Video: Economics is Fun: Why Economics Isn't (Natural) Science

Dr Madsen Pirie of Adam Smith Institute does a great job in explaining vivaciously why economics isn't (natural) science, which conventional practitioners try to mold them into--through statistical or econometric models.

Here's a good quote [1:07]

When an economist tries to simplify it by leaving out stuff by, so that a small model can be created you have assumed away the real world.

(hat tip Greg Ransom)



Economics is the youngest of all sciences to quote the great Ludwig von Mises.

And it is important to note that the science of economics represents a subdiscipline to the science of human action. Again Professor Mises in his magnum opus Human Action,

The scope of praxeology is the explication of the category of human action. All that is needed for the deduction of all praxeological theorems is knowledge of the essence of human action. It is a knowledge that is our own because we are men; no being of human descent that pathological conditions have not reduced to a merely vegetative existence lacks it. No special experience is needed in order to comprehend these theorems, and no experience, however rich, could disclose them to a being who did not know a priori what human action is. The only way to a cognition of these theorems is logical analysis of our inherent knowledge of the category of action. We must bethink ourselves and reflect upon the structure of human action. Like logic and mathematics, praxeological knowledge is in us; it does not come from without.

All the concepts and theorems of praxeology are implied in the category of human action. The first task is to extract and to deduce them, to expound their implications and to define the universal conditions of acting as such.

And the difference between the science of human action from natural science in the words of Mises (emphasis added)

WHAT differentiates the realm of the natural sciences from that of the sciences of human action is the categorical system resorted to in each in interpreting phenomena and constructing theories. The natural sciences do not know anything about final causes; inquiry and theorizing are entirely guided by the category of causality. The field of the sciences of human action is the orbit of purpose and of conscious aiming at ends; it is teleological.

Both categories were resorted to by primitive man and are resorted to today by everybody in daily thinking and acting. The most simple skills and techniques imply knowledge gathered by rudimentary research into causality. Where people did not know how to seek the relation of cause and effect, they looked for a teleological interpretation.

Shale Oil Revolution: (Laissez Faire) Capitalism Deals Peak Oil a Fatal Blow

I used to believe in peak oil. That all changed when I got immersed in Austrian school of economics. I have come to realize that we are dynamic, and not static, beings whose actions are driven by time and value scale based incentives in response to the changes in the environment and to social developments. In other words, human action is what drives economic values of goods or services.

And given the opportunity or the right environment or a society tolerant for experimentation that rewards success and penalizes failure, people will find ways and means to employ resources in a more efficient manner in order to improve on our current unsatisfactory conditions.

“Peak oil” as a social phenomenon, and not in the engineering sense, is about to be vanquished [unless socialists cloaked as environmentalists succeeds to put a political kibosh on this sunshine industry].

The phenomenal pace of advances in engineering technology has been intensifying the Shale Oil Revolution

From the New York Times Green Blog, (bold emphasis mine) [hat tip Professor Mark Perry]

The revolution in production in Texas and across the country is partly tied to the rising price of oil over much of the last decade, which propelled aggressive technological experimentation and development. (Government encouragement over the last several administrations helped as well.)

Horizontal drilling and hydraulic fracturing have been around for years, but over the last five years, engineers have fine-tuned these and other techniques, even as many environmentalists worry about their impact on water and air.

Computer programs have been developed to simulate wells before they are even drilled. Advanced fiber optics permit senior engineers at company headquarters to keep track of drillers on the well pad, telling them when necessary where to direct the drill bit and what pressure to use in injecting fracking fluids. Seismic work has become far more sophisticated, with drillers dropping microphones down adjacent wells to measure seismic events resulting from a fracking job so they can more accurately determine the porosity and permeability of rocks when they drill nearby in the future.

Just a decade ago, complete wells were fracked at the same time with millions of gallons of water, sand and chemical gels. Now the wells are fracked in stages, with various kinds of plugs and balls used to isolate the bursting of rock one section at a time, allowing for longer-reaching, more productive horizontal wells. A well that once took two days to drill can now be drilled in seven hours.

For instance, when the Apache Corporation began drilling in the 100,000-acre Deadwood field in the West Texas Permian basin in 2010, there had only been a trickle of production there. The deep shale, limestone and other hard rocks had potential, but for years they had not been considered economically viable. The rocks were so hard, they would have likely sheared off the usual diamond cutters on the blade of any drill bit attempting to cut through.

But new adhesives and harder alloys have made diamond cutters and drill bits tougher in recent years. Meanwhile, Apache experimented with powerful underground motors to rotate drilling bits at a faster rate. Now, a well that might have taken 30 days to drill can be drilled in just 10, for a savings of $500,000 a well.

