Showing posts with label bubble. Show all posts
Showing posts with label bubble. Show all posts

Saturday, March 28, 2015

Quote of the Day: Bubbles Don't Create Wealth

Bubbles do not produce new goods and services. They don’t create new wealth. For example, there was a copper bubble from 2009 to 2011. The price of copper more than tripled from $1.40 a pound to $4.60. Lots of people bet on it. Consider the fictional case of Joe, who bought $100,000 worth of copper. A few months later, he sold some. He took a profit, yet he still has $100,000 worth of metal. There is an old saying that you can’t have your cake and eat it too. And yet here’s Joe, who still has his money and he bought a motorcycle also. It’s not possible to consume without producing. Yet, while Joe’s copper wager produced nothing new, he consumed the bike. Logically, if Joe did not consume new production then he must be consuming old production. Joe consumed part of his savings. Joe doesn’t see the loss, because he is only thinking in dollars. Instead of looking at the trade in terms of paper, let’s focus on the loss of metal. Joe starts out with 15 tonnes of metal. He sells four to buy that new Harley, and has 11 left. Joe spent a big chunk of his copper, and now he has less. Most people don’t want to eat their capital. However, in a bubble they’re tricked. They think copper went up, but it’s just a mirage. In reality, the copper only went out—out the door. Now it’s gone. Speculating may seem similar to earning interest, but it achieves the opposite result. Interest creates new income by financing new production. Speculative gains come from paying out existing capital as income, and consuming it. We are all harmed by this destruction. Interest rate suppression undermines our civilization. It destroys the capital on which it depends.
This is from Keith Weiner president of the Gold Standard Institute USA and CEO of precious metals fund manager Monetary Metals published at the SNBCHF.com

Wednesday, March 20, 2013

Which is a Bubble: Bitcoins or Fiat Money?

The mainstream sees the exploding public interest on bitcoin as a threat and brands it a “bubble”.

Here is the Economist,
NOT MANY fund-managers have heard of Bitcoin, let alone put any of their clients’ money in it. But over the past few months, the world’s first “crypto-currency” has become one of the world’s hottest investments. Since September, when The Economist last wrote about it, the price of a unit of Bitcoin as recorded by Mt Gox, a popular Bitcoin exchange, has soared. Unlike other online currencies—such as the new Amazon Coins—the supply of Bitcoin is not determined by any central issuing authority. Instead, new coins are generated according to a predetermined formula by thousands of computers solving complex mathematical problems. As more coins are generated, these problems get ever more complex, increasing the cost of computing power necessary to generate them, and so setting a floor underneath the price. Mimicking gold, the currency is designed to be deflationary. However, there is every reason to think that the current Bitcoin boom will shortly bust. As the chart shows, online interest in the currency has spiked in recent months. Though an increasing number of legitimate businesses are adopting the currency—one Finnish software developer has offered to pay its employees in Bitcoin—it still has relatively few users. Its primary commercial use is probably to buy drugs from Silk Road, a sort of pirate eBay hidden in the “deep web”. This suggests that the new users are buying Bitcoin as an investment, not as a means of exchange. For any currency to thrive it needs users, not just speculators.
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The idea that bitcoins “still has relatively few users” ergo a bubble simply begs the question. This doesn’t establish the bubble properties.

The transition towards “moneyness” is a market process and doesn’t come instantaneously. Since the article admits that bitcoin attempts to "mimic gold", then the process entails the expansion of the commodity’s marketability which may have partly been exhibited by the chart.

As the great dean of Austrian economics Murray N. Rothbard explained,
Once a commodity begins to be used as a medium of exchange, when the word gets out it generates even further use of the commodity as a medium. In short, when the word gets around that commodity X is being used as a medium in a certain village, more people living in or trading with that village will purchase that commodity, since they know that it is being used there as a medium of exchange. In this way, a commodity used as a medium feeds upon itself, and its use spirals upward, until before long the commodity is in general use throughout the society or country as a medium of exchange. But when a commodity is used as a medium for most or all exchanges, that commodity is defined as being a money.

In this way money enters the free market, as market participants begin to select suitable commodities for use as the medium of exchange, with that use rapidly escalating until a general medium of exchange, or money, becomes established in the market.
Paradoxically the article mentions a Finnish software company offering to pay employees based on bitcoins.
 
Another good example for this could be Iran. Hammered by trade and financial embargo, part of the embattled nation’s economic activities have shifted to using bitcoins

So expanding public interest on bitcoins does not necessarily entail a bubble.

The reality is that the ECB and other central banks see bitcoins as threat to their monopoly over Seigniorage privileges and thus engage in negative publicity or propaganda to besmirch a potential market based competitor.

The essence of bubbles is really a “something for nothing” or a "free lunch" dynamic.

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If Bitcoins are generated with a huge cost, “As more coins are generated, these problems get ever more complex, increasing the cost of computing power necessary to generate them, and so setting a floor underneath the price”, then compare this with exploding balance sheets of global central banks, whom are simply digital entries as determined by political authorities to the banking system.

Guess which is unsustainable and has the character of a bubble?

Saturday, October 06, 2012

Imploding Solar Energy Bubble Even in China

Government sponsored renewable “green” energy (predicated on climate change) has been imploding, not only in the US (e.g. Solyndra scandal) and Europe but in China as well.

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From the New York Times (bold highlights)
China in recent years established global dominance in renewable energy, its solar panel and wind turbine factories forcing many foreign rivals out of business and its policy makers hailed by environmentalists around the world as visionaries.

But now China’s strategy is in disarray. Though worldwide demand for solar panels and wind turbines has grown rapidly over the last five years, China’s manufacturing capacity has soared even faster, creating enormous oversupply and a ferocious price war.

The result is a looming financial disaster, not only for manufacturers but for state-owned banks that financed factories with approximately $18 billion in low-rate loans and for municipal and provincial governments that provided loan guarantees and sold manufacturers valuable land at deeply discounted prices. 

China’s biggest solar panel makers are suffering losses of up to $1 for every $3 of sales this year, as panel prices have fallen by three-fourths since 2008. Even though the cost of solar power has fallen, it still remains triple the price of coal-generated power in China, requiring substantial subsidies through a tax imposed on industrial users of electricity to cover the higher cost of renewable energy.

