Quote of the Day: Standing Up Against Prevailing Beliefs

Would you rather be an honorable person perceived to be a fraudster, or a fraudster mistaken for an honorable person? The answer can help you understand why otherwise good people do devious things to avoid standing up against prevailing beliefs.

This is from Black Swan author Nassim Nicolas Taleb at Facebook

Quote of the Day: The Essence of the Ponzi Scheme is Not Statistical; it is Psychological

The essence of the Ponzi scheme is not simply its statistical unsustainability. The essence of the Ponzi scheme is that it is like an addictive drug. Once someone enters into it, he finds it psychologically impossible to face the reality of the unsustainable statistics of the program. He refuses to get out in time. His participation in the scheme fundamentally changes his outlook toward reality. He is no longer capable of being persuaded that he has made a fool of himself by entering into such a scheme. This includes the founder of the scheme.The essence of the Ponzi scheme is not statistical; it is psychological. It creates belief in that which is statistically impossible, and the degree of belief is so strong that anyone who points out the statistical impossibility of the scheme risks being cut off personally by the victim. Ponzi scheme economics creates the classic attitude: shoot the messenger.

(bold original)

This is from Austrian economist Gary North at his website on the Ponzi Welfare State economy. 

Let me add that financial bubbles are also Ponzi schemes which ultimately depends on unsustainable credit and monetary accelerated expansions that eventually backfires. This is why they are called bubble cycles.

A famous Wall Street idiom emblematic of this pathology is “left holding the empty bag”

In analyzing America’s Great Depression, dummies.com uses such phrase as description for the one of the major excruciating chapters of US economic and financial history

Many more had borrowed money from banks to buy stock, and when the stock market went belly-up, they couldn't repay their loans and the banks were left holding the empty bag.

The point is that market risks escalates when the public begins to manifest snowballing symptoms of espousing nirvana fallacies or delusions of grandeur by shunning economic reasoning and basic mathematical or even statistical realities, or at worst, common sense--or the Ponzi psychology. 

What to Expect in 2013

Wishing everyone a Happy, Healthy and a Prosperous New Year!!!

[I would like to thank my youngest son for helping me transcribe quotes from the book]

2013 has started with a bang!

Global markets have greeted the New Year with a bullish rampage to score fantastic gains over the week (see left window).

Following the joint ‘unlimited’ easing by the US Federal Reserve and the European Central Bank (ECB), whom has similarly been supported by the Bank of Japan (BoJ), global equity markets have become turbocharged.

This basically validated my main thesis last September, where I wrote[1],

I believe that the interim response from the FED-ECB policies, designed to prop up financial assets, will likely provide strong support to the global stock markets including the Philippine Phisix perhaps until the yearend, at least.

The mining index, which has underperformed all sectors, will likely expunge its year to date losses at least by the yearend.

The mining index will likely retake command of the leadership in 2013 as it has outperformed biyearly since 2007.

This week’s fiery opening has essentially signified a carryover from last year’s final quarter blitzkrieg (right window), a thrust which may last until the first quarter.

While the gist of my expectations for the local stock market has been mostly fulfilled, the domestic mining index sector failed to come through. Nonetheless, I still hold on to the premise that an inflationary boom will spur a rotation as it has done so for the past 8 years.

This is not based on the blind belief of repetition of patterns, but rather from the economic reasoning based on the relative transmission effects of credit and monetary expansion or the Cantillion Effects[2] as manifested in changes in relative prices.

In other words, all the money being created to “promote demand” will have to flow somewhere. And somewhere means that this will be manifested via relative pricing of equity securities, especially pronounced for an underdeveloped domestic equity market like the Philippines.

Such dynamic has become apparent in global financial markets, the same dynamic has also become evident within the Philippine Stock Exchange.

The Monkey Business Illusion and Mainstream Wisdom

Before I proceed I urge you to take this test on attention or cognitive science called the Monkey Business Illusion:

http://www.youtube.com/watch?v=IGQmdoK_ZfY

The test originally called the Invisible Gorilla[3] designed by Professors Christopher Chabris and Daniel Simons shows of people’s selective attention or inattentional blindness[4], where the limitations of people’s ability to focus leads to perceptual blindness.

In the video, people are asked to count on the number of ball passes made by team members wearing white shirts.

The stimuli to focus on the above instruction has led many observers to miss out on the appearance of the gorilla, the reduction of the number of black shirt team members and the change of color of the curtains. Half of the participants have missed the gorilla alone according to Professor Simons. [Have you been you part of those who missed one of the above? I didn’t miss the gorilla, but I overlooked the curtains]

Aside from inattentional blindness, the point is that the framing of the stimuli impels many if not most people to focus on the plausible, or what gives ‘cognitive ease’ or ‘coherent pattern of activated ideas’[5]

What has this got to do with the financial markets?

Many attribute the current financial market boom to economic performance. That’s how the mainstream experts and media frames or narrates it, especially the Philippine variety.

But if all these collective booms indeed reflected on economic performances, then why does it require global policymakers to—not only to massively cut interest rates—but to complement these credit easing measures with central bank’s balance sheet expansions?

More than half of the central banks[6] all over the world cut interest rates in 2012

Add to these the balance sheet expansions of central banks of developed economies[7]. This implies that these economies represent 95% of the $98.4 trillion bond markets from which governments share are about 45%[8]. In short, why does central banks need to support the bond markets if the world economy has been truly resilient?

If for instance, the Philippines has “solid economic growth, relatively stable exchange rate, responsive banking system that is able to withstand external shocks”, according to a Bangko Sentral ng Pilipinas (BSP) official[9], then why resort aggressive rate cutting?

What explains the parallel universe or the blatant disconnect or divergences between surging stock markets and sluggish economic growth[10] for the rest of the world in 2012?