“By saving that money, you can spend more on fracking, which translates into more sand and more stages and better productivity,” said John J. Christmann, the Apache vice president in charge of Permian basin operations.

All these serves as empirical evidence of how the price signaling channel sets in motion entrepreneur’s incentives to fulfill market demands through the employment of savings or capital accumulation in shaping the fantastic advances in technology (in spite of the numerous government interventions) in a market economy.

As the great Professor Ludwig von Mises wrote,

What distinguishes modern industrial conditions in the capitalistic countries from those of the precapitalistic ages as well as from those prevailing today in the so‑called underdeveloped countries is the amount of the supply of capital. No technological improvement can be put to work if the capital required has not previously been accumulated by saving.

Saving—capital accumulation—is the agency that has transformed step by step the awkward search for food on the part of savage cave dwellers into the modern ways of industry. The pacemakers of this evolution were the ideas that created the institutional framework within which capital accumula­tion was rendered safe by the principle of private ownership of the means of production. Every step forward on the way toward prosperity is the effect of saving. The most ingenious technological inventions would be practically useless if the capital goods required for their utilization had not been accumulated by saving.

The entrepreneurs employ the capital goods made available by the savers for the most economical satisfaction of the most urgent among the not-yet-satisfied wants of the consumers. Together with the technologists, intent upon perfecting the methods of processing, they play, next to the savers themselves, an active part in the course of events that is called economic progress. The rest of mankind profit from the activities of these three classes of pioneers. But whatever their own doings may be, they are only beneficiaries of changes to the emergence of which they did not contribute anything.

The characteristic feature of the market economy is the fact that it allots the greater part of the improvements brought about by the endeavors of the three progressive classes—those saving, those investing the capital goods, and those elaborating new methods for the employment of capital goods—to the nonprogressive majority of people. Capital accumulation exceeding the increase in population raises, on the one hand, the marginal productivity of labor and, on the other hand, cheapens the products. The market process provides the common man with the opportunity to enjoy the fruits of other peoples’ achievements. It forces the three progressive classes to serve the nonprogressive majority in the best possible way.

As seen from the shale oil revolution, the illustrious economist Julian Simon has been right anew, human beings have indeed been the ultimate resource.

17 Reasons to be a Rational Optimist

My favorite science and environmental columnist and author of the must read Rational Optimist, the eminent Matthew Ridley propounds 17 reasons why we should be cheerful:

1. We're better off now

2. Urban living is a good thing

3. Poverty is nose-diving

4. The important stuff costs less

5. The environment is better than you think

6. Shopping fuels innovation

7. Global trade enriches our lives

8. More farm production = more wilderness

9. The good old days weren't

10. Population growth is not a threat

11. Oil is not running out

12. We are the luckiest generation

13. Storms are not getting worse

14. Great ideas keep coming

15. We can solve all our problems

16. This depression is not depressing

17. Optimists are right

Read Mr. Ridley’s explanations here.

All the above redounds to a single most important theme: the human being.

Rational optimism is a bet on human capital, or in the context of the Austrian economic school, praxeology or the science of human action—purposeful behavior towards the fulfillment of an end which aims to substitute present unsatisfactory conditions.

Human actions in pursuit of constant improvements is likely to bring about positive changes, despite attendant challenges (especially from politicians, the regulators and cronies).

People are the ultimate resource, as the great author and Professor Julian Simon once wrote,

Only one important resource has shown a trend of increasing scarcity rather than increasing abundance. It is the most important and valuable resource of all—human beings

iPhone Shows How Trade Statistics are Flawed

I earlier pointed out that statistics hardly captures the realities of the swiftly shifting trade dynamics brought about by globalization as exemplified by the iPhone.

Here’s an update. From the Wall Street Journal Blog

The iPhone provides a good example of the problems with the way trade is currently calculated. The Apple device features hardware from all over the world, but because it’s manufactured in China that country gets credit for the entire wholesale export cost. According to research from Kenneth L. Kraemer of the University of California, Irvine, Greg Linden of University of California, Berkeley, and Jason Dedrick of Syracuse University, each iPhone sold in the U.S. adds $229 to the U.S.-China deficit. Based on 2011 cellphone activations from AT&T, Verizon and Sprint, Apple sold around 30 million iPhones in the U.S. last year — accounting for about $6.83 billion of the U.S.’s $282 billion 2011 trade deficit with China.