The outcome has left even the architects of China’s renewable energy strategy feeling frustrated and eager to see many businesses shut down, so the most efficient companies may be salvageable financially.
$18 billion and counting of China’s taxpayers money now in jeopardy.

As always, eventually economic reality expressed through the markets upend governments’ grand delusions, more from the same article:
Chinese companies have struggled even though a dozen solar companies in the United States and another dozen in Europe have gone bankrupt or closed factories since the start of last year. The bankruptcies and closures have done little to ease the global glut and price war because China by itself represents more than two-thirds of the world’s capacity.

To reduce capacity, foreign rivals have clamored for China to subsidize the purchase of more solar panels at home, instead of having Chinese companies rely so heavily on exports. But the government here is worried about the cost of doing so, because the price of solar power remains far higher than for coal-generated power.

The average cost of electricity from solar panels in China works out to 19 cents per kilowatt-hour, said Mr. Li. That is three times the cost of coal-fired power. But it is a marked improvement from 63 cents per kilowatt-hour for solar power four years ago.

China’s official goal is to install 10 gigawatts of solar panels a year by 2015, using 20-year contracts to guarantee payment for electricity purchased from them. If costs stay where they are now, the subsidies would be $50 billion over 20 years for every 10 gigawatts of solar power installed, based on figures supplied by Mr. Li.

Even if solar power costs fall by a third, as the government hopes, he said, “it’s big money.”
China’s government’s goal may or may not be attained, but one thing is for sure: costs are not benefits. China’s force feeding of solar energy will come at a great costs to her taxpayers and to the development of other possible alternatives, most prominently shale gas.

Alternatively, the explosive global growth of free market based Shale gas will add to the economic and financial woes of the solar and other government sponsored renewable industry.

Friday, April 30, 2010

In Spain, Pop Goes The Magic 'Green' Bubble

ONE of the likely casualty from the Greece led PIIGS debt crisis seems to be "Green" energy.

From Businessweek,

``Spain is lancing an 18 billion-euro ($24 billion) investment bubble in solar energy that has boosted public liabilities, choking off new projects as it works to cut power prices and insulate itself from Greece’s debt crisis...

"Spain is battling on several fronts to revive its economy and convince government bondholders it can avoid getting dragged into a Greek-style debt spiral after Standard & Poor’s cut its credit rating April 28. Solar-plant owners including General Electric Co. earn about 12 times what’s paid for power from fossil fuels. Most of that is a subsidy charged to customers

``Prime Minister Jose Luis Rodriguez Zapatero’s government last cut solar rates in 2008, hitting plants not built at the time. Now it’s weighing reductions for the thousands of installations already making power from the sun, wind and biomass.

‘Excessive Subsidy’

“This is necessary,” said Leon Benelbas, chairman of Atlas Capital Close Brothers investment bank in Madrid. “It’s an excessive subsidy at a time Spain has to gain competitiveness, and the cost of energy is a determining factor.”

``Spain’s fixed-price system for renewable power, which attracted more investment in solar panels in 2008 than the rest of the world put together, boosts the state’s liabilities even though they don’t show up on its balance sheet.

``That’s because the Spanish system delays payments by consumers for part of their electric bills for years. The government guarantees repayment to power suppliers such as Endesa SA and Gas Natural SDG SA. The cost of those unpaid bills rose last year by about 4 billion euros to 16 billion euros.

``Spain intends to revise the clean-energy rates down “to avoid damaging the competitiveness of industry,” Sebastian told the Spanish parliament yesterday."

This only shows that industries that cannot stand on its two feet, that can't compete, but survives mainly on government mandates and subsidies (or crutches), will be subjected to politics and this includes suffering from cuts in spending or support when austerity is required, especially in response to a crisis.

And the impracticality or non-feasibility would be eventually revealed from such retrenchment. In short, "the emperor has no clothes!"

Yet, "green energy" hasn't been proven to be a net positive contributor to the economy.

George Will comments on a study by Professor Calzada on Spain's alternative energy programs,

``Calzada says Spain's torrential spending -- no other nation has so aggressively supported production of electricity from renewable sources -- on wind farms and other forms of alternative energy has indeed created jobs. But Calzada's report concludes that they often are temporary and have received $752,000 to $800,000 each in subsidies -- wind industry jobs cost even more, $1.4 million each. And each new job entails the loss of 2.2 other jobs that are either lost or not created in other industries because of the political allocation -- sub-optimum in terms of economic efficiency -- of capital. (European media regularly report "eco-corruption" leaving a "footprint of sleaze" -- gaming the subsidy systems, profiteering from land sales for wind farms, etc.) Calzada says the creation of jobs in alternative energy has subtracted about 110,000 jobs elsewhere in Spain's economy."

Overall, like typical bubbles, resources spent on these government pet projects only means waste.

Friday, November 06, 2009

Graphic: Global Property Bubble

A graphic presentation of the 2007 global property bubble by McKinsey Quarterly.

According to
McKinsey Quarterly, ``Although the current crisis started with the bursting of the US housing bubble, other economies around the world are feeling the effects of their own real-estate booms and busts. From 2000 through 2007, a remarkable run-up in global home prices occurred (see exhibit). But that trend has reversed abruptly. In 2008, the value of US residential real estate fell 10 percent; the global average fared only somewhat better, declining by almost 4 percent. We estimate that falling home prices erased more than $3.4 trillion of household wealth in 2008. And because home prices are slow to correct, the current slide may persist for some time, which could depress global consumption."
Additional observations:

-The US bubble had been dwarfed by property bubbles mostly in Europe.


-3 major economies, Switzerland, Japan and Germany had no bubbles yet were similarly hit hard (transmitted from Banking and exports)


-Asia (and possibly emerging markets) was mostly exempt-except for Australia.

Sunday, March 08, 2009

Beware Of The Brewing Meralco Bubble!

``As government has destroyed one business opportunity after another, perhaps we should not be surprised that investment money has left domestic production and was diverted to financial markets. Investors want a return, and government agents and the political classes seem determined to destroy free markets — and the opportunities they present for economic growth.”-William L. Anderson, One Cheer for Paul Krugman, or Why the Bubble Economy?

