Monday, June 28, 2010

G20 moves to austerity planning

G20 summit with the theme “Recovery and New Beginnings”. Surprisingly, even the name of the summit can be called into question for the developed countries. The New Beginnings may be code for fiscal austerity.

The G20 pledged to “follow through on delivering existing stimulus plans,” while acknowledging “the need…to put in place credible, properly phased and growth-friendly plans to deliver fiscal sustainability.” This has the caveat that the rules will be “tailored to national circumstances in order not to derail the recovery under way.”

Advanced economies subscribed to fiscal plans that will halve deficits by 2013 and “stabilize or reduce government debt-to-GDP ratios by 2016.” I don't know how many times G20 restrictions were made and not kept but these are interesting proposals. We are still having riots in Greece over its austerity measures. The French may strike given it was proposed that retirement will be raised to 62.

Again, this will be the test of Keynesian stimulus versus what some have called the new Hooverism.

Thursday, June 24, 2010

You get pleasure from being with the crowd

A study in Current Biology finds brain activity that show that conformity or being with the crowd gives pleasure. We like to herd at a very fundamental basis. Agreement with experts gives the same response as a reward. You will also place more value on things that people tell you have more value. When experts agree, your awareness is heightened.

In other words, investors often go along with the crowd because—at the most basic biological level—conformity feels good. Moving in herds doesn't just give investors a sense of "safety in numbers." It also gives them pleasure. WSJ online

Fighting the crowd is never easy. Better to fail with the crowd than be unique?

Wednesday, June 23, 2010

Ignorance, Risk, and Uncertainty - Knowing our limitations

Hat tip to abnormal returns for the discussion of ignorance, uncertainty and risk with respect to BP.

We are slaves to our ignorance. At the extreme we may be too stupid to know we are stupid, so we have to know our limitations or as stated by Dirty Harry, "I like a man who knows his limitations".

The Dunning-Kruger effect:

When people are incompetent in the strategies they adopt to achieve success and satisfaction, they suffer a dual burden: Not only do they reach erroneous conclusions and make unfortunate choices, but their incompetence robs them of the ability to realize it.

Errol Morris opinion blog in NYT

Put simply, people tend to do what they know and fail to do that which they have no conception of. In that way, ignorance profoundly channels the course we take in life. And unknown unknowns constitute a grand swath of everybody’s field of ignorance.

To me, unknown unknowns enter at two different levels. The first is at the level of risk and problem. Many tasks in life contain uncertainties that are known — so-called “known unknowns.” These are potential problems for any venture, but they at least are problems that people can be vigilant about, prepare for, take insurance on, and often head off at the pass. Unknown unknown risks, on the other hand, are problems that people do not know they are vulnerable to.

A “known unknown” is a known question with an unknown answer. I can ask the question: what is the melting point of beryllium? I may not know the answer, but I can look it up. I can do some research. It may even be a question which no one knows the answer to. With an “unknown unknown,” I don’t even know what questions to ask, let alone how to answer those questions.

David Dunning, in his book “Self-Insight,” calls the Dunning-Kruger Effect “the anosognosia of everyday life.” When I first heard the word “anosognosia,” Anosognosia is a condition in which a person who suffers from a disability seems unaware of or denies the existence of his or her disability.

Donal Rumsfeld has set the standard for discussion son these issues.

“There are things we know we know about terrorism. There are things we know we don’t know. And there are things that are unknown unknowns. We don’t know that we don’t know. "

"All of us in this business read intelligence information. And we read it daily and we think about it, and it becomes in our minds essentially what exists. And that’s wrong. It is not what exists.”

Knowing what we do not know is relevant for investing. If the market is moving up and you don't know why you have to accept that there is something unknown to you.

Country PEG and capital flows

Equity capital flows has taken on greater importance in the global markets. Fixed income flows are larger but the equity flows can be especially important on the margin for emerging markets. Bespoke Investment group provide an interesting table in country PEG.

The definition is fairly easy and is consistent with the PEG definition for any company. Take the P/E ratio for the country index and divide by the growth rate of the country GDP. You are looking for cheap P/E country stock indices relative to the growth of the country. A good PEG would be less than one because then you are have a P/E less than country growth.

What is clear from looking at these values is the relatively high PEG for Europe relative to the emerging markets. You should want to buy companies that have high growth and low P/E. Of course, you usually find that PEG for emerging markets to be lower than for developed countries. There is less risk in the G7 so you should be willing to pay a premium versus growth prospects.

