a recent interview:

And as a special tip, I think I would short the Australian dollar, because talking about a housing bubble, Australia has 10 times a bigger bubble than China. In Australia you have what you said we don?t really have in China, namely the low leverage that we have in China, we have the opposite in Australia, very high household leverage. ? So I think a big downfall is about to happen.

The worst case scenario would be a falling AUD in the context of a currency crisis. Our favourite hedge against this will be in gold (see our book, How to buy and invest in physical gold and silver bullion).

### Is the Chinese export surge really good news?

Monday, June 14th, 2010

Last week, the mainstream financial news media was cheering on the news that China’s exports surged on a year-on-year basis. This led to the belief that China’s economic recovery is on track, which implies that the recovery in commodity demand will be sustained, which will then flow on to the Australian economy. As a result, according to media narrative, the stock market rose on that ‘good’ news.

But before we get carried away with this bout of optimism, let us put on our thinking caps and consider the bigger picture. Firstly, is the surge in Chinese exports and imports really a good news for Australian mining companies? To answer this question, consider this news article,

But rising textiles and electronics exports will do little to offset the slump in Chinese demand for Australian commodities that will come with an expected construction slowdown.

Construction starts for government infrastructure projects have slowed sharply and private sector transactions have been bludgeoned by government measures.

Private sector measures show real estate transactions fell by as much as 70 per cent from April to May in Beijing, Shanghai and Shenzhen, where policy restrictions have been most severe.

To put it simply, China’s demand for Australian commodities post-GFC is mainly influenced by China’s construction ‘boom’ in 2009. It is open knowledge that there’s overcapacity in China’s steel and cement industries. As we wrote in Marc Faber: Beware of investing in Australia (as it follows the Chinese business cycle),

It had been reported that China?s excess capacity for steel and cement production is around the current capacity of United States, Japan and India combined.

A rise in Chinese exports will not be likely to offset the slump in construction.

Next, when you look at the big picture in mind, an export surge is the last thing the world needs. In the this post-GFC world, where growth is anaemic and unemployment is stubbornly high, countries are covertly engaging in competitive currency devaluation in order to prop up their exports in order to prop their economies. The Americans wants to re-balance their? economy with more exports, which implies other countries have to import more from America. Yet, on the other side of the Atlantic ocean, as Niall Ferguson said in this recent interview, the Germans are shedding crocodile tears over the falling Euro because that would boost their exports, which in turn is good boost for their economy. As Marc Faber said in this interview, a falling Euro (i.e. rising US dollar) will give the Americans the excuse to print money to give their economy another adrenaline boost.

Unfortunately, growth-via-exports is a zero-sum game because a for every export, there is an import on the counter-party. If every country wants to increase their exports to boost economic growth, who’s the one doing the importing? Thus, China’s export surge is one step in the wrong direction. The world needs a rebalancing of exports and imports, not more of the same unsustainable imbalance.

A surge in Chinese exports and rising anger in the US Congress will put renewed pressure on China to allow its currency to rise against the US dollar.Chinese trade figures showed exports leaping by 48.5 per cent in May over the year before, way ahead of analysts’ forecasts. Data released in the US showed America’s trade deficit widening slightly in April, with some economists arguing that the improvement in net trade and its contribution to US growth appeared to have stalled.

The data gave more ammunition to China’s critics in the US Congress, who have said they will proceed with legislation to restrict Chinese imports to correct the perceived misalignment of the country’s currency. The US Treasury has been pursuing quiet diplomacy with Beijing to allow the renminbi to rise, but lawmakers said they were losing patience.

In the bigger picture, rising trade tensions between the US and China is moving them towards trade war. This can hardly be good news.

### Growing structural unemployment in Australia

Thursday, June 10th, 2010

Today, the Australian stock market and the Aussie dollar performed relatively well. Alan Kohler, the financial news commentator in ABC News gave the reason why- China and Germany?s industrial production, Australia?s job ?boom? and so on. Incidentally, this is an example of narrative fallacy and lazy induction as described in our book, How To Foolproof Yourself Against Salesmen & Media Bias. Anyway, we will leave you to follow up on the issue of media bias.

But first, we will look at this news article,

Australian employment jumped a strong 26,900 in May to extend a remarkable run of jobs gains that suggests wage pressure could build earlier than thought and require yet further action on interest rates.