Meralco is in a SEMINAL bubble.

The Case For A Brewing Bubble

The Lopez owned utility firm skyrocketed 40% last week and is 111% up on a year to date basis.

Meralco’s free floated market capitalization share to the Phisix index has leapt to 5.48% as of Friday’s close from less than 1% share late last year and has catapulted to the FOURTH spot among the top weighted issues, following PLDT 34.15%, Bank of the Philippine Island 7.17% and Ayala Corp 5.52%. Previously Meralco wasn’t even in the top 12!

Meralco’s outperformance seen in its soaring share prices coupled with the languid performances of the price values of the traditional heavyweights- such as BPI, AC, Metrobank , SM Investments , SM Primeholdings have expanded MER’s influence on the Phisix.

This means that a sharp reversal of MER’s share price trend would risks placing unnecessary onus on the Philippine benchmark. And this could unduly influence the overall market especially if it unwinds under today’s melancholic global atmosphere.

Moreover, MER’s weekly traded volume in PESO has accounted for a cumulative 53.3% of the entire trade, 48.55% of the trades at the close of February 27th and 32.37% on the close of February 20th. Previously Meralco had less than 5% share of total trades.

We recall that the last time we saw bubbles with nearly the same magnitude was in BW Resources (1998-1999) and Philweb (2000) days see figure 5.

Figure 5: Philweb (red), BW Resources (blue) Bubble and Phisix (black) Bear Market

If memory serves me right, the controversial BW Resources (blue line) corralled about 70% of the entire market’s PESO traded volume during its zenith, and in fact, fleetingly displaced San Miguel Corp as the largest listed company based on market cap in the Phisix then.

Incidentally, both bubbles- BW Resources which today is listed under a new management Sun Trust Realty (of the Megaworld group) and Philweb (red line)- occurred during the bear market of 1998-2002.

Although one may argue that the scale of price increases may not be similar YET, where BW (approx 5,000%) and Philweb (estimated 1,200%), whereas MER’s prices has only increased by about 200% (based on June 2008 trough), the common feature of ANY bubble is the transition from a MANIC phase to a BLOW OFF phase characterized by parabolic movements in the underlying share price trend (see figure 6).

Figure 6: Moneyweek.com: Stages of A Bubble

Meralco seems to be in a manic phase. And we hope to see some temperance rather than a progression to the Blow off phase.

As you would notice in the previous chart, both BW and the Philweb boom-bust cycles have the same dynamics as the typical vicious bubble cycle above. To add, in both times the bubbles went bust, the overall markets suffered dearly.

And attempting to “time” bubbles by the ordinary market participants may only lead to more tears and mental anguish.

King Kong Versus Godzilla

Another common feature of the localized bubble is the “takeover” component which rationalizes the market action.

In BW Resources series, it was the hyped tale of a supposed (but aborted) buy-in of the Macao’s gambling magnate Mr. Stanley Ho.

On the other hand, the surge in Philweb share prices came about over the company’s successful takeover of the Cabarrus owned South Seas Oil and Minerals (formerly SSO), which likewise partially piggybacked on the peaking sentiment of the US dot.com boom.

Of course, one may further argue that Meralco is a cash flow rich utility vastly different from “third tier issues”. But NO economic or corporate fundamentals justify such exuberance except for the same “takeover” story.

The apparent action in Meralco has been allegedly due to corporate maneuverings by rival groups in contest for the management prize.

According to the grapevine, the Lopez camp, which is the incumbent managers with substantial ownership of Meralco is allegedly being aided by PLDTs Manny Pangilanan (with speculations of access to the Indonesia’s Salim group), while at the same time reportedly seeking other allies (Henry Sy?), to fortify its position in the utility company by acquiring shares in the market, against a possible hostile takeover attempt by PGMA ally in San Miguel Corp.

If this floated story is anywhere near correct, then MER, which is a regulation instituted monopoly, whose prized possession is being bitterly contested by politically privileged groups signify an engagement between “crony capitalists” representative of the opposite side of the political fence.

It’s like a King Kong versus Godzilla movie, where one monster eventually wins but the rest of the city is devastated.

This means that joining the bandwagon risks a disaster for most of the ordinary market participant. Why? Since it is a high profile corporate struggle, the flow of information is largely asymmetric. Movements of share prices tend to favor insiders and their affiliates who seem to be “gaming” the issue.

Yet even insiders can’t be assured of their newfound paper wealth. If we learn by history, in the BW case, allegedly some insiders or even the BW owner Dante Tan, reportedly lost a fortune in the pointless exercise to buttress a deflating bubble.

In addition, such maneuvers will obviously come to an end, possibly on one or a combination of the following reasons: 1) share price will be high enough to dissuade anyone of the contending parties from further pursuing their agenda, 2) budgets of one of the opposing camps have been drained, 3) political goal accomplished-alliance confirmed and management role retained or successful takeover and or 4) lastly, basic economics-high prices will eventually lure more sellers than buyers.

The Psychology of Bubbles

It is disheartening to see a bubble-like activity emerge anew in an environment resembling a bear market, even when the overall domestic market seems to be on the mend. If history were to rhyme and the MER saga transforms into a full blown bubble which eventually goes bust, then this could extrapolate to additional selling pressures on the local markets anew.

Nonetheless, the vulnerability of the public to get hooked to a bubble is understandable; in a somber environment like today, there is an added desire to squeeze some earnings from momentum driven trades.

Besides, the dearth of trading opportunities in a bear market which have been handicapped by the lack of accessible “short” facilities may have increased participants desire to speculate.

Moreover, negative real interest rates account for as a big incentive to chase yields. When your savings account yields lower returns than the inflation rate, then the temptation to gamble or the appetite to speculate is whetted.

Perhaps these are some of the reasons why a localized bubble coincides with a bear market here.

But unknown to most participants, bubbles operate similar to getting finagled by a Ponzi scheme like the recent Bernard Madoff or Robert Allen Stanford case or the US real estate-securitization cycle.

