Archive for November, 2010

Epistemic arrogance, running through traffic lights & Black Swans

Thursday, November 25th, 2010

Today, we received an email from one of our readers. After reading Failure to understand Black Swan leads to fallacious thinking, this is what he thought:

I liked your use of the term “Epistemic arrogance”. Recently I was driving and almost ran straight through a red light at a pedestrian crossing and I was trying to think how I could have been so reckless. I mean I am a great driver (?) and I had been down that road numerous times, yet I still almost managed to run down an almost-unfortunate couple. Sure the red light is in a seemingly random position, and the green light at the intersection 50m down the road can cause very slight confusion, but a red light is a red light.

Its then I theorised the issue. If it was my first time driving, or my first time driving down this road, there would be no way that I would have missed this red light. I would watch out for all hazards because I know that I don’t know. An arrogant driver on the other hand, as I was, thinking they know the lay of the land, can get into strife when the unexpected (in their mind) pops up.

Its this “epistemic arrogance” which leads the learned to cause crashes and accidents… I’m sure there are many top minds in the world who fail to look beyond their view… Learning from one’s mistakes is a great way to improve your management of risk!

This is a very great point. And by the way, it is Nassim Nicholas Taleb that came up with the term “”epistemic arrogance.”

We also have an example that is relevant to investing. Marc Faber once mentioned that the financial valuation of asset prices severely underestimate the possibility of geo-political Black Swans. The recent North Korean artillery pot-shots at their southern neighbour is a case in point. The US and South Koreans are planning to hold military exercises this coming Sunday in response to North Korea’s provocation. The North Korean had already warned repeatedly that they will be provoked with such actions, especially when they are happening so closely to the border. With a juvenile rookie dictator-in-waiting probably calling the shots in Pyongyang, we wonder at the wisdom of the American and South Koreans.

The Korean peninsular is just one example of geo-political Black Swans. We can also include Afghanistan, Lebanon, Iran, Pakistan as well.

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Posted in Geopolitics & Politics, Investor Education, Thinking Tools | 3 Comments »

Is there any benefit for Aussies to invest in gold?

Tuesday, November 16th, 2010

Recently, one of our readers who bought How to buy and invest in physical gold and silver bullion wrote to us,

I live in Perth so am looking to buy bullion from the mint, just down the road, literally, however I?m concerned about how the fluctuating US dollar affects my investment. Surely during hyperinflation of the US dollar gold will obviously go up, but also the Aussie dollar will strengthen significantly at the same time. If the Aussie dollar goes up more than the gold price, I actually loose money in Aussie dollars for which i use to pay my gold (If I use us money trading account…i will loose money when i finally exchange us to aus $$ if the exchange rate is super high)…is this a realistic situation or in a case of hyperinflation, is gold likely to spiral upwards whereas the Aussie dollar marginally increase in relation to the US$…….i.e will the spiralling gold price and hyperinflation in the states cause equivalent hyperinflation worldwide and therefore maintain the “approx” AU/US $$ exchange rate.? I can see gold skyrocketing but if the Aussie dollar also sky rockets also…this is of no benefit is it>>> or is it???

our dollar is very strong at the moment and predicted to get stronger, hence, i will loose money by investing in gold or silver, but i have no trust in the US financial system. Is there a way i can hedge myself against a strengthening Aussie dollar??

I realise u don’t have a crystal ball…I’m not holding you to anything i just want your opinion.

As we can all see, currently there?s a correlation between Australian dollars (AUD) and gold price. Hence, from the point of view of Australian investors of gold, a rising gold price (in USD) does not benefit them. We see that correlation working out in 2007 and today. Today, even though gold prices had hit a record high in USD terms, it is still below the record high in AUD terms- gold hit a record high of around AU$1500 in 2009 when the AUD was very ?weak?.

To answer our reader?s question, we have two points to make:

Back to the basics?