You do have a problem because globalization pollutes the ratios. Many EU companies have significant sales in emerging markets which will increase the PEG when measured against domestic growth. Still. it is a good simple measure for which countries may be cheaper and will attract new capital flows. The numbers are generally consistent with the currency movement we have seen in the last year.

German and US eocnomic policy at odds

We are getting much clearer signs that the G20 is all over the map with respect to economic policy. UK and Japan are following an austerity program of cutting government expenditures. Now Germany is weighing in with e export driven fiscal austerity program. As stated by Chancellor Merkel in a press conference and call to President Obama,

  • cutting government debt is “absolutely important for us,”
  • “But what we certainly can’t do is influence our export strength,” she said. “It’s a fact. It’s the right thing.”
President Obama is right to be concerned about global imbalances caused to a high degree by the export engines in Germany and China. He also is correct in noting that a cut of stimulus at this time could hurt the fragile recovery, but we are in an especially complex time where rules of the past may not apply. This comment is not trying to be cute and avoid the issue. The fact that we are still in a debt bubble that has to be adjusted. Switching public for private debt while adding more structural deficits is not gong to solve the problem. It just changes the debtors.

Tuesday, June 22, 2010

The big austerity versus stimulus test

UK's prime minister Cameron has delivered a tight budget with tax increases. Japan is moving to tighten its budgets and increase taxes on the wealthy. The US is still in the spending mode. with the year 2 of the $847 billion stimulus package So now we have an interesting test of whether fiscal austerity or Keynesian spending will be the driver for economic growth.

The answer should be easy. Follow the Keynesian prescription especially when there is an output gap. But the reality is never so simple. The tighter budgets in some European countries is a reaction to the sovereign debt problems in the EU. The basis for the tighter budgets is that capital will move out of risky sovereigns driving p interest rates which will reduce investments. Clerly, at the extrems this will be true, but this seems very similar to the tightening proposed during the Great Depression. It can have unintended effects. I would argue that the market looks for counter-cyclical spending during a recession This is helpful because there is less private investment. The market doe snot like structural deficits which have been building across Europe and Japan.

Some have argued that the key is to cut spending without raising taxes. Goldman Sachs economist have found that a 1% cut in spending will led to a .6% increase in growth Raising taxes to GDP by 1% will cut growth by .9%. The multiplier effects are not what is normally expected. Paul Krugman, on the other hand, argues that any cut in stimulus would be "utter folly". The "folly seems to be the new trend in Europe.

China makes the currency change for just a bit

It has finally happened. A change in the link between the yuan and the dollar. It was sooner than expected, but coming on the eve of the G20 meeting certainly has the impact of recurring pressure of being called a currency manipulator.

The market move from 6.83 to 6.80 was not large; however, it has been the greatest move in five years. At approximately .4%, the move will not have enough impact to change the terms of trades or affect profit markets for exporters. Interestingly, the last time the yuan was allowed to appreciate there was little impact on the trade balance The recession had a much bigger impact and the overall direction in the dollar was larger contributor. The yuan will have to move more to stem the rise in inflation seen domestically. The yuan has been said to be anywhere from being at fir value and 50% undervalued.

Tuesday CNY prices were actually higher, so it is difficult to determine what is going. The move in exchange rates for other countries is based on the expectation that this will be a start of a much larger move over time. This should be good news for Asian currencies which compete with China for dollar business. Asian exports to China should also pick up, but again it may not be as large as expected. Global growth rates and domestic policies may have a greater impact on trade balances.

Friday, June 18, 2010

Making mistakes is normal

We are human. We make mistakes. We are actually pretty good at it We have to learn how we make mistake to avoid them. Joseph Hallinan in Why we Make Mistakes: How we look without seeing, forget things in seconds, and are all pretty sure we are way above average, is a breezy review of many of the key behavioral biases we face in everyday life. I like looking at these books because the complexity of the human decision process is fascinating issue which has too often been assumed away through the assumption of rationality.

We look but do not see because we skim and not look for visual details. We see what we expect to see, We recall parts but not all things. We forget. We make snap judgments. We remember our successes. Hindsight isn't 20/20, but after the fact we give events higher probability. We are easily distracted. As something becomes more familiar we tend to notice less. We are all overconfident.