But the researchers note that such estimates overstate China’s contribution. Though the iPhone is assembled in China, most of its component parts come from elsewhere. Separate research by Yuqing Xing and Neal Detert for the Asian Development Bank Institute noted that for the iPhone 3G just about 3.6% of the wholesale price came from China, the rest could be attributed to inputs from companies in Japan, Germany, Korea and even the U.S. (Read more about that study here.)

The iPhone is just one example. This same phenomenon is happening all over the world in products ranging from cars to children’s toys. In an attempt to better gauge which countries are benefiting or losing the most through trade, the Organization for Economic Co-operation and Development and the World Trade Organization announced that they will be working on a project that identifies where value-added flows are coming from.

More confirmatory evidence where human action cannot be quantified.

This only validates Professor Ludwig von Mises who wrote

The impracticability of measurement is not due to the lack of technical methods for the establishment of measure. It is due to the absence of constant relations. If it were only caused by technical insufficiency, at least an approximate estimation would be possible in some cases. But the main fact is that there are no constant relations. Economics is not, as ignorant positivists repeat again and again, backward because it is not "quantitative." It is not quantitative and does not measure because there are no constants. Statistical figures referring to economic events are historical data. They tell us what happened in a nonrepeatable historical case. Physical events can be interpreted on the ground of our knowledge concerning constant relations established by experiments. Historical events are not open to such an interpretation.

To add, the deepening of the information age will further complicate trade dynamics as commerce will become increasingly more about niches and specialization or decentralization.

Lastly, the other implication is that using flawed trade statistics to argue for political actions (such as protectionism) is like shooting oneself in the foot.

Are High IQs Key to Successful Investing?

Yale Professor Robert Shiller thinks so.

Writing at the New York Times,

YOU don’t have to be a genius to pick good investments. But does having a high I.Q. score help?

The answer, according to a paper published in the December issue of The Journal of Finance, is a qualified yes.

The study is certainly provocative. Even after taking into account factors like income and education, the authors concluded that people with relatively high I.Q.’s typically diversify their investment portfolios more than those with lower scores and invest more heavily in the stock market. They also tend to favor small-capitalization stocks, which have historically beaten the broader market, as well as companies with high book values relative to their share prices.

The results are that people with high I.Q.’s build portfolios with better risk-return profiles than their lower-scoring peers.

Certainly, caution is needed here. I.Q. tests are controversial as to what they measure, and factors like income, quality of education, and family background may not be completely controlled for. But the study’s results are worth pondering for their possible implications.

So how valid is such claim?

Let’s get some clues from some of my favorite investors.

Here is the legendary Jesse Livermore (bold emphasis mine)

The market does not beat them. They beat themselves, because though they have brains they cannot sit tight. Old Turkey was dead right in doing and saying what he did. He had not only the courage of his convictions but also the intelligence and patience to sit tight.

When I am long of stocks it is because my reading of conditions has made me bullish. But you find many people, reputed to be intelligent, who are bullish because they have stocks. I do not allow my possessions – or my prepossessions either – to do any thinking for me. That is why I repeat that I never argue with the tape.

Mr. Livermore simply posits that intelligence can be overwhelmed by egos and cognitive biases (particularly in the second quote the endowment effect, Wikipedia.org—where people place a higher value on objects they own than objects that they do not.).

Here is the 10 investing principles by another investing titan the late Sir John Templeton

1. Invest for real returns 2. Keep an open mind 3. Never follow the crowd 4. Everything changes 5. Avoid the popular 6. Learn from your mistakes 7. Buy during times of pessimism 8. Search worldwide 9. Hunt for value and bargains 10. No-one knows everything

More from John Templeton

“Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

Here is value investor turned crony, Warren Buffett. I’d say that Mr. Buffett’s original wisdom has been a treasure. (bold emphasis mine)

‘I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.’

‘Read Ben Graham and Phil Fisher read annual reports, but don’t do equations with Greek letters in them.’

‘Never invest in a business you cannot understand.’

‘You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right – that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else.’

Does all the above sound like high IQ stuff? Evidently they represent more common sense and the school of hard knocks stuff.

Yet to the contrary, high IQs can translate to portfolio disasters.

The landmark bankruptcy by Long Term Capital Management in 1998 had been a company headed by 2 Nobel Prize winners. The company’s failure has substantially been due to flawed trading models.

In 2008, the 5 largest US investment banks vanished. These companies had an army of economists, statisticians and quant modelers, accountants, lawyers and all sort of experts who we assume, because of their stratospheric salaries and perquisites, had high IQs.

When Queen Elizabeth asked why ‘no one foresaw’ the crisis coming, the reply by the London School of Economics (LSE)

"In summary, Your Majesty," they conclude, "the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole."

Imagination had been scarce because the same army of experts heavily relied on mathematical models in dealing with investments. They did not follow the common sense advise by the real experts.