Such fraudulent conducts or unsustainable trends require exponential acceleration of fresh flow of money from new entrants, whom are seduced with records or appearances of sustainability of past performances-persistent high yields or strong capital returns-even when the underlying business model is questionable or flawed or even non-existent.

In short, most people buy on emotions and not on rationality.

Yet, the more the entrenched the trend, such as the dot.com or US Real Estate, or the more “socially” known people are involved, the greater the attraction to join the bandwagon, such as the Bernard Madoff case.

This is a cognitive bias which humankind in general won’t overcome-the Herd mentality- simply because it is hardwired into our genes. Our ancestors didn’t have the privilege of rationalizing and used intuitions or mental short cuts rather than risks becoming the next meal for carnivorous predators such as tigers and or lions.

But we don’t live in primordial times anymore. We have advanced and will continually do so but our instincts remain.

Worst of all, having a PhD or even an army of highly decorated or awarded professionals does not guarantee protection from fraud. Again as in the Bernard Madoff case, it had among its victims Banks, Insurance companies or hedge funds [see Madoff Ponzi Scam and Boom-Bust cycles].

Yet this world appears to be more fixated with academic and professional credentials whose rich “quantified” trainings or experiences haven’t reduced their ability to read through risks. Thus, the perpetual cycle.

Actually, it is the process ability from emotional intelligence that distinguishes plain academic or technical expertise from being streetsmart or market smart.

Conclusion

The present price actions in Meralco appear headed towards a full blown bubble.

We hope to see the issue make a gradual ascent instead. Moreover we hope that the positive sentiment from its recent activities spillovers to the general market which should reinforce the case of a general market turnaround thereby strengthening the case for MER’s sustained long term uptrend. For a boom to be sustained this requires a recovery in the general market sentiment, especially for the largely underdeveloped liquidity and sentiment sensitive Philippine equity markets.

On the other hand, a bursting bubble, which implies a decline in a similar degree to the preceding upside momentum, will only dampen sentiment as losses are likely to be swift and severe.

In learning from the lessons of history we understand that a bubble bust risks undermining the progress in the local market. This happens even if the bubble is a residual specific risk or is based on a particular company, mainly because the bubble has commanded a substantial share of the market’s attention. Thus, a bubble works like a temptress-they are seductive but fatal.

Unfortunately markets don’t operate on hope.

Applied to the analogy of Dante Alighieri’s who wrote in his classic "Divine Comedy"…

“Before me things create were none, save things

Eternal, and eternal I endure.

All hope abandon ye who enter here."

Therefore my advice, caveat emptor.



Sunday, February 01, 2009

What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis

``The most popular method of deprecating capitalism is to make it responsible for every condition which is considered unsatisfactory. Tuberculosis and, until a few years ago, syphilis, were called diseases of capitalism. The destitution of scores of millions in countries like India, which did not adopt capitalism, is blamed on capitalism. It is a sad fact that people become debilitated in old age and finally die. But this happens not only to salesmen but also to employers, and it was no less tragic in the precapitalistic ages than it is under capitalism. Prostitution, dipsomania, and drug addiction are all called capitalist vices. Ludwig von Mises Economic Teaching at the Universities

Lessons from Nassim Taleb

There are two important things I’ve learned from my favorite iconoclast Nassim Taleb, the chief proponent of the Black Swan Theory.

One is that he cautions the public to indulge in the study of markets or economies centered upon highly flawed but popular econometric models which are nothing but algorithms designed to operate on sterilized environments similar to classroom or laboratory conditions.

Since these computer models unrealistically operate on the assumption that every factor can be anticipated, examined and evaluated, risks are therefore assumed to be under control. Yet, the complex nature of our world can lead to manifold variables which can’t be read, evaluated or anticipated. The impact of which is known as randomness or the BLACK SWAN, a low probability but HIGH impact event, and is the nemesis of these ‘quant’ models. For instance the humongous losses in today’s financial crisis have been be partially blamed on the failure of quant models to anticipate risks from statistical fat tails.

Second, the other lesson taught by our unorthodox savant is to avoid getting trapped with cognitive biases such as projecting past connections and outcomes into the future.

The Sanctity of Delusion

Today we are told that the world is going to the sewer.

That is because the US, which has functioned as the only major ‘aggregate demand’ of the world, can’t live up to its role as it is undergoing a deep recession. In corollary, these experts further assert that the world won’t be able won’t replace the US as the provider of demand because of its sheer size. In other words, past performance guarantees tomorrow’s outcome.

Based on their economic premise, where supply exists only as a function of demand, then with today’s imploding private sector credit bubble, which has deeply dented the demand equation, must be replaced and absorbed by the government. Therefore, the government’s role MUST be to create artificial demand by printing up as much money in order to sustain the bursting bubble structure.

Tersely said, from the private sector, the credit bubble now is being reconfigured to one known as a government credit bubble. And this seems to be what we are seeing all around the world. From nationalization, “bad bank” or other means of government interventions, the idea is to transfer the leverage and the attendant losses to the government.

The same logic says that if Bernard Madoff was a fraud, and had operated on an unsustainable platform which didn’t last, the government’s insistence of operating on the same an unsustainable platform, but charged to the taxpayers and meant for the “good of the citizenry”, MUST SUCCEED. The difference was that Madoff was a felon, while governments sustaining bubbles for chimerical prosperity, are deemed as legitimate and for a good cause.

Unfortunately for Madoff, he was an individual and not privileged to conduct the same scheme which is equally being thrown to the public by governments. But the underlying principle of both Madoff and the governments is the same: to get something from nothing!

In other words, you resolve the problem of drug addiction by providing more drugs. If you are Madoff you get charged with drug pushing. But if you are the government, you receive plaudits for a fighting for a good cause.

In a reality check, unsustainable trends which can’t last, won’t! NO amount of the printing press nostrums will make illusions a reality.

Reality has finally landed in Zimbabwe. The Mugabe-Gono government finally capitulated to the marketplace realities by allowing the depressed African economy to trade in foreign currencies which in effect jettisoned the local currency, the Zimbabwe dollar. This also means the Mugabe-Gono government will fall soon. And in the same vein, all nationalizations or government guarantees are only as good as the real capital standing behind these.

