Posts Tagged ‘Peter Bernstein’

Fund managers bewildered by Bell curve breakdown

Tuesday, November 4th, 2008

Today, we will talk about the Bell curve again. As we quoted Nassim Nicholas Taleb in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud,

So the Gaussian [Bell curve] pervaded our business and scientific cultures, and terms such as sigma, variance, standard deviation, correlation, R square, and the eponymous Sharpe ratio, all directly linked to it, pervaded the lingo. If you read a mutual fund prospectus, or a description of a hedge fund?s exposure, odds are that it will supply you, among other information, with some quantitative summary claiming to measure ?risk.? That measure will be based on one of the above buzzwords derived from the bell curve and its kin. Today, for instance, pension funds? investment policy and choice of funds are vetted by ?consultants? who rely on portfolio theory. If there is a problem, they can claim that they relied on standard scientific method.

For the mainstream money-shuffling professionals in the finance industry, their training are rooted on the Bell curve. The Bell curve was formulated back in early 19th century by a mathematician named Carl Friedrich Gauss. It gave a ‘structure’ for systematically evaluating risk and estimating probability. It is the root of mainstream finance and economics and is used everywhere, from options valuation, risk management and measurement, forecasting, portfolio allocation and so on.

There is an underlying assumption with the Bell curve. As Peter Bernstein wrote in his book, Against the Gods- The Remarkable Story of Risk,

… two conditions are necessary for observations to be distributed normally, or symmetrically, around their average. First, there must be as large a number of observations as possible. Second, the observation must be independent, like rows of the dice…

People can make serious mistakes by sampling data that are not independent.

In today’s volatile financial market, price movements are not independent. As we mentioned in Fading glory of the financial services and ?wealth? management industry, October 2008 saw the most fear and panic in the financial markets. We see instances whereby highly leveraged funds have to sell because prices are falling, which in turn depresses prices further. Traders and investors, being confused about what is going on, reacted as prices moved, which in turn leads to more price movements. Funds have to liquidate their positions because investors are demanding redemptions due to falling prices, which in turn lead to more falling prices. Central bankers, governments and regulators observed the behaviour of the financial markets and reacted accordingly, while the markets observed and reacted according to authorities’ reaction. New information about the economy are confusing, contradictory and yields no insight, therefore forcing market participants to base their decision on other participant’s reaction. If price movements are not independent, this basic assumption of the Bell curve breaks down. If so, then all these financial theories that the finance and economics industry rely on breaks down as well.

Assuming that governments are going to fight vigorously the natural deflationary forces with inflation, we can expect more confusion and volatility ahead. Meanwhile, there will be more soul-searching, witch hunts and re-evaluations in the finance and economics industry.

Is this the beginning of the loss of confidence in fiat money?

Sunday, September 21st, 2008

Events from the past week are tumultuous. It started from the nationalisation of Freddie and Fannie (we were mulling about the implication of nationalisation 2 months ago in How do we all pay for the bailout of Fannie Mae and Freddie Mac?). Then came the bankruptcy of Lehman Brothers and takeover of Merrill Lynch. Then we have the nationalisation of AIG. Gold prices surged by more than US$100 in two days (it had declined since), which was the most rapid surge in 26 years. At the same time, the Dow plunged by more than 400 points. It looked as if there was a panic from stocks straight to gold, which meant even cash was distrusted.

Then we have another massive rally in stocks for the past two days when there was hope that the US government, in conjunction with the Federal Reserve are doing something to solve the root of the rot in the financial system. Reports come out that they are planning to use taxpayers’ money to buy up bad assets at sale price. As always the case, the devil is in the details. At this point in time, there is no definitive figure on the cost. Make no mistake about this: this is no trivial task. As this New York Times article reported, Ben Bernanke warned the Congressional leaders,

As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program ?Good Morning America,? the congressional leaders were told ?that we?re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.?

Mr. Schumer added, ?History was sort of hanging over it, like this was a moment.?

When Mr. Schumer described the meeting as ?somber,? Mr. Dodd cut in. ?Somber doesn?t begin to justify the words,? he said. ?We have never heard language like this.?

By now, it should be clear that this global financial disaster has the potential of even surpassing the Great Depression of the 1930s!

Is this crisis a surprise? If you listen to the mainstream economic schools of thought, central bankers, mainstream financial media, captains of the financial industry and so on, it looked as if this looming financial disaster is something that no one can see coming. The common underlying excuse (that was un-said, un-written but implied) goes something like this: “No one could ever foresee this! It’s impossible! Only hindsight can tell!”

Now, we would like to make it clear that this is completely false. Please note that we are not accusing individuals of lying. Instead, our point is that this excuse is a sign of collective mass delusion. If you look at the 6000 years worth of the history of human civilisation, you will find that humanity is repeatedly capable of mass delusions. Always, only the minority could see through the lie. In this case, students and practitioners of the non-mainstream Austrian School of economic thought SAW IT COMING. Some of them sounded the alarm as early as 2004! To press our point further, let’s us show you the chronicle of our warnings in this blog since 2006…

  1. In May 2008, when the world was in denial about the precarious state of the global financial system, Satyajit Das warned that the credit crisis was just the end of the beginning (see Is the credit crisis the end of the beginning?).
  2. Back in November 2007, if you look at the list of major US financial institutions that was compiled by Nouriel Roubini at How solvent are some of the major US financial institutions?, only half of them are left standing. Interestingly, Merrill Lynch was the safest among the insolvents and today, it failed to live. If Merrill Lynch was insolvent, what about the remaining ones today (i.e. Goldman Sachs, Morgan Stanley, Citigroup)?
  3. In June 2007, in Epic, unprecedented inflation, we warned that

    How much longer will the roaring global economy fly? We do not know the answer, for this boom may last longer than what we anticipated. However, please note that in the entire history of humanity, all bubbles (and we repeat, ALL) burst in the end. Thus, a global painful hangover will ensue?the greater the boom, the more painful the eventual bust. This is the theme that we had repeated many times.