My favorite iconoclast author Nassim Taleb in Fooled by Randomness offers an explanation (emphasis added)

it is also scientific fact, and a shocking one, that both risk detection and risk avoidance are not mediated in the “thinking” part of the brain but largely in the emotional one (the “risk as feelings” theory). The consequences are not trivial: It means that rational thinking has little, very little, to do with risk avoidance. Much of what rational thinking seems to do is rationalize one’s actions by fitting some logic to them.

What the consensus mistakenly thinks as rational is, in reality, the emotional. Thus, we need more Emotional Intelligence (EI) rather than high IQs

The most important observation or lesson is one of the repeated botched attempts by high IQ people to transform investing into ‘science’.

Well, because investing involves people’s valuations and preferences, all of which constitutes human action, in truth, investing is more than science…

As the great Ludwig von Mises explained. (bold highlights mine)

For the science of human action, the valuations and goals of the final order at which men aim constitute the ultimate given, which it is unable to explain any further. Science can record and classify values, but it can no more "explain" them than it can prescribe the values that are to be acknowledged as correct or condemned as perverted. The intuitive apprehension of values by means of understanding is still not an "explanation." All that it attempts to do is to see and determine what the values in a given case are, and nothing more. Where the historian tries to go beyond this, he becomes an apologist or a judge, an agitator or a politician. He leaves the sphere of reflective, inquiring, theoretical science and himself enters the arena of human action.

...but rather, investing is an art.

Again Professor Mises from the same article.(emphasis added)

The position of science toward the other values of acting men is no different from that which it adopts toward aesthetic values. Here too science can do no more with respect to the values themselves than to record them and, at most, classify them as well. All that it can accomplish with the aid of "conception" relates to the means that are to lead to the realization of values, in short, to the rational behavior of men aiming at ends.

Bottom line: The art of managing our emotions or emotional intelligence, via common sense and self-discipline, is more important than having high IQs.

Putting Into Perspective Brazil’s Ban on Outdoor Billboards

Since 2006, São Paulo, Brazil has eliminated billboard ads

Image from Smartplanet.com

From Newdream.org

Imagine a city of 11 million inhabitants stripped of all its advertising. It’s nearly impossible when the clutter and color of our current urban landscapes seem inextricably entwined with the golden arches of McDonald’s or the deep reds of Coca-Cola.

Yet for the residents of São Paulo, Brazil, this doesn’t require imagination: city dwellers simply have to walk down the street and look around to see a city devoid of advertisements.

In September 2006, São Paulo’s populist mayor, Gilberto Kassab, passed the so-called “Clean City Law," outlawing the use of all outdoor advertisements, including on billboards, transit, and in front of stores.

Before being enacted, the law triggered grave alarm among city businesses and other economic constituents. Critics worried that the advertising ban would entail a revenue loss of $133 million and a net job loss of 20,000. Fears that the city would look worse without the mask of the media alarmed residents. Despite the concerns, the law passed and the 15,000 billboards cluttering the world’s seventh largest city were taken down.

Five years later, São Paulo continues to exist without advertisements. But instead of causing economic ruin and deteriorating aesthetics, 70 percent of city residents find the ban beneficial, according to a 2011 survey. Unexpectedly, the removal of logos and slogans exposed previously overlooked architecture, revealing a rich urban beauty that had been long hidden.

Articles like this like to paint the world as operating in a vacuum. The idea is once a law has been imposed, what you see is what you get.

In reality, there is much beyond what has been stated above. Part of the consequence of the Clean City Law has been to bring Brazil’s advertisement industry underground.

According to the Financial Times

Advertising creatives and marketing directors were forced quickly to find new ways to spend money that had been earmarked for outdoor advertising, especially since the law came into effect almost immediately. “Usually in Brazil it takes a little time for laws to get set up,” says Marcello Queiroz, an editor at Propaganda and Marketing newspaper in São Paulo. “It was really dramatic how quick things changed. Big companies had to change their focus and strategies.”

Marketing directors had to find a place to spend the money they previously put into billboards. The result, they say, was a creative flowering of new and alternative methods – including indoor innovations such as elevator and bathroom ads – but primarily in digital media.

“The internet was the really big winner,” says Mr Oliveira. In 2007, there was already a move towards the internet, digital media and social networking marketing worldwide, but the Cidade Limpa law gave Brazilians an extra push, he says.

So advertisements have shifted from the outdoor to the indoor and mostly to the web.

Second, Brazilian companies realized that billboard ads were hardly as effective or as feasible as they were, such that even those with advertisement licenses diverted their money elsewhere.