The world is filled with mistakes which creates the opportunities for others to succeed. The number of mistakes we make are astounding:

  • 30 percent of people forget their password after one week.
  • A survey of 3,000 found that 1/4 could not remember their phone number.
  • Teams that wear black get penalized more often.
  • Changing your answers on multiple choice tests improves results.
  • 84 percent of doctors thought their colleagues were influenced by gifts. Only 16 percent thought they were influenced.
  • Plane crashes by human error for no apparent reason are frequent enough to be called CFIT, Controlled Flight into Terrain
  • Multitasking does not work. We are prone to distraction and find it difficult to screen out distractions.
  • Quantity limits at stores boosts sales.
  • The better we are the more likely we will skim which increases the chance of errors.
Hallinan provide a great number of interest stories which stick in your mind and more power to the fact we live in a less than rational world.

China - a complex split personality

William Callahan provides a different perspective on China in his book, China:The Pessoptimist Nation. It introduces a good filter in understanding why China will not take specific economic actions on exchange rate policy. It does not want to be perceived as being pushed by other nations. While this may be a perspective of most countries when foreigners suggest a policy change which may not be in its interest, there may be heightened sensitivity in China.

The pessoptimist view argues that China's history with the West and with all foreigners has been a source of anxiety that may cloud its current behavior even as its power grows on the international stage.

Interaction across nations is always confused by cultural differences. This gulf may be greater between China and the rest of the world. Growth and size may not change the fact that China may view itself differently from others who have actually less economic power.

The view of China was altered with the summer Olympics of 2008. It was China's introduction as a great power, yet China itself is fighting with its identity. It is on the surface a optimistic country. The growth and strides made in the last 25 years have been amazing. The dream of a better China for all citizens is strong. The belief that China is a major country on the international political scene is clear.

Yet, there is history that is presented by the country of humiliation at the hands of foreigners which provides a barrier for negotiations with all other countries. In the normal give and take of politics, this past history has made the Chinese more senstive to any loses or perceived slights. Negotiations become more difficult if this view of past injustice and need for adjustment is present at the table. Rising nationalism combined with China's growing power makes for country dynamics which can be very uncertain.

Callaham makes a very good case for a country which "lends itself to hyperbole - both positive and negative", what he calls the pessoptimist nation. He argues that the "heart of China's foreign policy is a dilemma of identity. Who is China and how does it fit into the world" Give the dramatic change in history especially from the century before 1949, the view of itself is unclear. Do you forget the past or use it as a basis for identity. While recent success and strength are celebrated, there is also a focus on never forgetting the "national humiliation" at the hands of imperialists. There is a strong view that Chinese civilization has always been under assault by the barbarians, outsiders. This view of history will have an influential effect on all behavior both inside and outside the country.

The issue of identity is complex with China because there are key issues with defining China. For example, "When is China?" The history of China has been in a state of flux. The issue is not with the most recent events but events pre-1949. The changing emphasis of the historical record has adapted the views of all educated in China. The book also argues the important issue of "Where is China?" Historical maps of China shows a country which has not been clearly defined so that any issue of defining border is not easily resolved. The question of "who is China" is also not something that can be easily defined. Identity politics have an impact in dealing with neighbors and borders. The who is China also has an effect on self criticism. Issues of identity make for more difficulty with criticism of the government.

The pessoptimist nation is not a conventional view of China and certainly not the view that the government would like to promote; nevertheless, it provides a different perspective on a challenging issues. How do you deal with a major world power that has a complex and dynamic history?

Monday, June 14, 2010

Gold versus commodity markets - no link

Bloomberg chart of the day shows the ratio of gold to commodities as measured by the CRB spot index. The argument from Brian Belski of Oppenheimer is that the ratio is too high and that gold is set for a fall.

If you placed this trade when the markets got above its old ratio high, you would have been hit with huge losses. Gold is just a different animal from other commodities especially at this time.

Previously gold has been used as a flight to safety again inflation. Under that environment, other commodity pries also would have been increasing. Inflation would have lifted all prices. But we are currently in a deflationary environment. Inflation is higher in emerging markets, but inflation expectations have been very stable for the G10.

Now gold could be trying to tell us about longer-term inflation, but my guess is that gold is serving as a credit protection against sovereign risk. In this scenario you can have commodity prices decreasing and gold increasing. This would cause the ratio to widen out to level as that we have not seen.

The ratio will start to decrease if global growth increased which will cause commodity prices to rise and there was strengthening of government balance sheets. This would reduce the reason to hold gold as principal protection mechanism. Since we have not sen strong signs that this environment ill change, there is little reason to see this ratio to increase.

The deflation and sovereign risk story seems to make sense if we look at bonds. Bond markets have been rallying at the same time that god has been increasing. The inflation story would give a different answer. In that case, rates would be rising with gold as inflationary expectations rose. We are not seeing this. Gold has taken on a new safety characteristic.