What further explains the seemingly tight correlation[11] between the world’s top performing stock markets of 2012 and the aggressiveness in interest rate cuts by their respective national central banks? Sheer coincidence?

In short, like the invisible gorilla, many people would prefer to rely on the spoon feeding of superficial and loosely correlated ideas (stimulus) or what behavioral psychologists call as “the illusions of understanding” rather than to examine on their veracity or the soundness of their suppositions.

In a world of uncertainty, the illusion of understanding provides comfort for people in search for cognitive ease and coherence.

Dr. Kahneman explains[12]

The illusion that one has understood the past feeds the further illusion that once can predict and control the future. These illusions are comforting. They reduce the anxiety that we would experience if we allowed ourselves to fully acknowledge the uncertainties of existence. We all have a need for the reassuring message that actions have appropriate consequences, and that success will be reward wisdom and courage.

In the same context, people who insist on “contractionary forces” have been misled by the consistency bias or the error of remembering past environment and behavior as supposed to resemble today.

Money does not exist in a vacuum.

While consumer price inflation may not be apparent yet, what has been conspicuous has been a global asset boom. In short, monetary expansion has led to a global asset boom or global asset inflation.

In the recap of wold markets, Doug Noland in his Credit Bubble Bulletin[13] captures it best:

Various recent headlines support my “right tail” analysis:  “Record-setting Year for Corporate Debt;”  “Record Year for Junk Bonds;” “Mortgage Bonds Soar on Fed’s Refinance Push;”  “[Corporate] Sales Approaching $4 Trillion in Stimulus Repast; “A Banner Year For Riskiest Debt;” “Fourth-Quarter M&A Surge Spurs Optimism..;” “Leveraged Loan Volume: $456bn in 2012, Thanks to Torrid Fourth-Quarter Market.”

The fact of the matter is, in restating Newton’s third law of motion, for every episode of inflation, there will be an equal and opposite dimension of deflation. This is known as the business cycle or bubble cycles.

Unfortunately policymakers have been attempting to prevent market from clearing, which is why the intensifying recourse on activist monetary policies.

The Psychological Impact of the Inflationary Boom

It is important to point out that inflationary boom materially affects people’s psychology and their corresponding actions.

From the behavioral finance perspective, people’s seduction to the inflationary boom can be imputed to the some of the following cognitive biases:

Outcome bias. Where people judge past decisions based on the outcome and not based on the quality or soundness of the action which led to such outcome. The Outcome bias, writes Nobel laureate Professor Daniel Kahneman, “leads observers to assess the quality of a decision not by whether the process was sound but by whether its outcome was good or bad”[14].

Halo Effect. The outcome bias prompts people to bear overall impressions or generalized conclusions or the Halo Effect. Professor Kahneman describes such cognitive bias as the “tendency to like (or dislike) everything about a person—including things you have not observed”[15]. Thus, if you like the president’s politics, Prof Kahneman analogizes, then the likehood is that you would also his voice and appearance.

Applied to the recent boom, whether one relates to the economy or politics, the current quasi-euphoric environment has been viewed by the public as having been hunky dory or as having been sanitized of risks and or that every political act by the current administration seems like King Midas.

Regression to the mean. Extraordinary may transform to mediocre performance and vice versa. Because it has been intuitive or innate for people to search for casual explanations, the idea of luck determining outcome has instinctively been rejected.

Again Dr. Kahneman[16] 

When our attention is called to an event, associative memory will look for its cause-more precisely; activation will automatically spread to any cause that is already stored in memory. Casual explanations will be evoked when regression is detected, but they will be wrong because the truth is that regression to the mean has an explanation but does not have a cause.

Feedback. I have always stated that everyone’s a genius in a bullmarket. That’s because intuitive experience mostly based on false causation, tends to get reinforced by the policy induced distorted pricing mechanism.

In George Soros’ reflexivity theory[17], the current stage of the boom bust cycle encapsulates the transition of the boom phase, specifically from the growing conviction resulting in the widening divergence between reality and expectations, and the flawed perception which eventually leads to the climax—all reinforced by the manipulated price mechanism. 

Substitution. Pressed for the rigors of theory or empirics to prove one’s ingrained belief, the public impulse has been to resort to “generating intuitive opinion on complex matters”. In short, people substitute hard questions with related but easier to answer question based on heuristics. This is how non-sequitor arguments are triggered and employed.

Again Dr. Kahneman explains[18],

When called upon to judge probability, people judge something else and believed that they have judged probability

Affect Heuristics. The feedback mechanism between prices and intuitive experience leads to the strengthening of convictions.

For instance in the deepening of a bullmarket, contrarian opinion will increasingly be rejected and treated as heresy. People will increasingly rely on group behavior for confirmation of their beliefs

Affect heuristic essentially deals with the emotional attitude of people when their beliefs are confronted with the tradeoff between cost and benefits.

Again Dr. Kahneman[19],

If you dislike any of these things, you probably believe that the risks are high and its benefits negligible.

As markets segue into periods of excessiveness, people’s biases will increasingly be driven by their risk taking appetite. Pollyannas will markedly overestimate on the benefits of stock market investing while distinctly underestimate the risks.

The bottom line is that the inflationary boom compounds on the many psychological errors of the public that aggravates volatility, escalates risk taking activities, i.e. what the public reads as “greed”, and sadly, eventual losses (bust).

But for the meantime, the public’s desire to placate the brain’s dopamine “pleasure chemical” neurotransmitter[20] via an orgy of speculations has made the inflationary policies quite popular.

To quote the great Austrian economist Ludwig von Mises[21], (bold mine)

The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy [p. 577] against the evils which inflation and credit expansion have brought about

Key Factors for 2013 

Pattern seekers should be concerned that the Phisix bullmarket may have reached a potential stage of maturity—the aging of the bubble.