Does the words of Karl Marx in Das Kapita in 1867…``Owners of capital will stimulate the working class to buy more and more of expensive goods, houses and technology, pushing them to take more and more expensive credits, until their debt becomes unbearable. The unpaid debt will lead to bankruptcy of banks, which will have to be nationalized, and the State will have to take the road which will eventually lead to communism"…ring a bell?

Fairy Tales Cures and Self Righteousness

Yet popular opinion believes in fairytale cures.

To call for market forces to rectify the situation, one risks being labeled as insane, inhuman or bloodless.

Nevertheless just look at level of desperation policymakers are into so as to consider ridiculous ideas to restore an unsustainable structure of economic growth:

-In déjà vu to the hog reduction program of the Great Depression of the 1930s, US policy makers are considering to boosts car sales via a program known as "cash for clunkers". (CNNmoney) Yes, the US government plans to buy and junk old cars so as to motivate its populace to buy new ones. If the policy gets enacted, this is going to be a waste of productive resources.

-Moreover, they are considering “to renegotiate mortgages it owns that might otherwise enter foreclosure” (Washington Post) or allow “bankruptcy judges to modify the mortgages of troubled homeowners” (Washington Post) all at the expense of the property rights of American people.

To add, not content with plans to impose tons of regulations on the national level, the statists have been contemplating on to expand impositions abroad. Signs of protectionism, which had greatly contributed to the Great Depression of the 1929, are surfacing in the political arena. At the confirmation hearing, Treasury Secretary Tim Geither unleashed what he “believes that China is manipulating its currency” (Wall Street Journal). In addition, the stimulus bill which was recently passed by Congress contained a “Buy America” rider (Washington Post).

All these actions seem to agitate for a mutually devastating global trade war.

And why would authorities engage in such potentially calamitous actions? We understand 3 possible things: economic ignorance, messianic complexity or plain political rhetoric.

Realities say that the US doesn’t produce enough, that’s why it incurs trade deficit. And a trade war would mean massive catastrophic shortages. Think oil. The US imports 60% of its oil requirements (CNNmoney). If world trade shuts, the economic implication would be a collapse in the US economy with a geopolitical implication of a possible World War 3.

And also considering that the US is the largest debtor nation in the world, it wouldn’t be far where a trade war would also extrapolate to an equally internecine debt default. And what’s to stop these interventionists fools from inciting a war economy or the misguided belief that only war, after everything else fails, can stimulate the economy?

Now we turn the tables and wonder who is insane, inhuman or bloodless? Does provoking a trade war which has dire consequences similar or worst in scale than the Great Depression a humane and charitable option? How altruistic is it, if the world goes into war out of the desire to stimulate the economy? How does hyperinflation as in the case of Zimbabwe lead to progress? How charitable can it be to live a world of self delusion?

Does the 2008 Global Trade and Production Collapse Signify Posttraumatic Stress Disorder?

If a bubble structure can be characterized by unrestrained credit creation, speculative excess seen in asset inflation and unparalleled concentration of financial wealth and power, then in as much as the massive wage or income disparities or “Shameful bonuses” in Wall Street relative to the average Americans had been a function of a bubble structure, the world’s production-supply chain structure have also been partly been built around the same bubble environment.

And today’s bursting bubble which has prompted for “demand destruction” has been met by more “supply destruction”.

Yet what seems to be remarkable has been the sharp collapse in global production and trade.


Figure 3: IMF World Economic Outlook: Collapse of Global Industrial Production and Merchandise Trade

The chart IMF’s World Economic Outlook demonstrates the seeming peculiarity of the last quarter’s world trade and production activities.

If you are to compare with the dot.com days or the previous bubble bust and its ensuing recession, you’d notice that the same trends went into a steady decline over a period of time (years). But this hasn’t been the case last year. The outright collapse in just ONE MONTH by both economic variables suggests that world suddenly stopped doing anything and merely watched in shock and awe!

And why would the world do that? The obvious answer is the shock emanating from the near meltdown of the US banking system subsequent to the Lehman debacle. This has been prompted for by the institutional bank run in the US banking system as discussed in last October’s Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

So contrary to mainstream views which ANCHORS upon this collapse as their basis for prediction, we suggest instead that this could be a function of a Posttraumatic stress disorder (PTSD) where according to Wikipedia.org, ``is an anxiety disorder that can develop after exposure to one or more terrifying events that threatened or caused grave physical harm.”

As an example, the 9/11 terrorist attack on the World Trade Center was graphically captured in living color by media. The repeated airing of the deplorable terrorist event heightened the fear of air travel which thereby caused a shift or substitution in some of the public’s traveling patterns.

And the shift emanating from the fear, resulted to more casualties from the higher risk land transportation.

According to a study The Impact of 9/11 on Driving Fatalities: The Other Lives Lost to Terrorism by Garrick Blalock, Vrinda Kadiyali, Daniel H. Simon, ``We find that driving fatalities increased significantly following the terrorist attacks of September 11, 2001, an event which prompted many travelers to substitute less-safe surface transportation for safer air transportation. After controlling for time trends, weather, road conditions, and other factors, we attribute an increase of 242 driving fatalities per month to additional road travel undertaken in response to 9/11. In total, our results suggest that about 1,200 driving deaths are attributable to the effect of 9/11. We also provide evidence that is consistent with the 9/11 effect on driving fatalities weakening over time as drivers return to flying. Our results show that the public response to terrorist threats can create unintended consequences that rival the attacks themselves in severity.”

Why is this so? According to Trevor Butterworth, ``Because fear strengthens memory, catastrophes such as earthquakes, plane crashes, and terrorist incidents completely capture our attention. As a result, we overestimate the odds of dreadful but infrequent events and underestimate how risky ordinary events are. The drama and excitement of improbable events make them appear to be more common.”

So given Mr. Butterworth’s tread, could we be “overestimating the odds of dreadful but infrequent events and underestimating how risky ordinary events are”?

Evidences of PTSD

Some evidences show we are.

One, global barter trade has been picking up. [see Does Growing World Barter Trade Suggests Of Bigger Cracks In Today's Monetary Order?]