First, let?s revisit the basics. As we wrote in How to buy and invest in physical gold and silver bullion, when we invest in gold, we are not so much into ?making? money. We are doing so to hedge and protect our existing wealth. In other words, gold is not so much of an investment. Instead, it is more of an insurance policy. Therefore, we wouldn?t be so concerned if our ?investment? in gold is not turning out well in terms of AUD. However, what we are more concerned is the possibility of an AUD currency crisis. We have written about that in Will there be an AUD currency crisis?. We are not saying it will happen. Instead, we are suggesting that there?s a possibility that it may happen and by ?investing? in gold, we are hedging ourselves against that.

USD the reserve currency

Regarding the mess in the US financial system, it would be quite an entertaining spectacle if the US is just an inconsequential banana republic like Zimbabwe (which incidentally fell into hyperinflation- a object lesson for the US to learn). In that case, the case for ?investing? in gold will be much weaker.

Unfortunately, the US is not an inconsequential banana republic. It is a superpower whose currency is the world reserve currency. As we wrote in How to buy and invest in physical gold and silver bullion,

The United States, with ?helicopter? Ben Bernanke at the helm of the Federal Reserve, is committed to money printing to solve America?s economic woes. To the extent that the US dollar is the world reserve currency, it will affect the rest of the world.

Because it is the world?s reserve currency, China ?saved? most of the fruits of its hard work in the form of that reserve currency (a cool US$2 trillion worth). Same thing for Japan. Ditto for many other countries.

By printing money, the US is devaluing the world?s reserve currency. But the world cannot afford to have its reserve currency devalued towards the value of confetti. As we wrote in Why did the foreigners bail out cash-starved financial institutions?,

China?s trillions of US dollars reserve is a form of savings that will be used to acquire their future needs for resources to power their economy in the long term. Therefore, any threat to the long-term value of their savings will be a long-term threat to their economy.

So, what is the solution to the devaluation of the reserve currency? As we wrote in What if the US fall into hyperinflation?,

Now, in this age of freely fluctuating currencies, the currency?s value is a relative concept. For example, a falling US dollar implies a rising Australian dollar. Therefore, one way to ?maintain? the value of the US dollar relative to the Australian dollar is to devalue the Australian dollar. Perhaps this is the route that central bankers will concertedly take to instil ?confidence? in the US dollar in order to create the illusion that the US dollar is still a reliable store of value? Well, they can try, but growing global inflation and skyrocketing gold price relative to all currencies will be tell-tale signs of such a dirty trick.

That?s why there?s a threat of a currency war between the US and China right now. The US is accusing the Chinese of manipulating their currency while the Chinese are pissed off with the US for exporting their inflation to China. As the US prints and devalue its reserve currency, China will be hard pressed to devalue theirs too (in the form of a currency peg). If China let their yuan soar in value, their exports will collapse, which will severely affect their economy and social stability. Japan is in the same situation too. A strong yen (relative to the USD) is very bad for their economy too. That’s why Japan recently cut their already super-low interest rates and there’s talk of more money printing on the Japanese’s part.

Now, look at Australia. Let?s imagine that the AUD reaches US$1.20 and is threatening to march forward to $1.40 and beyond. If the AUD gets too strong, it will hurt the Australian economy. In such a situation, Australia will be hard pressed to devalue its currency too (e.g. by cutting interest rates, direct intervention). Or maybe impose capital controls.

In other words, the world is in a situation where there?s a competitive devaluation of currencies. In the recent G-20 summit, countries are pledging not to engage in that. Well, if you doubt their words, then you will sleep better to have your own reserve currency in the form of gold.

In any case, it?s going to be very rough ride in the forex markets. If you are forex speculator, this is heaven. If not, then it is going to suck.

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Posted in Currencies | 3 Comments »

How ‘speculative’ is the AUD (and other currencies)?

Thursday, November 11th, 2010

Recently, we took a look at this report from the Bank for International Settlements (BIS). The average daily foreign exchange turnover (including derivatives) is around US$3.9 trillion. The Australian dollar is the 5th most traded currency (at 7.6% of volume).

So, roughly AU$300 billion of AUD are turned over daily. Of that, US$249 billion of the trade is in the AUD/USD currency pair alone.

Now, let?s take a look at Australia?s balance of payment data. If you take the last 4 quarters of import and export volume, approximately AU$500 billion worth of goods/services are traded in one year.

Compare the amount of AUD that is traded daily in the foreign exchange market and the value of the import/export in one year. What do you see?