    Thus, do not be surprised if a second Great Depression were to strike.

  4. In the same month, the Bank for International Settlements (BIS) warned that the world was in danger of another Great Depression (see Bank for International Settlements warns of another Great Depression).
  5. Back in January 2007, in Spectre of deflation, we wrote that

    But we smell danger.

    It is a danger in which many in the finance industry failed to fully appreciate?deflation. Such complacency is beyond our belief. In the 1990s, Japan experienced it, with dire consequences for their economy. At least, the ordinary Japanese had their savings to fall back on. For many Americans, with their negative savings rate, what can they fall back on? Have they not learned from the mistakes of others in the past?

  6. In the same month, Trichet, the president of EU central bank warned of a coming asset re-pricing (see Prepare for asset repricing, warns Trichet).
  7. Back in November 2006, in How will asset-driven ?growth? eventually harm the economy?, when the global economy was still booming in apparent ‘prosperity’, we quoted the late Ludwig von Mises (the in which the Mises Institute of the libertarian Austrian School of economic thought is named after) and warned that

    That collective error in judgement resulted in the economy misallocating scarce resources into housing sector?in the case of the US, a significant proportion of the jobs created during the asset-driven ?growth? was related (both directly and indirectly) to the housing boom. Since economic resources are always scarce, any misallocation of it implies an opportunity cost on the other sectors of the economy. The result is a structural damage to the economy that can only be corrected through a recession.

    This is the reason why we believe a recession is on its way.

  8. In October 2006, we quoted the late Dr. Kurt Richeb├Ącher (an Austrian School economist) and questioned in The Bubble Economy,
  9. These are some of the serious questions we would like to ask:

    1. As the US spends its way into economic ruin, its economy is being damaged structurally. How much longer can the US sustain its colossal debt?
    2. Right now, the US housing bubble is deflating. Will it eventually burst and wreck havoc on the rest of the economy?

Other contrarians who sounded the alarm long ago (and we quoted often) include Marc Faber, Jimmy Rogers, Robert Shiller, Peter Bernstein, Nouriel Roubini and our local Aussie economist, Professor Steve Keen.

Our readers should, by now, appreciate the colossal magnitude of this financial crisis. When you listen the media, the phrase “since the Great Depression” is often mentioned. Make no mistake about this, this has the potential to be worse than the Great Depression (note: we are NOT predicting that it will happen).

The world’s stock market is rallying in the hope that the US government’s plan to nationalise the financial industry will be successful in stopping the core of the rot. New legislations has to be rushed through Congress by the end of next week to change the rules to make the plan legal. As in everything done in haste, we believe there will not be enough thought put into them to understand the long-term ramifications. It is probable that once the changes are in place, they will not be revisited again.

As we warned in Recipe for hyperinflation,

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 civilisation.

Pressure on global financial system is still simmering away

Monday, April 28th, 2008

One of the financial veterans you have to respect is Peter Bernstein. As this Wall Street Journal article, One Guy Who Has Seen It All Doesn’t Like What He Sees Now said,

Peter Bernstein has witnessed just about every financial crisis of the past century.

As a boy, he watched his father, a money manager, navigate the Depression. As a financial manager, consultant and financial historian, he personally dealt with the recession of 1958, the bear markets of the 1970s, the 1987 crash, the savings-and-loan crisis of the late 1980s and the 2000-2002 bear market that followed the tech-stock bubble.

Today’s trouble, the 89-year-old Mr. Bernstein says, is worse than he has seen since the Depression and threatens to roil markets into 2009 and beyond — longer than many people expect.

If you look at the financial press today, you will find that the market is ‘optimistic’ that the credit crisis is turning for the better. It has hope that the situation will get better. Consequently, you get to see some recovery of financial stocks and the US dollar. But Peter Bernstein is not so hopeful. As he said,

If China goes into a recession, God knows. The Iraq war and the whole situation with terrorism, we really don’t know where that is going to come out. There are so many things that have got to get buttoned down before you say that the future looks good enough to take a risk.

In other words, there are too many unknown unknown lurking around (see Failure to understand Black Swan leads to fallacious thinking). We share his concern about China and had written a long article about it in Can China really ?de-couple? from a US recession?. Peter Bernstein will only start to get hopeful when he sees that

… housing trouble has to at least flatten out. As long as that is going on, I think the pressure on the credit system is going to persist. It is kind of the leading indicator. It is where the trouble started. We have to underpin the consumer. That is why this is different. That is why this is like nothing we have had before.

This brings us to the Credit Default Swaps (CDS). As we said before in Potential global economic black hole: credit default swaps (CDS),

What happens if these waves of bad debts trigger the contingent obligations of CDS sellers to honour these mass of credit defaults? If these CDS sellers default themselves, what will happen to those who depend on CDS to remain solvent in the event of defaults?

As long as the house price deflation is still under way, the solvency of the financial system will be under pressure, which in turn will lead to further deflation and contagion of credit default. That will test the CDS. As this Economist article said, Swap shop,

However, many market participants were equally reassuring about the health of the CDO market in early 2007?and look how that turned out. Independent observers will not be really reassured until the system survives the test of a big, juicy default. Given the weakness of the American economy and the scale of the credit crunch, it probably will not be long before that test comes along.

If the CDS time bomb explodes (and some will argue that it is a matter of when), the first share market casualty will be the financial stocks. Just as the Germans did not know when and where D-Day will occur (though they knew it was a matter of time), so will the day of CDS reckoning be.