Again from the same FT article,

Anna Freitag, marketing manager of Hewlett-Packard Brazil, says a realisation came that outdoor advertising is less effective than these newer strategies. “A billboard is media on the road. In rational purchases it means less effectiveness . . . as people are involved in so many things that it makes it difficult to execute the call to action,” she says.

“HP decided to go deeper and understand consumer behaviour – the path to purchase, and place media in this direction . . . The internet and social media are the big trends associated with point of sale presence.”…

The law is now so popular that some companies that were able through legal action to maintain some outdoor presence chose not to, so as not to be seen as flying in the face of Cidade Limpa.

And considering that Brazilians were hooked into the web, the local advertisement industry followed the money…

Again from the same FT article

It also helped that Brazilians were extremely active in social media. The country has one of the highest percentages of active Twitter users in the world and Brazilians are avid social networkers.

Lalai Luna, co-founder of Remix, a new agency specialising in digital and social media strategies, often focusing on music culture, says this opened up opportunities and cash flow for young creatives with experimental models to develop their craft.

“Companies had to find their own ways to promote products and brands on the streets,” she says. “São Paulo started having a lot more guerilla marketing [unconventional strategies, such as public stunts and viral campaigns] and it gave a lot of power to online and social media campaigns as a new way to interact with people.”

The point is that people incentives, or in this case the advertising industry's incentives, adjusts or responds to regulations.

Since consumer’s preferences in Brazil have already been shifting (even prior to the law), the outdoor ban only expedited the transitional process, thus giving the impression of the positive externality from the said regulation.

Another very important point to stress has been the radical impact of digital media to the advertisement industry.

Nevertheless Brazil’s politics have their idiosyncrasies too.

Politicians got rid of outdoor ads, but decriminalized graffiti (which for me is a good thing).

From Untappedcities.com (image theirs too)

In March 2009, the Brazilian government passed law 706/07 which decriminalizes street art. In an amendment to a federal law that punishes the defacing of urban buildings or monuments, street art was made legal if done with the consent of the owners. As progressive of a policy as this may sound, the legislation is actually a reflection of the evolving landscape in Brazilian street art, an emerging and divergent movement in the global street art landscape. In Brazil, there is a distinction made between tagging, known as pichação, and grafite, a street art style distinctive to Brazil.

Perhaps the defining line between “street art” and “advertisement” may converge or may become a gray area.

Quote of the Day: Life is More than Math…

"It's not prime enough"

"That number is too even... can you make the next one even odder?"

The thing about math is that it's right or wrong, on or off, yes or no. Seven is a prime number, there's no improving it.

The thing about life/business/culture and the things we make and do is that they are not math.

From my favorite marketing guru Seth Godin. Indeed, life is about human actions.

Mainstream Analysts Capitulates on Bear Market Views

From Bloomberg,

Strategists at the biggest banks are capitulating on their bearish forecasts after the best start to a year for global stocks since 1994 and gains of more than 7 percent in emerging-market currencies.

Just two weeks after saying that investors should “remain cautious,” Larry Hatheway, the chief economist at UBS AG (UBSN), raised his recommendations on global shares and high-yield bonds in a Jan. 23 note to customers entitled, “Wrong, but not too late.” Royal Bank of Scotland Group Plc (RBS), and Benoit Anne, the global head of emerging-markets strategy at Societe Generale (GLE) SA, said their estimates for developing nations were proven wrong.

The MSCI All-Country World Index (MXWD) climbed 5.7 percent in January, surprising strategists at Bank of America Corp. (BAC),Goldman Sachs Group Inc. (GS) and Barclays Plc (BARC) who had forecast first-half losses because of Europe’s debt crisis. JPMorgan Chase & Co. (JPM) and Citigroup Inc. (C), which predicted the rally in stocks, say it will continue as the U.S. housing market rebounds and China eases lending restrictions to bolster economic growth.

Another instance where the mainstream admits to have gotten their analysis, and subsequently their predictions, all so wrong. Independent (usually contrarian) thinking pays. And most important is adhering to the methodology taught by Professor Ludwig von Mises.

There is only one way of dealing with all problems of social organization and the conduct of the members of society, viz., the method applied by praxeology and economics. No other method can contribute anything to the elucidation of these matters.

What To Expect in 2012

Everything we know “based on evidence” is actually based on evidence together with appropriate theory. Steven Landsburg

Prediction 2011: Largely on the Spot But Too Much Optimism

First, a recap on the analysis and the predictions I made during the end of December of 2010 in an article “What to Expect in 2011”[1]

I identified four predominant conditions that would function as drivers of global financial markets (including the Philippine Phisix) as follows:

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

How they fared.