The previous secular bullmarket cycle evolved around 11-12 years. Today’s bullmarket is about 10 years old. If the past will make a replay, then the Phisix must be or will likely enter a blow-off phase soon.

From the regression to mean, we are hardly seeing the same phenomenon as the 1986-1996 cycle.

Average returns from 1985 to 2012 or over 27 years is about 26% based on the annual nominal local currency. The first cycle (1985-1996) generated 50% nominal returns yearly. This cycle (2003-2012) has yielded only 23.61%, still distant from the 27 year average or from the post martial law first cycle.

This is NOT to suggest that the Phisix will need to repeat the returns of the first cycle boom, whose environment has been immensely distinct from today’s cycle. The Philippines then emerged from economic stagnation, high inflation, a debt moratorium[22] and from the clutches of the two decades of dictatorship.

But if the 27-year average should come into play, then this means that the Phisix will need to deliver far greater returns than 2012, particularly 47.45% for 2013, just to reach the mean. This assumes that the Phisix boom ends next year, which I doubt.

But I am not dependent on patterns, nor do I rely on numerical averages. In addition, this bullmarket cycle will be determined not by media and mainstream pontificating on political self-righteousness, but from the feedback loop of policymaking and the market’s response on them.

As I have written in my New Year’s edition on 2011 and 2012[23], the same dynamics that shaped the markets then will remain in play for this year:

1. Monetary authorities of developed economies will fight to sustain low interest rates.

2. More Inflationism: Bailouts and QEs To Continue

3. Effects of Divergent Monetary Policies

4. The Globalization Factor

I may add a fifth variable: other forms of financial repression via regulatory controls: capital controls, price controls, border controls, and bank-capital regulations.

Let me repeat: the direction of the Phisix and the Peso will ultimately be determined by the direction of domestic interest rates which will likewise reflect on global trends.

Global central banks have been tweaking the interest rate channel in order to subsidize the unsustainable record levels of government debts, recapitalize and bridge-finance the embattled and highly fragile banking industry, and subordinately, to rekindle a credit fueled boom.

Yet interest rates will ultimately be determined by market forces influenced from one or a combination of the following factors as I wrote one year back[24]: the balance of demand and supply of credit, inflation expectations, perceptions of credit quality and of the scarcity or availability of capital.

For the moment, most of the monetary expansion has been absorbed by financial markets which will likely remain so until at least the first quarter of 2013.

While most central banks, including the BSP, foresees prolonged era of low interest rates, such prospects are mere guesswork.

Authorities understand that there has barely been any penalty for miscalculations, for policy mistakes and or for portraying an environment favorable to the incumbent political masters.

Moreover, crises have provided ripe opportunities for governments to exercise more control over society: the former Obama’s Chief of Staff Rahm Emmanuel (today’s Mayor of Chicago) famous quote resonates “This crisis provides the opportunity for us to do things that you could not do before."[25]

In short, authorities have been motivated or incented to produce social policies that have popular short-term effects at the expense of the future, because such policies provide intertemporal benefits to the political class: A boom projects an aura of political success that generates votes, while a crisis provides an opportunity for expanding social controls using social justice as pretext. Said differently, for many a boom makes one feel good for the taxes one pays, a bust will mean more taxes, whether you like it or not.

The knee jerk nostrums of implementing the Babel of regulations and controls has only fostered more unintended consequences and has provided benefits to those with political connections.

Two examples, one Basel Accord and the US Dodd Frank

From the Bloomberg[26],

The first Basel agreement on global banking regulation, adopted in 1988, was 30 pages long and relied on simple arithmetic. The latest update, known as Basel III, runs to 509 pages and includes 78 calculus equations…

The Securities Industry and Financial Markets Association, another lobbying group, estimates that regulators will end up writing 29,000 pages of directives once Dodd-Frank is completely in place.

Complexity of rules translates to more lobbying, more revolving door relationships, more corruption, regulatory arbitrage and other unethical relationships (sex power and moolah), which works in favor of those firms who can afford such political horse trading, while at the same time works at the expense of small companies who can’t play the insider’s game.

The recent controversial US Fiscal cliff deal is an example of a supposed crisis in the making that ended up with economic concessions for the politically connected[27] and essentially pushed back any reforms on government spending. This means more political struggles ahead (as the debt ceiling debate nears) and equally more interventions by the US Federal Reserve as insurance against default.

This validates my recent view of the US fiscal cliff[28],

Nonetheless any deal reached by the two houses of Congress will likely be cosmetically in favor of increasing taxes, as against farcical spending cuts where the latter will likely be premised on growth rates rather than real cuts.

Three, watch the actions of FED which will increasingly become President Obama’s major instrument for obtaining statistical economic growth, as well as, the actions of the Fed’s major collaborator, the ECB. Both of whom will likely aggressively employ balance sheet expansions that may get reflected on gold and other commodity prices.

This, despite the blarney as revealed by the FOMC minutes of the supposed dissension by growing number of FED board members of the bond buybacks for 2013. This, for me, serves as another Poker bluff[29] by the Fed.

And since there will hardly be any genuine reforms to encourage the growth of the business environment, which serves as the real source of real wealth, global and local political authorities increasingly have been resorting to central banking activism to conceal on their policy shortcomings. 

For instance despite the seeming newfound tranquillity in the Euro area and in Japan, all these have represented mirages as consequence of government and central banking prestidigitation. Example, Spain’s stealth use of her Social Security Reserve Fund[30] as buyer of Spanish government bonds may have helped in bringing down sovereign yield.

Dr. Ed Yardeni rightly notes of the magic wand from ECB’s Mario Draghi in the collapsing yield[31]:

These extraordinary declines weren't triggered by any improvement in the sorry state of state finances in the euro zone. Rather, they started when ECB President Mario Draghi declared in late July of last year that he would do “whatever it takes” to defend the euro, including buying the sovereign notes of euro zone governments. So far, the ECB hasn’t had to do much to back up Draghi’s declaration. His willingness to implement unlimited “outright monetary transactions” (OMT) has worked wonders.