According to the Financial Times, ``Officials estimated that they ranged from $5m for smaller contracts to more than $500m for the biggest.” It could be more. There have been accounts of barter since this episode has unraveled.

And the reported cause? ``Failure to secure trade financing as bank lending has dried up.”

The fact that governments have traded OUTSIDE the financial system, means demand and supply seems intact for basic necessities for them to conduct trade. The fundamental problem lies within the traditional means of facilitating payment and settlement via the banking system.

Two possible reasons why governments have been undertaking barter, which is a primitive method of trade:

One, the banking system remains dysfunctional despite the heavy interventions by global governments and

Two, there is a growing distrust for the present medium of exchange. The second finds a voice in Russian Prime Minister Vladimir Putin’s speech in Davos, ``Excessive dependence on a single reserve currency is dangerous for the global economy. Consequently, it would be sensible to encourage the objective process of creating several strong reserve currencies in the future. It is high time we launched a detailed discussion of methods to facilitate a smooth and irreversible switchover to the new model.”

The next evidence could be seen via the surging Baltic Dry Index see figure 4.


Figure 4: stockcharts.com: Rising Baltic Index=Rising Oil and Copper?

The Baltic Dry index according to the wikipedia.org is ``a number issued daily by the London-based Baltic Exchange. The index provides "an assessment of the price of moving the major raw materials by sea. Taking in 26 shipping routes measured on a timecharter and voyage basis, the index covers Handymax, Panamax, and Capesize dry bulk carriers carrying a range of commodities including coal, iron ore and grain.”

Plainly put, the Baltic Index is the cost of freight to move raw materials or basic commodities. It could be seen as a leading indicator.

So far the Baltic Index has risen by 60%, whereas oil and copper appears to be consolidating or “bottoming” even as the US dollar index has been going up. To recall, during the October-November collapse, the US dollar has inversely accompanied the rapid declines of the Baltic index as with the oil and copper.

The seeming divergence could be added signs of the diminishing influences of debt deflation.

Furthermore, even in the US, there are signs that production and inventory or supply destruction have been catching up with its counterpart demand destruction see figure 5.

Figure 5: Danske Bank: Is the US Manufacturing Sector Beginning to Recover?

These observations from the Danske Team (bold emphasis mine),

``First, prior to the recession the US manufacturing industry ran very lean inventories. Second, the liquidity squeeze from the credit crisis has led to an unusually fast alignment of production to demand fundamentals.

``Consequently, the pace of production is now undershooting the slowdown in demand. Hence, it will merely take stabilisation in demand growth to spark an industrial recovery.

The Danske team suggests that the first signs of recovery will be manifested over the ISM index which may stabilize and recover over the coming 3-6 months. In addition, a recovery in the ISM index will most likely add pressure to long US bond yields and signal stabilization in corporate earnings.

While I don’t necessarily share the optimism of the Danske team, the point is that the recent collapse have meaningfully adjusted both the demand and supply equation possibly enough to generate some market based (and not government instituted) revival.

So from growing world barter activities, buttressed by the rising Baltic Dry index, and a potential run down of inventories and similar downside adjustments in the supply side production could mean a semblance of restoration of global trade.

And if indeed the Danske Team is right about their forecast about the manufacturing recovery in the US, then this could signal a potential trough or nearing close of the US recession.

But then again, as a reminder, the cardinal sins in policymaking that could lead to prolonged bear markets: protectionism (nationalism, high tariffs, capital controls), regulatory overkill (high cost from added bureaucracy), monetary policy mistakes (bubble forming policies as negative real rates), excess taxation or war (political instability). Except for the last threat, the 4 seems likely a clear and present danger.

Will An Easing PTSD Lead To A Resurgent Asia?

Nonetheless, if the US supply side has adjusted to counterbalance the sharp fall in demand, then it is likely that the spate of sharp declines in the economic activities in most of Asia can be construed as the same degree of supply/production side adjustments.


Figure 6: DBS Bank: Asia’s Industrial Production Recovered earlier during the .com recession

Like in 2001, Asia’s heavy exposure to the technology sector hit exporters. Today, the sharp decline in US consumer spending has equally affected Asia’s exports as much as it also affected production. However, the sharp drop late last year could likely be explained by the Posttraumatic stress disorder (PTSD) emanating from the distress in the banking system.

But unlike in 2001, which saw Asia as floundering from the nasty side effects of the Asian Crisis, where there essentially had been no domestic demand, this isn’t the case today. Asia has simply grown bigger and more dynamic and with ample shield from its high savings enough to potentially generate its own demand.

The recent DBS bank outlook says it best, ``Asia now generates almost as much new demand every year as the US- and it is that fresh demand that’s the very definition of global growth. The US is still a key driver and will remain so for a long time. But it is not the driver it used to be.” (bold emphasis mine)

And the Economist seems to agree, ``The question is, might domestic demand now take up some of the slack? There are reasons to think so. Falling commodity prices are boosting consumers’ purchasing power, just as they squeezed it last year. More important is the impact of monetary and fiscal expansion…(bold emphasis mine)

And the Economist sings to be singing a tune similar to ours, ``Asia has never before deployed its monetary and fiscal weapons with such force. Every country across the region has cut interest rates and announced a fiscal stimulus. In previous downturns, Asian governments were often constrained by dire public finances or the need to support currencies. But most countries entered this downturn with small budget deficits or even surpluses. All the main Asian emerging economies apart from India have relatively low ratios of public debt to GDP.” (bold emphasis mine)

In our Will “Divergences” Be A Theme for 2009?, we brought up the Austrian economics explanation that ``market rate of interest means different things to different segments of the structure of production.

In essence we believe that convergent actions by global central banks will ultimately lead to divergent responses based on the capital and production structure of every economy.

Where the same amount of rain is applied to a desert land, forest land or grass land, the output will obviously be different. And to complement the DBS and Economist outlook, we recently said ``this crisis should serve as Asia’s window of opportunity to amass economic, financial and geopolitical clout amidst its staggering competitors. But this will probably come gradually and develop overtime and possibly be manifested initially in the activities of the marketplace.”