1. Low Interest Rates Regime

I noted that the US Federal Reserve has the “penchant to artificially keep down interest rates until forced by hand by the markets”; this has apparently been validated last year even as most of the market’s focus has shifted to the Eurozone.

In fact, suppressing interest rates has not just been undertaken by the US Federal Reserve, whom has promised that current zero bound rates (ZIRP) would be extended to 2013[2] aside from manipulating the yield curve via ‘Operation Twist’, but by major developed and emerging central banks as shown above[3].

Apparently, the worsening debt crisis in Eurozone compounded by Japan’s triple whammy natural disaster and China’s slowing economy (or popping bubble?) has intuitively or mechanically prompted policymakers to respond concertedly, nearly in the same fashion as 2008. This has resulted to a decline of global interest rates levels to that of 2009[4].

2. Bailouts and QEs Did Escalate

Except the US Federal Reserve, major global central banks have already been actively adapting credit easing or money printing policies.

The balance sheets of top 3 central banks has now accounted for almost 25% of world’s GDP[5]. Yet this doesn’t include the Swiss National Bank[6] (SNB) and the Bank of England[7] (BoE) whom has likewise scaled up on their respective asset purchasing programs.

The world is experiencing an unprecedented order of monetary inflation under today’s fiat standard based modern central banking.

3. Divergent Impacts of Monetary Policies on Financial Markets

I previously stated that

Divergent monetary policies will impact emerging markets and developed markets distinctly, with the former benefiting from the transmission effects from the latter’s policies.

While global equity markets have been down mostly on partial and sporadic signs of liquidity contraction arising from the unfolding Euro crisis and from indications of a global economic slowdown, monetary policy activism or strong responses by central banks did result to distinctive impacts on the marketplace.

Emerging markets with the least inflationary pressures exhibited resiliency. ASEAN 4 bourses, going into the close of the New Year, were among the ten world’s best performers[8] and served as noteworthy examples of the above.

The relative performances of global bourses have likewise been reflected on the commodity markets[9].

4. Globalization Remained Strong which Partly Offset Weak Spots

While there had been signs of partial stagnation of global trade in terms of volume during the last semester of the 2011, trade volumes remained at near record highs and have hardly reflected on signs of severe downturn or a recession[10] despite the Euro crisis.

Since deepening trends of globalization (in finance and trade) has also been expanding the correlations of the financial markets[11], which has been largely characterized as ‘Risk On’ and ‘Risk Off’ environments, the aggressive actions by central banks and the non-recessionary global environment in the face of the Euro crisis and patchy signs of economic slowdown has partly neutralized such tight relationship which allowed for selective variances in asset performances.

Overall, almost every condition that I defined in December of 2010 had been validated.

5. Mostly Right Yet Too Optimistic

On how I expected the markets to perform, I wrote,

Unless inflation explodes to the upside and becomes totally unwieldy, overall, for ASEAN and for the Philippine Phisix we should see significant positive gains anywhere around 20-40% at the yearend of 2011 based on the close of 2010. Needless to say, the 5,000 level would seem like a highly achievable target. What the mainstream sees as an economic boom will signify a blossoming bubble cycle.

Of course my foremost barometer for the state of the global equity markets would be the price direction of gold, which I expect to continue to generate sustained gains and possibly clear out in a cinch the Roubini hurdle of $1,500.

To repeat, Gold hasn’t proven to be a deflation hedge as shown by its performance during the 2008 Lehman collapse. The performance of Gold during the Great Depression and today is different because gold served as a monetary anchor then. Today, gold prices act as a temperature that measures the conditions of the faith based paper money system.

2011 saw the Philippine Phisix and ASEAN bourses marginally up, which means that I have been too optimistic to suggest of a minimum 20% return that was way off the mark.

Nevertheless, it hasn’t been that bad since the long-time darling of mine, the Philippine mining index, overshot on my expectations.

And given that the mining sector’s extraordinary returns has alternated every year[12], it is unclear if mining index will remain to be the horse to beat. Yet, current global monetary dynamics may change all that.

Aside, another observation of mine has been validated.

Gold, allegedly a deflation hedge/refuge, has not turned out as many have said.

Except for the July-September frame, gold prices have largely moved along with the price direction of the S&P 500 (blue circles).

The July-September frame which marked a short-term deviation from the previously tight correlations seems to coincide with the end of the QE 3.0. This along with the unfolding Euro crisis put pressure on US equity markets first, which eventually culminated with FED chair Ben Bernanke’s jilting of the market’s expectations of QE 3.0.