Draghi’s fairy dust also stopped the massive capital outflows out of Spain and Italy into Germany, as evidenced by the flattening of TARGET2 balances since last summer. Among the best-performing stock markets last year were the ones in the euro zone: Greece (33.4%), Germany (29.2), Ireland (17.1), and France (15.2).

Eventually, the current boom will get out of hand, which will be manifested through rising interest rates, which the mainstream vernacular will call “economic overheating” or may be upset by micro political-economic factors, such as the resurfacing of the solvency or credit quality issues of crisis stricken nations as the above.

Governments then will reattempt to force down rates, using downside volatility to justify such actions.

Yet such inflationism will likely spillover serially to price inflation, where the feedback loop of fighting inflation with more inflation leads to greater price inflation, or eventually market turbulence based on stagflation.

Here, the more governments rely on central banks to financial their requirements via debt monetization, the greater the risks of price inflation[32].

Expect Greater Volatility in 2013

For 2013, I expect the current global financial market boom to persist until at least the first quarter. The same dynamic should apply for the Philippine Phisix and the Peso.

Everything else after will depend on the direction of interest rates which will signify as manifestations of the market’s response to social policies and vice versa.

In short, expect markets to be fluid and highly, if not wildly, volatile. So far volatility has been on the upside.

For the Phsix, if domestic interest rates continue to remain low, perhaps we may see a blowoff phase (Phisix 8,000-8,500???) by the yearend.

Such boom may be compounded by the acceleration of capital flight into ASEAN from developed economies whose central banks have been massively expanding their balance sheets such as Japan whose outflows to Emerging Markets have been ballooning[33].

In addition, the regional and local stock market boom may likely be accompanied by the intensification of the credit financed bubble in the property sector in the real economy mostly bankrolled by the banking system.

On the other hand, if interest rates begin to marginally rise, then the Phisix may underperform or fall below consensus expectations via meagre (single digit) or even negative returns.

Nonetheless, for as long as the inflationary boom remains, I also expect a rotation towards last year’s laggards: the mining sector and possibly the service industry.

Finally it would be naïve to see lagging gold prices as underperforming. This would tantamount to the ticker tape mentality.

Despite falling short of my expectations, gold prices which I suspect has recently been subjected to politically orchestrated attacks have risen for the 12^th straight year in 2012[34] in US dollar.

Although, so far, with the exception of gold, no trend has moved in a straight line, so it would be natural for gold to undergo a year of negative returns.

Nonetheless all these will also depend on the actions of monetary authorities.

In the fullness of time, markets eventually exposes on the façade erected by politically instituted controls.

I will close this week’s outlook with another noteworthy quote from the great Professor von Mises[35],

The masses, the hosts of common men, do not conceive any ideas, sound or unsound. They only choose between the ideologies developed by the intellectual leaders of mankind. But their choice is final and determines the course of events. If they prefer bad doctrines, nothing can prevent disaster.

For as long as the public continues to genuflect on the altar of politics, crises are inevitable.

---

[1] see FED-ECB’s Nuclear Policies: Risk ON is Back! September 17, 2012

[2] See Phisix and the Rotational Dynamics, January 30, 2012

[3] Christopher Chabris and Daniel Simons Invisible Gorilla Invisiblegorilla.com

[4] Wikipedia.org Inattentional blindness

[5] Daniel Kahneman, Thinking, Fast and Slow Farrar Straus and Giroux p. 104

[6] Central Bank News Global Monetary Policy Rate Index Interest Rates

[7] Zero Hedge How Central Bank Policy Impacts Asset Prices Part 5: How Far Can They Go? October 29, 2012

[8] See Japan PM Abe’s Economic Elixir: Inflationism December 18, 2012

[9] Malaya Business Insight BSP to keep rates low January 4, 2013

[10] See Quote of the Day: Central Banking Heroics Produced a Parallel Universe in 2012 January 5, 2012

[11] See Charts: Stock Market Boom Bust Cycles and Interest Rates December 26, 2012

[12] Kahneman, Op. cit., p.204-205

[13] Doug Noland 2012 In Review December 28, 2012 Credit Bubble Bulletin PrudentBear.com

[14] Kahneman, Op. cit., p.203

[15] Ibid. p.82

[16] Ibid. p.182

[17] George Soros, Reflexivity in the Stock Market, The Alchemy of Finance p.58 John Wiley & Sons

[18] Kahneman, Op. cit., p.98

[19] Ibid. p.103

[20] University of Michigan Health System Pleasure And Pain: Study Shows Brain's 'Pleasure Chemical' Is Involved In Response To Pain Too biopsychiatry.com

[21] Ludwig von Mises, The Market Economy as Affected by the Recurrence of the Trade Cycle, Chapter 20 Section 9, Human Action, Mises.org

[22] Country-data.com Philippines External debt

[23] See What To Expect in 2012, January 9, 2012

[24] See I Told You Moment: Philippine Phisix At Historic Highs! January 15, 2012

[25] Wall Street Journal In Crisis, Opportunity for Obama November 21, 2008

[26] Bloomberg.com Basel Becomes Babel as Conflicting Rules Undermine Safety January 9, 2013

[27] See The Fiscal Cliff Deal and Crony Capitalism January 3, 2013

[28] See The Fiscal Cliff Deal and Crony Capitalism January 3, 2013

[29] See Poker Bluffing FOMC: Probable Stop in Bond Buying January 4, 2013

[30] Wall Street Journal Spain Drains Fund Backing Pensions, January 13, 2013

[31] Ed Yardeni Europe, January 3, 2013

[32] See Phisix’s Inflationary Boom: Normal Profit Taking From Record Highs, December 16, 2012

[33] See More Signs of Japan’s Capital Flight January 5, 2013

[34] James Turk Gold rises for the 12th consecutive year January 2, 2013 Goldmoney.com

[35] Ludwig von Mises 3. The Illusion of the Old Liberals XXXVII. THE NONDESCRIPT CHARACTER OF ECONOMICS, Human Action, Mises.org

Quote of the Day: The Illusions of Pundits

People who spend their time, earn their living, studying a particular topic produce poorer predictions than dart-throwing monkeys who would have distributed their choices evenly over the options. Even in the region they knew best, experts were not significantly better than non-specialists.