Mind you, we are just taking the AUD as an example. The volume of daily turnover in the foreign exchange (for all currencies) far exceeds the value of import/exports. If you look at the report from BIS, between 2004 and 2007, turnover increased by 73%! No wonder forex trading has now become a cottage industry.

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Posted in Currencies | 7 Comments »

Is China really the Saudi Arabia of rare earths?

Wednesday, November 3rd, 2010

It is no secret that China has a  stranglehold on rare earths. For those who are uninitiated, rare earth elements (REE) comprise 17 metallic elements with a variety of modern industrial and commercial applications ranging from petroleum refining to laptop computers to green energy applications to radar. It has been reported that China produces 95% of the world?s REE.

As a result of China?s monopoly in supplying the world?s REE, the recent alleged unofficial REE embargo against Japan had caused alarm among REE importer nations, of which Japan is the largest.

However, as investors, we have to understand clearly what China?s ?monopoly? on REE is and isn?t. Although it?s true that China has a commercial monopoly on rare earths, it does not mean that it is a real monopoly. To understand what we mean, consider this recent news article,

China has 30 percent of the world?s reserve of rare earths, but mines it cheaply and effectively. More than 90 percent of the world?s available supply is currently mined in China.

Basically, China has less than one-third of the world?s REE reserves but produces 95% of the world?s REE. Hence, do you see a problem?

REE are not as rare as their name suggests. There are plenty of REE scattered around the world. Before 1979, the US was the largest producer of REE. So, what happened? A recent report from Stratfor wrote,

The story of REE is not the story of cheap Chinese labor driving the global textile industry into the ground. Instead, it is a much more familiar story of the Chinese financial system having a global impact.

Unlike Western financial systems, where banks grant loans based on the likelihood that the loans will be repaid, the primary goal of loans in China is promoting social stability through full employment. As such, the REE industry ? like many other heavy or extractive industries ? was targeted with massive levels of subsidized loans in the mid-1980s. At the same time, local governments obtained more flexibility in encouraging growth. The result was a proliferation of small mining concerns specializing in REE. Production rates increased by an annual average of 40 percent in the 1980s. They doubled in the first half of the 1990s, and then doubled again with a big increase in output just as the world tipped into recession in 2000. Prices predictably plunged, by an average of 95 percent compared to their pre-China averages.

Most of these Chinese firms rarely turned a profit. Some industry analysts maintain that for a good portion of the 2000s, most of them never even recovered their operating costs. At the same time, an illegal REE mining industry ran rampant, earning meagre profits by disregarding worker safety and the environment and ruthlessly undercutting competing prices. With an endless supply of below-market loans, it did not matter if the legitimate mining concerns were financially viable. It was in the environment of continued Chinese production despite massive losses that nearly every other REE producer in the world closed down ? and that the information technology revolution took root.

In fact, if not for China?s massive overproduction, the technological revolution of the past 15 years would not have looked the same. In all likelihood, it would have been slowed considerably.

This is a classic predatory pricing. As we wrote in Chinese strategic plans: control of the supply of rare earth metals,

Predatory pricing is an anti-competitive practice by monopolies to bankrupt their competitors by slashing price so much that everyone makes a loss. Since the loss-making monopoly will eventually outlast their loss-making competitors, it is only a matter of time competition is eliminated and the monopoly can increase prices.

So, what this means is that China will only maintain its commercial monopoly on REE as long as prices remain uneconomically low.

Now, do you see a long term problem that China faces?

As we wrote earlier, China has less than one-third of the world?s REE reserves but produces 95% of the world?s REE. That means that they are supplying REE to the world by running down their REE reserves first before anyone else. Obviously, that will be problematic for them in the future because one day, the tables will turn against them as they start to run out of REE. From that perspective, it makes sense for them to curb REE exports to feed their own domestic needs first.

Of course, if China halt all exports of REE tomorrow, it will cause immediate big problems to the rest of the world because there are not many functioning REE mines (and expertise) outside of China. But in the long run (say more than 5 years later), as new production come online, the world?s dependence on China for REE will decline.

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Posted in Commodities | 2 Comments »