The belated collapse of gold prices (red circle), in response to Mr. Bernanke’s frustrating of the market expectations for more asset purchasing measures, had been aggravated by other events such as the forced liquidations by MF Global[13] to resolve its bankruptcy and several trade ownership issues aside from other trade restrictions or market interventions[14] that has stymied on gold’s rally.

Nevertheless, the gold-S&P 500 linkage appears to have been revived, where both gold and the S&P has taken on an interim upside trend (green line).

The S&P 500 closed the year with microscopic losses while gold registered its 11^th year of consecutive gains, up 10% in 2011.

Expect Volatile Markets in 2012

When asked to comment on the prospects of the stock market, JP Morgan’s once famous resounding reply was that “It [Markets] will fluctuate”.

1. Markets will Fluctuate—Wildly

2012 will essentially continue with whatever 2011 has left off.

Since 2011 has been dominated by the whack-a-mole policies on what has been an extension of the global crisis of 2008, which in reality represents the refusal of political authorities for markets to clear or to make the necessary adjustments on the accrued massive malinvestments or misdirection of resource allocation in order to protect the political welfare based system anchored on the triumvirate of the politically endowed banking sectors, the central banks and governments, then we should expect the same conditions in 2011 to apply particularly

1. Monetary authorities will continue to keep interest rates at record or near record low levels.

2. Money printing via QE and bailouts will continue and could accelerate.

3. There will be divergent impact from different monetary policies and

4. Globalization will remain a critical factor that could partly counterbalance the nasty effects of the collective inflationist policies (unless the ugly head of protectionism emerges).

I would add that since presidential election season in the US is fast approaching, most candidates or aspirants including the incumbent have been audibly beating the war drums on Iran[15], where an outbreak may exacerbate political interventions in the US and in the global economy and importantly justify more monetary inflationism.

One must realize that continued politicization of the marketplace via boom bust and bailout policies compounded by various market interventions and the risk of another war has immensely been distorting price signals which should lead markets to fluctuate wildly.

2. China and Japan’s Hedge—Steer Clear of the US Dollar

And where reports say that China and Japan have commenced on promoting direct transactions[16] by using their national currencies hardly represents acts to buttress the current system.

The Bank of Japan has also been underwriting their own Quantitative Easing (QE) which means the Japanese government are engaged in ‘competitive devaluation’ which is no more than a ‘beggar thy neighbour’ policy.

Instead, what this implies is that Japan and China, being the largest holders of US debt, seem to be veering away from their extensive dependence on the US economy as they reckon with, not only interest rate and credit risks, but also of currency, inflation, political and market risks. Even China and Japan appear to be taking measures to insure themselves from wild fluctuations.

On the other hand, China’s bilateral currency agreement with Japan plays into her strategy to use her currency as the region’s foreign exchange reserve[17].

3. Heightened Inflation Risks from Monetary Policies

QE 3.0 has not been an official policy yet by the US Federal Reserve but their balance sheet seem to be ballooning anew (chart from the Cleveland Federal Reserve[18]).

Yet this, along with surging money supply and recovering consumer and business credit growth, will have an impact on the US asset markets which should also be transmitted to global financial markets, as well as, to the commodity markets.

Yet given the large refinancing requirements for many governments (more than $7.6 trillion[19]) and for major financial institutions this year amidst the unresolved crisis, I expect major central banks to step up their role of lender of last resort.

Again the sustainability of the easy money environment from low interest rates and money printing by central banks will depend on the interest rates levels which will be influenced by any of the following factors: 1) inflation expectations 2) state of demand for credit relative to supply 3) perception of credit quality and or 4) of the scarcity/availability of capital.

Today’s bailout policies have been enabled and facilitated by an environment of suppressed consumer price inflation rates, partly because of globalization, partly because of the temporal effects from price manipulations or market interventions and partly because of the ongoing liquidations in some segments of the global marketplace such as from MF Global, the crisis affected banking and finance sectors of the Eurozone and also perhaps in sectors impacted by the economic slowdown or the real estate exposed industries in China, which may be suffering from a contraction.

However I don’t believe that the current low inflation landscape will be sustainable in the face of sustained credit easing operations by the central banks of major economies. Price inflation will eventually surface that could lead to restrictive policy actions (which subsequently could lead to a bust) or sustained inflationism (which risks hyperinflation). Signs from one of which may become evident probably by the second semester of this year.

Yet I think we could be seeing innate signs this: Given the current monetary stance and increasing geopolitical risks, oil (WTI) has the potential to spike above the 2011 high of $114 which may lead to a test of a 2008 high of $147.