Those who know more forecast very slightly better than those who know less. But those with the most knowledge are often less reliable. The reason is that the person who acquires more knowledge develops an enhanced illusion of her skill and becomes unrealistically overconfident. “We reach the point of diminishing marginal predictive returns for knowledge disconcertingly quick,” Tetlock writes. (Philip E. Tetlock, University of Pennsylvania in 2005 book Expert Political Judgment: How Good is It? How Can We Know?—Prudent Investor) “In this age of academic hyperspecialization, there is no reason for supposing that contributors to top journals—distinguished political scientists, area study specialists, economists, and so on—are better than journalists or attentive readers of the The New York Times in ‘reading’ emerging situations”. The more famous of the forecaster, Tetlock discovered, the more flamboyant the forecasts. “Experts in demand,” he writes, “were more confident than their colleagues who eked out existences far from the limelight.”

The above quote is from 2002 Nobel laureate psychologist and professor Daniel Kahneman in his insightful book Thinking, Fast and Slow p.219

There are many reasons not to trust pundits, aside from overconfidence, which essentially oversimplifies human action.

I believe that the substantial chunk of “expert errors” emerge from the influences of conflict-of-interest relations, particularly the principal-agent problem, where “experts” tend to promote the interests of employers, sponsors, donors, grant providers and or even political agents (perhaps through implicit ambition to be part of the political institution) whom are sources of the self-interests of such pundits.

Forecasting inaccuracies may also be linked to the rigid application of ideology and or on the overreliance on math models (scientism).

Add to this the desperate desire by “experts” to attain social acceptance via social signaling.  Such would include making extreme (media attracting) projections or providing the veneer of expertise on what truly is about populism—forecasting based on what is popular, or as I previously wrote 

For many, thus, expertise signify more as social signaling (posturing or seeking social acceptance) and or “telling people what they want to hear” but predicated on certain technically based paradigms which produces an aura of supposed superiority rather than representative of the true domain knowledge.

Dr. Kahneman suggests that to determine “true expertise” from merely displays of the “illusions of validity”, one should identify conditions where pundits have excelled in “an environment that is sufficiently regular to be predictable” and from their having “to learn these regularities through prolonged practice” (p 240). In short, in an unpredictable world, expert opinion should be less trusted.

However by simply associating expertise with “regularity” and “prolonged practice” seems to contradict logically his earlier critique of pattern seeking behavior (which is about the human psychological propensity to seek regularity or constancy through patterns while at the same time underestimating the role of randomness). The nuance will be on the marginal efforts applied by practitioners via  “prolonged practice” in dealing with such regularities. 

The point is despite being able to minimize the influences of “expert or non-expert” intuition on decision making that may result to lesser degree of judgmental errors, behavioral economics/finance will not lead to omniscience or come close to solving the knowledge problem: a complex society will always be subject to irregularities and unpredictability from the dynamic and intricate feedback mechanism of human action and of environmental changes. Dr. Kahneman acknowledges this: "Errors of prediction are inevitable, because the world is unpredictable" (p. 220)

Nevertheless the best way to acquire “expertise” is primarily through investing in oneself

Quote of the Day: The Illusion of Stock-Picking Skill

Professional investors, including fund managers, fail a basic test of skill: persistent achievement. The diagnostic for the existence of any skills is the consistency of individual differences in achievement. The logic is simple: if any individual differences in any one year are entirely due to luck, the ranking of investors and funds will vary erratically and the year-to-year correlation will be zero. Where there is skill, however, the rankings will be more stable…

There is general agreement among researchers that nearly all stock pickers, whether they know it or not—and a few of them do—are playing a game of chance. The subjective experience of traders is that they are making sensible educated guesses in a situation of great uncertainty. In highly efficient markets, however, educated guesses are no more accurate than blind guesses.

This excerpt is from 2002 Nobel laureate psychologist and professor Daniel Kahneman in his insightful book Thinking, Fast and Slow p.214

Well Mr. Kahneman’s thesis seems to have been recently validated as passive long term investment funds (via equity bond index) has trumped active fund management represented by hedge funds 

The Economist notes,

The S&P 500 has now outperformed its hedge-fund rival for ten straight years, with the exception of 2008 when both fell sharply. A simple-minded investment portfolio—60% of it in shares and the rest in sovereign bonds—has delivered returns of more than 90% over the past decade, compared with a meagre 17% after fees for hedge funds...

The widening disparity means that randomness or providence or lady luck has increasingly played a bigger role in determining the performances of the fast expanding hedge fund industry. 

The same Economist article subliminally acknowledges this,

The average hedge fund is a lousy bet, and predicting which will thrive and which will disappoint is a task that would tax even a Nobel prizewinner.

Yet in the finance industry where many of the participants believe that they possess presumptuous knowledge which in reality exhibits inflated egos, the role played by luck/randomness exists in a vacuum. 

Why? As Mr. Kahneman from the same book p 216 explains,

The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions—and thereby threaten livelihoods and self esteem—are simply not absorbed. The mind does not digest them. This is particularly true of statistical studies  of performance, which provide base-rate information that people generally ignore when it clashes with their personal impressions from experience.