That article was published just before 5 pm. Coincidentally, in the streets of Sydney, another news article reported,

Thousands of protesters marched through the streets of Sydney’s CBD today, waving colourful banners and chanting demands for equal pay for women.

This is the sort of things that the RBA fears and give them a reason to raise interest rates. However, though the falling aggregate unemployment rate looks good, it masks a hidden problem. The problem is of the same nature as we described in Overproduction or mis-configuration of production?,

This is the key insight from the Austrian School of economic thought. Over-production or over-investment is not the problem. Rather, the trouble lies in the mis-configuration of production and mal-investments

In the same way, it is not the aggregate level of unemployment that tells the whole story. Rather, if unemployment is to be a threat to the Australian economy, it will be its configuration that is the cause. Recently, we saw this article, Recovery doesn’t extend to long-term jobless,

LONG-TERM unemployment continues to rise sharply and has increased for 18 straight months, despite the better performance of the economy and the overall improvement in th1e labour market.

A Herald analysis shows that Centrelink payments to people without a job for more than a year have risen by 27 per cent, or nearly 72,000, to 334,244 people in the year to April.

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While the economic stimulus package has been credited with saving Australia from a deep recession, there remain pockets of deep disadvantage.

This mis-configuration between surplus supply of unemployable labour and shortage of employed labour is what economists call ?structural unemployment.? Also, according to the ABS, the youth unemployment rate in Australia is 3 times the national average. This is another large pool of structural unemployment.

As that article continued,

A senior analyst at the University of Sydney’s Workplace Research Centre, Mike Rafferty, said it appeared that as the economy had improved it was people moving jobs or within jobs that had benefited.

”The people who are benefiting first are perhaps those that already have jobs and are able to move into better jobs or perhaps from part-time to full-time work,” he said. ”It’s not the same picture for the people not in the labour market.”

Since the official unemployment is based on a sample of surveys whereas Centrelink payments is based on the actual number of people seeking welfare, we can argue that the latter presents a more accurate picture of the unemployment situation in Australia.

A rising structural unemployment will increase the drag in the economy as government welfare payment will have to be increased. If this growing trend is not arrested, then this growing pocket of disadvantage will increase, resulting in social problems down the track. Unfortunately, these structural unemployed do not make it to the aggregate figures.

### Japan, the next country to fall into sovereign debt crisis?

Tuesday, June 8th, 2010

We all know about how badly indebted the Greek government is. With its national debt at 115% of GDP, everyone sees Greece as a basket case.

If Greece is a basket case, what about the world?s second largest economy, Japan? It?s national debt is fast approaching 200% of GDP this year. It all began in the 1990s, as we wrote in Are governments mad with ?stimulating??,

In the 1990s, when the Japanese bubble economy burst and fell into debt deflation, its banks were crippled with bad debts. In the ensuing decade, the Japanese government embarked on massive government stimulus programs. Roads to nowhere were built and there were even comments about resorting to military spending (which of course was dismissed later as mere rhetoric because of neighbouring countries? sensitivities to Japan?s wartime past). When the first stimulus programs proved to have failed in its objective, a second and bigger one was announced. When that failed too, a third and bigger one was announced. Altogether, the Japanese government had embarked on 10 stimulus programs totalling 30 trillion yen.

For Japan, they are a nation of mighty savers. More than 90% of their government debt are owned by their citizens at pathetically low interest rates. That is the reason why the purchasing power of the yen had not gone down the drain- the Japanese government?s spendthrift ways are financed by the savings of its people.

But now, Japan is facing a problem. It?s population is aging fast and more and more retired/elderly Japanese need access to their savings (that they generously loaned to their government) as they leave the workforce. As this Bloomberg article reported,

?Japan?s inability to finance its debt sales domestically is approaching,? Kusano said. ?And when that time comes, you can?t expect foreign investors to accept Japanese debt with such a low coupon of 1.2-1.3 percent.?

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?If bond yields spike, Japanese financial institutions will take a heavy blow, shaking the nation?s financial system,? Kusano said.

We do not know when the financial wolf packs will turn their eyes on Japan. But you can be sure that hell will break lose when it happens, because Japan is the world?s second largest economy.