4. Phisix: Interim Fulfilment of Expectations and Working Target

In the meantime, I expect the Philippine Phisix and ASEAN markets to continue to benefit from the current easy money landscape helped by seasonal strength, improvements in the market internals, and in the reversals of bearish chart patterns as forecasted last December[20]

The bearish indicators of head and shoulders (green curves) and the ‘death cross’ have now been replaced by bullish signals as anticipated[21]. The Phisix chart has now transitioned to the golden cross while ‘reverse head and shoulders’ (blue curves and trend line) has successfully broken out of the formation. It doesn’t require relying on charts to see this happen. Even the Dow Jones Industrials has affirmed on my prognosis[22].

The S&P 500, oil (WTI) and the Phisix seem to manifest a newfound correlation or has reflects on a synchronized move,whether this relationship will hold or not remains to be seen.

I believe that the Phisix at the 5,000 level should represent a practical working yearend target; where anything above should be a bonus.

Again all these are conditional to the very fluid external political-financial environment, which includes risks from not only from the Eurozone, but from China and the importantly US—whose debt level is just $25 million shy from the debt ceiling[23] (probably the debt ceiling political risk will become more evident during the last semester).

Moreover, I believe that gold prices will continue to recover from the recent low.

Gains will crescendo as global policymakers will most likely ramp up on the printing presses. Gold will likely reclaim the 1,900 level sometime this year and could even go higher and will end the year on a positive note.

But then again all these are extremely dependent or highly sensitive to the situational responses of global policymakers.

Predicting social events or the markets in the way of natural sciences is a mistake.

As the great Ludwig von Mises explained [24],

Nothing could be more mistaken than the now fashionable attempt to apply the methods and concepts of the natural sciences to the solution of social problems. In the realm of nature we cannot know anything about final causes, by reference to which events can be explained. But in the field of human actions there is the finality of acting men. Men make choices. They aim at certain ends and they apply means in order to attain the ends sought.

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[1] See What To Expect In 2011, December 20, 2010

[2] See US Federal Reserve Goes For Subtle QE August 10, 2011

[3] Centralbanknews.info What Will 2012 Bring for Global Monetary Policy? December 27, 2011

[4] See Global Central Banks Ease the Most Since 2009, November 28, 2011

[5] Zero Hedge Top Three Central Banks Account For Up To 25% Of Developed World GDP, January 5, 2012

[6] See Hot: Swiss National Bank to Embrace Zimbabwe’s Gideon Gono model September 6, 2011

[7] See Bank of England Activates QE 2.0 October 6, 2011

[8] See Global Equity Market Performance Update: Philippine Phisix Ranks 6th among the Best, December 17, 2011

[9] See How Global Financial Markets Performed in 2011 December 31, 2011

[10] Key Trends in Globalization, New world trade data indicates slowdown but not recession in the global economy, November 25, 2011 ablog.typad.com

[11] Allstarcharts.com BCA Research: High Equity Correlations Are Here To Stay, January 4, 2011

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

[13] See MF Global Fallout Haunts the Metal Markets, December 12, 2011

[14] See War On Gold: China Applies Selective Ban December 28, 2011

[15] See Could the US be using the Euro crisis to extract support for a possible war against Iran? January 8, 2012

[16] Bloomberg.com China, Japan to Back Direct Trade of Currencies, December 26, 2011

[17] See The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency, April 20, 2011

[18] Cleveland Federal Reserve Credit Easing Policy Tools

[19] See World’s Biggest Economies Face $7.6 Trillion Bond Tab as Rally Seen Fading January 4, 2012

[20] See Phisix: Primed for an Upside Surprise December 11, 2011

[21] See How Reliable is the S&P’s ‘Death Cross’ Pattern?, August 14, 2011

[22] See US Equity Markets: From Death Cross to the Golden Cross, December 31, 2011

[23] Zerohedge.com Here We Go Again: US $25 Million Away From Debt Ceiling Breach, January 5, 2012

[24] von Mises Ludwig Misapprehended Darwinism, Refutation of Fallacies, Omnipotent Government p.120

US Equity Markets: From Death Cross to the Golden Cross

Like the Philippine Phisix, the evolving chart patterns of major US equity market bellwether appear to be on path to validate my prognosis.

Below is the imminence of the transition to the ‘golden cross’ by the Dow Jones Industrials (INDU).

The S&P 500 (SPX) will likely follow the Dow Industrials soon

This serves as further evidence of the dependability and reliability of the study of human action (methodological individualism or praxeology) in ascertaining price trends of the marketplace.

As I have repeatedly been emphasizing, contrary to popular opinion, patterns don’t drive prices, human action does. I questioned the efficacy of the current ‘death cross’ pattern here