Video: Celebrity Prank

From WorldTalkLIVE, (hat tip Zero Hedge)

On the night of July 27th, 2012, a huge prank was pulled in New York City and this is the video of what took place. Brett Cohen came up with a crazy idea to fool thousands of pedestrians walking the streets of Times Square into thinking he was a huge celebrity, and it worked! Not only did it work, it caused quite a stir. This social experiment, of sorts, makes a profound statement about how modern culture is so attracted to pop culture, without any real credibility needed.

He dressed up like a typical celebrity and was accompanied by an entourage of two professional bodyguards, two assistants, and photographers pretending to be paparazzi. While the assistants and photographers waited for Brett to exit the 49th street marquee at NBC Studios, they started a buzz that a "big star" was about to walk out, thus making it worth their while to wait and get a picture. Many asked the crew whom Brett was, and no answer was given. They were forced to either make something up, or just take a picture with him in hopes that their Facebook friends or Twitter followers might have a better idea.

As the crew walked over to Times Square, the crowds around Brett grew on each consecutive block. Very few people even questioned who he was, where he was from, or what he does. Brett took pictures with nearly 300 people before the stunt ended. The video even includes interviews with people who had just taken a picture with Brett, and puts them in an awkward position when they're asked questions such as, "Where do you know Brett from?" and "What's your favorite movie he was in?" Many of them were overwhelmingly excited over Brett's walk through Times Square, and it showed.

While the video may have been intended to amuse audiences, there is a subtle message from it: They reveal of the cognitive biases from which the most people fall for, in particular the framing effect (people tend to reach conclusions based on the 'framework within which a situation was presented), the survivorship bias (tendency for people to look at the visible, particularly the winners or the survivors) and rationalization (making excuses).

Beware of the popular, because they are most likely illusions.

Philippine Mining Index: Will The Divergences Last?

In my view, a very significant divergence unfolding within the Philippine Stock Exchange over the past few weeks could highlight a pivotal development.

A Southbound Philippine Mining Index

While the local benchmark, the Phisix continues to drift at the near record highs, the biennial market leader, the mining sector, appears to have substantially weakened.

I say biennial because as I have pointed out in the past, the mining index outperformance-underperformance has been rotating every other year[1].

Year-to-date, the mining sector has plummeted by about 10%.

Yet more than half or 5.8% of such losses accrued only from this week. This makes the mining sector a dismal laggard relative to the others.

The mining sector has fundamentally spearheaded the “rising tide” or the broad based rally of the Philippine Stock Exchange since 2002. This can be seen via nominal returns. Measured by the sector’s index trough in 2002 as against recent peaks, the mining sector produced an astounding 26x as against 4x for the Phisix.

Nevertheless, the ebbs and flows or the undulations of the Phisix (green line chart) have been for most of the time, highly correlated with the mining sector (black candle) throughout this duration.

In other words, even during years where the mining sector trailed the others, the former flowed along with the rest to reflect on the same (positive or negative) directions of returns. The nuances have only been in the degree.

The correlation has not been perfect though, as there had been accounts of divergences.

This can be seen in the colored ovals in the above charts. In 2010, the Phisix outperformed (orange) as the mining index hibernated. In 2011, the mining index sprinted miles ahead (red) as the Phisix wavered. However eventually, these anomalies got smoothed out and both moved towards the same path.

In short, the rotating market leadership meant that as one index stagnated, the other index advanced.

The Mining Sector’s Divergence From the Phisix

Today there appears to be a different type of divergence; the Phisix and the Mining sector has moved in opposite directions.

Technically speaking, the mining index has already infiltrated into the bear market territory (20% loss). Based on Friday’s close and from the recent top this May, this translates to about 22% decline. Thus the year-to-date figure understates the true extent of the losses. As always, the point of reference matters.

Yet the last time the mining index fell into a bear market, which came in conjunction with a bear raid on the Phisix and on global equity markets as the public’s heavy expectations for QE 3.0 had been frustrated by the politically shackled US Federal Reserve chair Ben Bernanke[2], the mining index lost 33% peak-to-trough before recovering.

I do not expect a repeat of the same pattern as the major influence will emanate from external forces.

Besides, the technical picture likewise exhibits a bearish ‘double top’ which may only exacerbate the current negative sentiment.

There has been imputation that the recent declines have been due to issue specific related incidents. For instance, some people have speculated that political authorities may initiate investigations on an innuendo of alleged malfeasances committed by a firm as exposed by a blind item article in a popular broadsheet. This, they think, has been an important factor in the recent price declines.

It is interesting to see that many people fall prey to such scuttlebutts.

Yet it is dangerous to believe that all hearsays require government intervention. If this becomes reality then serial witch-hunting would only mean severely politicized and convoluted markets and a bloated government which only would extrapolate to chronic economic and political imbalances. Think Greece.

People seem to forget that many accounts of the financial market improprieties have operated in the shadows of the underhand of politics.

The infamous Dante Tan led BW Scandal sets a shining example of the political complicity and the failure of insider trading regulations[3]. The accused Mr. Tan has been absolved of two criminal cases for violation of The Revised Securities Act by the Supreme Court in August of 2010[4]. How about the US property-mortgage bubble crash of 2008[5]?

Worst, people seem to have developed impression of entitlements, such that the only politically correct direction for the stock market has been UP. Thus, falling markets become objects for political interventions. The unfortunate Calata episode serves an example[6].

And this is why central banking inflationist interventions have become so popular, it gives a boost to the gambling appetite and to the serotonin, all at the expense of personal accountability and responsibility.

I don’t have a clue to the truth or validity of such allegations. But as Black Swan author Nassim Taleb points out from his upcoming book[7] we easily get hooked to sensationalism.

There was even more noise coming from the media and its glorification of the anecdote. Thanks to it, we are living more and more in virtual reality, separated from the real world, a little bit more every day, while realizing it less and less. Consider that every day, 6,200 persons die in the United States, many of preventable causes. But the media only reports the most anecdotal and sensational cases (hurricanes, freak incidents, small plane crashes) giving us a more and more distorted map of real risks. In an ancestral environment, the anecdote, the “interesting” is information; no longer today. Likewise, by presenting us with explanations and theories the media induces an illusion of understanding the world.