So to refrain from overestimating the odds of dreadful but infrequent events and underestimate how risky ordinary events are, we revert to the study of Garrick Blalock, Vrinda Kadiyali, Daniel H. Simon who concludes, ``Although we are unable to identify precisely reasons for either the 9/11 effect or its weakening, the existence of the effect is consistent with theoretical models in behavioral economics and psychology of inaccurate assessment of risks by consumers and exaggerated adjustments to risk assessments. The fortunate weakening of the 9/11 effect may be attributable to consumer learning over time in response to environmental changes. For example, the perceived risk of flying may have declined with the absence of any further terrorist incidents since 9/11, or travelers may have become accustomed to the increased inconvenience of flying.”

No we don’t just read past data and project them to the future like most of the experts. Instead, we try to understand that human action, to quote Ludwig von Mises, is a purposeful behavior!


Sunday, January 18, 2009

A Primer On Stock Markets-Why It Isn’t Generally A Gambling Casino

This article is dedicated to my friends at RC Mandaluyong.

People normally bear the misimpression that stock markets function as some variant of gambling “casino”.

Never have they realized that stock markets bear a significant financial and economic merit. Any country that desires to adopt some degree of market based economy requires the presence of a stock market. Even in places which are deemed as economically, socially or politically chaotic or unstable such as Iraq, Zimbabwe or Nigeria has an operating stock market.

Basic Function

The stock market operates similar to the markets where we buy our food. Basically both of these markets function as platforms for conducting exchanges between buyers and sellers. The difference is in the products traded. For our “conventional” markets, it is based on comestible stuffs and or other household wares, whereas for the stock market they involve corporate financial securities such as common stock or preferred stocks or Exchange Traded Funds (ETF).

Going deeper, stock markets- as part of the capital markets- often reflect the basic function of money as medium of exchange, unit of account and a store of value.

-they function as a platform to trade financial securities (medium of exchange),

-they serve as a repository of collateral since they represent ownership in companies that are backed by assets and stream of revenues (store of value) and

-they are valued through the pricing mechanism whether these are driven by momentum or emotions, corporate fundamentals or micro/macro economy as “inflation” (unit of account).

Since all financial markets are driven by the price mechanism, the following variables represent as key drivers in ascertaining prices:

-a collective assessment of the fluctuating balance between demand and supply

-accounts for the subjective value judgments by market participants

-signifies the time dimension in shaping for market participants expectations, whether it short medium or long term, and lastly

-primarily influenced by psychological dimensions (such as greed or fear) and cognitive biases (such as overconfidence, anchoring, risk aversion etc.)

And because markets are determined by divergent psychological expectations they result to a variable flux in prices as seen in the tickertape. This is known as volatility.

Yet prices are always set on the margins. What you read on the stock market section in the newspapers account for as prices determined by marginal investors, where daily traded volume represent only a fraction of total shares outstanding or market capitalization, and not the majority owners.

And the resultant price volatility set by marginal investors is what accounts for as the conventional impression of gambling “casino” like actions.

Risk and Uncertainty

The common impression of the public is that price fluctuations or volatility are a function of sheer randomness. And because of the perception of such unpredictability they are deemed to be risky, which adds to the gambling misperception.

But as market savant James Grant says, ``The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price.”

Of course, whether it is stock market or any non-financial enterprise or even public governance the fundamental problem will always be tomorrow’s uncertain outcome. We can’t even be certain if we will see the sun shine tomorrow. As an old saw goes, there is nothing certain in this world except death and taxation.

The point is- the aversion to the stock market is generally not about its unpredictability, but about having an insufficient understanding of how markets operate. To quote, the world’s richest and most successful stock market investor Mr. Warren Buffett, ``Risk comes from not knowing what you are doing.”

Yet if one scrutinizes the market, it can be generally observed that markets rarely operate on random.

This makes uncertainty of the future a measurable component. The same uncertainty is what can be translated to as “risk” or a “state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome” to quote economist Frank Knight.

In addition, compared to a dice toss, or a bet on a lottery, or a horse race which is immediately determined by the end result of one particular event, markets can be distinguished from these high return high risk activities, because they operate as a continuing process.

This makes time a significant contributor to risk assessment.

From the distinguished finance author Peter L. Bernstein, ``Risk and time are opposite sides of the same coin, for if there were no tomorrow there would be no risk. Time transforms risk, and the nature of risk is shaped by the time horizon: the future is the playing field.”

Reward Risk Tradeoff

Everyone wants to profit. But in financial or stock markets or in any “market based” entrepreneurship endeavor, profits come by as returns of investments (ROI). In other words, one has to accept some degree of risk in order to generate profits.

Applied to regular business enterprises, this also translates to same dynamics: risk capital has to be deployed, in the expectations of future stream of revenues, which fundamentally determines your return on capital. The difference is that in the stock market as a shareholder, you become a passive investor.

Yet because we are uncertain about tomorrow, there is always the risk of undesirable or adverse outcome in the marketplace.

Again like any entrepreneurial activities, success or failure in the stock market always entail offsetting risks relative to your capital to determine your expected returns. This is what is known as the Risk-Return Tradeoff.

Put differently by understanding and limiting your risk, you can amplify or optimize your returns.

This brings us to the basics of risk identification. Fundamentally, there are 3 major risks to consider;

-systematic risks or market risk- risks to the general stock market such as government policy repercussions as war, protectionism, regulatory overkill, monetary policy mistakes, excessive taxation or risks of an economic recession or risk from bubbles: asset-liability mismatch seen in domestic balance sheets or in currency framework or overleverage in the financial or economic system etc…

-residual common factor risks or risks relative to a specific industry such as industry directed regulations, tariffs, etc... and lastly,

-residual specific risks (e.g. risk relative to a particular stock or company such as profitability, management, labor, inventory, etc…)

This means that once the above risks can be assessed, which correspondingly may determine one’s risk reward profile and subsequently applied to the configuration of a portfolio mix, the much feared losses can be minimized while the profit opportunities optimized.

Let me cite a common example; some financial institutions as banks offer Unit Investment Trust Funds (UITFs). Such investment vehicle essentially accounts for as fiduciary fund generally designed to cater to an investor’s risk appetite. But the portfolio mix is standardized; it is offered in either foreign (US dollar) or domestic (Peso) denominated funds and generally split into a choice of equity, fixed income (bond or money market) or balance fund (50% equity-50% balance).