Yet from the big picture perspective, the appeal to innuendos represents the cognitive fallacy of availability heuristic[8] or judgment based on information that can easily be remembered. This may even the account as the logical Post Hoc “after this therefore because of this” fallacy which mistakes coincidences as causes[9].

How do I say so? Because of the synchronized actions of the mining issues.

From the one year chart, we can note that the Phisix and the mining index suffered from the recent post-Operation Twist and Euro crisis selloff this May.

However in contrast to the broader markets, which piggybacked on the swift resumption of the RISK ON environment primed by serial promises by major central banks of interventions, the rally in the domestic mining index have faltered.

What is in front of us or have been self-evident we have frequently overlooked in favor of those narrated, the tangible or the personal.

Again some behavioral lessons from Nassim Taleb[10]

people tend to concoct explanations for them after the fact, which makes them appear more predictable, and less random, than they are. Our minds are designed to retain, for efficient storage, past information that fits into a compressed narrative. This distortion, called the hindsight bias, prevents us from adequately learning from the past.

Yes coincidentally, a day AFTER Philippine president Benigno Aquino III affixed his signature on the much ballyhooed Mining-Tourism compromise via Executive Order 79[11], stock prices of MOST of the mining issues began to deteriorate.

Except for Semirara Corporation [PSE:SCC, black candle] prices of the mining heavyweights—Philex Mining [PSE: PX, blue], Lepanto Consolidated [PSE:LC, light green], Atlas Mining [PSE:AT, orange] and Manila Mining [PSE: MA violet]—have all been suffering from synchronized decline.

Such seemingly coordinated downturn have been no different from the second tier issues, whose string of losses has exceeded the majors: Nihao Minerals [PSE: NI black candle] Nickel Asia [PSE: NIKL, green] Geograce Resources [PSE:GEO, blue] and Oriental Peninsula [PSE:ORE, red].

Oil issues, whether as component of the mining index or not, have not been spared: Oriental Petroleum [PSE:OPM, black candle] and PetroEnergy [PSE:PERC, red] seem to have stagnated while The Philodrill Corporation [PSE:OV, green], and Philex Petroleum [PSE: PXP, blue] have exhibited signs of contagion based selling pressures.

Yet current infirmities in the domestic mining-oil sector may represent a belated response to the falling prices of products which underpins the operations of these companies: Gold, copper and industrial metals (GYX) have been on a slump for at least a last year. Oil (WTIC) on the other hand, still trades below the May 2011 high.

The state of the commodities has apparently been replicated on the benchmarks of global mining issues. These can be seen in the performance of US mining stocks [XME—SPDR S&P Metals & Mining Index], global mining stocks [CMW.TO—iShares S&P/TSX Global Mining Index Fund], emerging market mining stocks [EMT—emerging global shares dow jones emerging markets metals/mining titans], and US oil stocks [$DJUSEN Dow Jones US Oil & Gas Index]

In short, falling commodity prices may have been interpreted as crimping on the operating leverage[12] of these resource companies, thereby reducing profitability[13] whose consequence has been the year-long torpor of global mining equities.

Ironically, however, global mining and oil issues seem to have staged a rally despite the languid state of commodity prices.

This perhaps could have been prompted by snowballing anticipations of the possible “grand bazooka” to be launched by the European Central Bank and or the US Federal Reserve.

Implications of Divergences and of Philippine Mining Political Trends

There are several insights from the above: In defying global market trends, domestic mining and oil equities may have overextended gains. Perhaps current the correction phase exhibits the market process of regression to the mean or similarly defined in psychological terms[14] or in finance[15] as the tendency of the markets to average out.

Yet one cannot discount that such valuations overreach may also represent symptoms of excessive speculations or the unwinding of mini-bubbles.

Add to these the elements of political and regulatory uncertainty introduced by the new executive order by the President and on the suggestion by the IMF for the Philippine government to hike taxes on the mining industry[16].

Reports say that a tax increase in the mining industry for President Aquino may momentarily not be a priority “for the next year or two”. But prospects of it may have also compounded on the current uncertainties considering the proposed doubling of excise taxes from “the current 2% to a range of 5-7%”, as well as “a 5% royalty in future mining contracts and areas to be declared as mineral reservations”[17].

Of course given that the mining sector has been one of the industries that have the biggest potential to boost President Aquino’s obsession with approval ratings through statistical economic growth, I believe the political burdens of the mining industry will likely be mitigated.

The compromise between mining and tourism industry via EO 79 and tax deferment seems like evidences of these. I might add that the same instances also serve as wonderful proof public choice theory at work, where vested political interest groups have a significant sway or influence or logrolling on policymaking[18]. Yes tourism industry has their share of political concentrated group interest too.

While the Executive Order has been meant to placate on these squabbling groups, the major beneficiary here is the Philippine government whose attendant edict extrapolates to more control and discretion of choosing winners and losers and bigger budgets for the bureaucracy for the supervision and enforcement of such fiat, all at the expense of society through prospective higher taxes and politicized distribution of economic opportunity.

Of course another major beneficiary will be the cronies who will get the gist of the license to explore and operate mines.

This means that the increased politicization of the mining industry will favor the entrenched groups at the expense of small scale miners and other professional miners.

Yes despite the massive scale of regulations by the Philippine government, the informal gold mining sector has fundamentally become the dominant contributor to the nation’s gold production output.

Such statutory compromise will hardly bring such informal sector to the surface for the reasons stated above.

And yet part of the growth of the informal sector, ironically, has been facilitated by the Bangko Sentral ng Pilipinas (BSP), through their gold buying program.