For an investor of the UITF it means 3 things:

First, passive investment-investment allocation is determined by the fund manager assigned for a particular portfolio distribution. Your risk reward ratio is subject to the fund manager’s risk distribution activities. This means your portfolios performance is also subject to management risk.

Two, since the balance of accepting risk is standardized; a choice of all fixed income (conservative risk taking), balance fund (moderate risk) and equity fund (aggressive), the unforeseen risk is the opportunity cost of being “flexible”. In short, a standardized portfolio could be deemed as rigid.

Lastly, a foreign currency denominated fund means expanding your risk spectrum to include the currency risk or volatility from currency valuations.

However in an actively managed portfolio, you can apply the same risk allocation strategies, but this time, being more malleable to your risk profile and time frame based returns expectations.

Market Cycles

Whether we talk about economics or markets, we always deal with psychology.

It is because people act, based on their perceived values or priorities or guided by incentives, to attain certain desired ends.

Thus, the prevailing social psychology, as reflected in moods and actions, underpins the economic activities of savings-consumption-investment decisions, aside from cycles in the financial markets.

Here is an example of flow of the psychological cycle that drives market and or economic cycles.

Generally speaking, since people as social beings, we tend to act in crowd like fashion. This essentially forges extreme swings from outright optimism to downright depression, brought upon by our base instincts of “fear and greed”.

Applied to the economy we see the same wavelike movement…

Thus, economic trends transit from recovery, prosperity, contraction and recession which defines the general economic cycles, and which are nearly identical with the flow of the public’s social moods or psychology.

And as mentioned earlier, stock markets are likewise driven by crowd psychology. This in essence determines the price actions. And because crowd psychology is shaped by time influences, such invariably leads to trends which determine what is known as the stock market cycles.

The stock market cycle can be identified as bottom, advance, top and decline. In the above, the Philippine Phisix chart since 1980 shows that we appear to be undergoing a second leg of a long term cycle.

Again whether it is the stock market, or real estate or any asset class subjected to price actions, they are all influenced by the general trends of psychology.

The same can be applied to boom-bust cycles.

Boom bust cycles account for as the extreme flow of fund swings to certain industries which are typically manifested or vented on financial markets. Boom cycles are usually fueled by massive credit expansion, overspeculation and euphoria, while the bust cycles are the opposite of boom cycles; credit contraction, massive losses from liquidations, liquidity constraints, retrenchment of economic activities or plain risk aversion.

The present bust in the US, preceded by a boom in its housing industry, is emblematic of this phenomenon.

Speculation and Economic Benefits of the Stock Market

Because we can’t foretell of the future accurately, any act of capital allocation basically represents as speculative activity. But where the difference lies, again, is in the degree of volatility. A dentist may have less volatile flow of patient visits compared to a businessman engaged in distribution of cellphones.

However, most speculative actions in the marketplace are always associated with short term movements. Yet, unknown to most, the speculative component helps increase the liquidity or tradeablity of a security or markets, which essentially produce greater pricing efficiency or reliability of market price signals.

Remember, price signals function as our principal incentives for deciding how to allocate resources which can be seen in the context of saving, investing or consuming.

Finally, there are other economic benefits that the stock market provides to the society:

1. The stock market is a vital part of the process from which we coordinate production. Ideally stock prices should reflect the productivity of business firm aside from market’s discernment of the entrepreneurial judgments concerning future productivity.

2. It competes with the banking sector in determining the degree of mobilization of savings into investment. From a national scale this becomes a formidable channel for economic advancement in terms of efficiency of capital deployment.

3. Unknown to many, stock markets often function as forward indicators, such that they have been known to predict upcoming recessions or prospective recoveries. Thus, movements in the financial and stock markets can give a clue to the transitioning business environment, which should help management or businessmen, in allocating resources or in applying their business strategies going forward.

4. It operates as alternative avenues for fund raising (public listing), intermediation (using shares as collateral for borrowing-lending) or liquidity generation (buying or selling a company).

5. Because the markets operate as an organized platform of exchange, the ease from a market’s liquidity allows companies to save on transaction costs: search cost (matching buyers and sellers), contracting costs (cost of negotiation) and coordination cost (meshing securities of different industries into a single platform), which frees up capital for other usage.

6. Allows wider public participation in the ownership of major companies, which expands the concept of private property ownership.

7. Allows some individuals to save from taxation (e.g. inheritance taxes)

8. Because stock markets function as repository of collateral or store of value, it can serve as protection or safehaven against hyperinflation or a severe form of a loss of purchasing power of a currency.

In the case of Zimbabwe where (hyper) inflation rate has reached an astounding 231,000,000%, its stock market has skyrocketed 960 QUADRILLION percent on a year to date basis as of November 4th, (All Africa.com) considering more than 5 years of severe economic contraction and 85% unemployment rate. Unfortunately because of some political reasons, the Zimbabwe Stock Market has been suspended since December 17th (Bloomberg).

Stock Market Is Generally Not A Casino Until…

The overall the goal of this article is to enlighten the public from the mistaken notion that stock markets generally represent as gambling casino.

Given that the stock market has measurable risk-reward variables, involves time continuum dynamics and value added functions (as dividends) it operates like any entrepreneurial undertaking.

Moreover, it has an economic wide and social significance which is largely unappreciated by the uninformed public.

Hence, the speculative ‘casino’ trait is often associated to individual actions or participants who engage in the markets with a short term outlook and without the proper understanding and scrutiny of risk. [Further reading please see Professor Alok Kumar of McCombs School of Business, University of Texas in a recent paper, Who Gambles in the Stock Market?]

Lastly of course government interventions can tilt or distort any markets away far from its price signaling efficiency. This is where the level of the playing field or the distribution share of the odds are skewed to favor one party over the others, mostly the recipients or beneficiaries from these interventions. Where the governments assume the role as the HOUSE and the beneficiaries as the DEALERS, then all other participants operate as PLAYERS, hence your basic description of a gambling casino.