As the World Gold Council notes[19]

Looking at informal production, it is understood that the bulk of this is sold at buying stations maintained by the central bank. This is due to the fact that gold is normally bought on a noquestions-asked basis, and on very attractive terms. Nevertheless, there remains a small portion of informal production, mainly from the province of Mindanao, that is not sold to the central bank.

It is important to impress to readers that mining per se has not been responsible for environmental degradation. If such allegations were true then Chile, the US, Australia, Canada would have been transformed into howling wilderness.

In reality, environmental preservation and optimizing revenues from the mining industry are strongly associated with the resource curse dilemma[20], that which is the politicization of the resource industry.

As the World Bank a 2002 study notes[21],

Fighting corruption, self-interested rent-seeking, and a general deterioration in the quality of governance in the face of large revenue streams is no doubt a challenge for countries with otherwise short histories of sound and competent institutions. There is no easy panacea to managing this challenge. At the same time, there is simply no other way to manage a mining sector successfully, and indeed a successful economy in general, than to engage in the challenging task of building effective political and economic institutions and finding competent individuals to run them. This is the essence of the development process.

Informal economy, corruption, rent seeking and a general deterioration in the quality of governance are symptoms or are products of asphyxiating regulations, bureaucracy, high burdens from taxes and the cost of compliance[22], insecure property rights and involuntary exchanges or the intense politicization of the industry.

Nevertheless also do expect more massive illegal and wildcat mining in the 78 areas that has been prohibited from mining which should lead to environmental degradation. The people who will undertake the fly by night mining operations will likely be wards of politicians.

In the realm of politics, natural laws of economics simply vanish or will submit to the will of politicians.

Short Term Bearish, Long Term Bullish

Have recent events signaled the end for the bullmarket in Philippine mining? I guess not. This looks more cyclical than structural as explained above. The momentum suggests that the ongoing retrenchment phase could or may likely continue.

Although I also think, over the interim, the mining industry’s divergence signals two major routes:

One, the leveling out of the divergences through

A. A sustained rally in the global equity markets or a prolonged RISK ON environment that will eventually percolate to prices of general commodities and thus would likely truncate the current correction phase of the local mines or

B. The Mining sector’s bear market could spillover to the general market.

Second, that the divergence becomes a lasting feature. This eventually paves way for stagflation. In such scenario, I expect the mines to go opposite ways with the general stock market. But this will likely become a global phenomenon too. So actions in the local markets should be in sync with the world. So far there has been little evidence on this.

I lean on condition (B) or where the bear market of the mining sector will likely percolate into the general market, due to growing risks of contagion.

However everything really depends on how and what future policies will be conducted, especially in the US, as previously discussed.

So far, gains from the global equity markets have emerged from intensifying hopes and prayers of rescue (if not narcotics) from central banks. The Bank of America estimates that the markets has already priced or factored in a humungous 80% of QE 3.0[23] which implies of the enormous pressure on policymakers to deliver. And market now becomes highly sensitive or susceptible to changes in expectations which may be swift and dramatic.

Central banking stimulus continues to exhibit diminishing returns[24].

This also suggests that in order to have a meaningful effect, central bank steroids would need to have a “shock and awe” in scale or a far larger than the current dosage. Failure to satisfy the markets could switch sentiment to a RISK OFF volatility.

This is why current environment seems so uncertain and so vulnerable to instability.

Yet given that political election season approaches in the US, one cannot discount that markets may be boosted by political authorities for political goals[25].

But at the same time, market risks from a global slowdown contagion have continuously been escalating.

Trade cautiously.

---

[1] see Graphic of the PSE’s Sectoral Performance: Mining Sector and the Rotational Process, July 10, 2011

[2] see Bernanke Jilts Markets on Steroids, Suffers Violent Withdrawal Symptoms September 22, 2011

[3] See Insider Trading: What is Legal isn’t Necessarily Moral, November 17, 2011

[4] Supreme Court of the Philippines SC Clears Dante Tan of BW Charges

[5] See 2008 US Mortgage Crisis: The US Federal Reserve and Crony Capitalism as Principal Causes, May 31, 2011

[6] See Phisix: Managing Through Volatile Times August 6, 2012

[7] Taleb Nassim Nicolas NOISE AND SIGNAL Facebook (May 21)

[8] changingminds.org, Availability Heuristic

[9] nizkor.org Post Hoc Fallacy

[10] Taleb Nassim Nicholas Learning to Expect the Unexpected, New York Times April 8, 2004

[11] ABS-CBN News PNoy's Mining EO No. 79, July 9, 2012

[12] Investopedia.com Operating Leverage

[13] Wikipedia.org Investment vehicles, Gold as an Investment

[14] Alleydog.com Regression Toward the Mean Psychology Glossary

[15] Wikipedia.org Mean reversion (finance)

[16] Abs-cbnnews.com Mining companies in PH not paying enough taxes: IMF August 9, 2012

[17] Abs-cbnnews.com Raising taxes on mining not a priority: Aquino July 18, 2012

[18] See Public Choice in Action: Logrolling in the Philippine Mining-Tourism Policy, June 21, 2012

[19] World Gold Council Central Bank case studies: The Philippines

[20] Wikipedia.org Resource curse

[21] World Bank Treasure or Trouble? MINING IN DEVELOPING COUNTRIES, WORLD BANK AND INTERNATIONAL FINANCE CORPORATION 2002 p.14

[22] See Does The Government Deserve Credit Over Philippine Economic Growth? May 31, 2010

[23] Real Time Economics Blog, BofA Sees 80% Chance of QE3 Priced Into Markets Wall Street Journal, August 10, 2012

[24] Zero Hedge It's A Centrally-Planned World After All, With Ever Diminishing Returns August 11, 2012

[25] See Has Ben Bernanke Been Working to Ensure President Obama Re-election, February 5, 2012