Of course there has been strong buying of gold and at some point there will be increased demand for other metal substitute but this will not come relative to the CRB spot index. The CRB index is very diverse. It is comprised of six categories: metals, textiles and fibers, livestock and products, fats and oils, raw industrials, and food stuffs. This is a business cycle not an inflation index.

Using a ratio to determine relative value is risky especially when there is not inherent arbitrage between these markets.

Does this sound like a country that will raise its exchange rate?

China’s foreign ministry spokesman Qin Gang said “A huge amount of facts has demonstrated the CNY exchange rate is not the main cause of the imbalance in Sino-US trade … Do not politicise the CNY exchange rate issue”

Vice foreign minister Cui Tiankai, said “The CNY is China's currency, so I don't think it is an issue that should be discussed internationally”. Zhang Tao, head of the central bank's international department, said “The Chinese government will decide on its foreign exchange rate policy according to both domestic and global economic situations”.

This does not sound like a government what will change it position on the currency in the near-term.. We should not expect much work being done on solving the global imbalance issue. Consequently, there is greater risk that capital controls and trade policy will drive macro decisions more so than capital flow and price adjustments.

Known, unknown, and unknowable risks

We are all taught what is known, but we rarely learn about what is not known, and we almost never learn about the unknowable,''

Ralph E. Gomory, the president of the Sloan Foundation, wrote in Scientific American in 1995.

I have been reading research on the risk management topic of the known, unknown, and unknowable. This has been called by some, KuU risk. While there could be a better name, the concept is very important and seems to be a good extension of the Knight-Keynes distinctions on risk and uncertainty. There are risk that are know or knowable. This would be through actual experience. There are also risks which are unknown which are difficult to model or describe. There are also risk which we just do not known and are unknowable and unforeseen.

The market has gotten good at measuring known risks. This is best depicted as the volatility in price. We have data and can measure the width of the distribution. Almost all of the work of risk manages have been focused on this area. If you can measure and model it, it can be discussed.
Investors have not been as good at dealing with the "unknown" or risk which are difficult to measure and have done limited work at trying to protect gain the unknowable.

Education will be able to move some of the unknown risk to the known category. As we better understand the process of prices e can adapt to a world with fat tails and move away from Gaussian normal distribution. As some unknowable events occur like 9/11, we can place them in the context of the possible.

Still the unknown and unknowable risks are the ones which will create the largest problems for any investors, yet we do not have any tools to look at these issues.

Friday, June 11, 2010

ECB opening QE

Trichet announced that the ECB would provide unlimited funding at the 3-month tenor and it will not absorb the excess liquidity through issuing debt. This policy along with their May 10th action to buy EU debt in the market to help with the Greece crisis and to change their collateral standards all lead to the conclusion that the ECB is embarking in uncharted water with EMU monetary policy. At the same time Trichet argues that the bank's action is not quantitative easing.

“We are not engaged in any form of ‘quantitative easing’,” Trichet said in a speech in Frankfurt today. The program “is designed to ensure an effective functioning of the monetary policy transmission mechanism by helping to resolve a malfunctioning of some segments of the euro-area securities markets.”

An interesting way to put it.

The latest action by the ECB are at odds with comments they made to the contrary just weeks ago. Some have argued that this is a sign of central bank maturity. The ECB responds to a crisis. Other have argued that this monetary response to the crisis t is a sign of weakness and a loss of independence. Yes, rates have not changed but the funds are available even for risky purchases of debt.

We agree with those who argue that this is a significant change in behavior and not just an act of pragmatism. The monetary authority is now validating the financing problem. This is not a liquidity problem, but a simple means to make life easier for the EU. The euro reaction agrees with this view even with the improvement over the last few days.

The right view of China trade

Many pundits talk about China being the factory of the world. This is misleading. China might be more accurately thought of as the assembler of the world. While last year it was the world’s biggest exporter, it was also one of the world's biggest importers.

- Marc Chandler, Brown Brothers

This characterization that China is a the great assembler is a good description of China. Their margins are low and much of their business is through outsourcing from US retail firms. The assembler view means that the raising of exchange rates will have uncertain effects. Exports prices will go up but import prices will decline. The normal effects will be less pronounced. Hence it is not clear what will be the change in trade flows.

Japan getting fiscal temperance?

New PM Kan was out saying “We cannot sustain public finance that overly relies on issuing bonds … As we can see in the Euro-zone confusion that started from Greece, there is a risk of default if the growing public debt is neglected and if trust is lost in the bond market.”

This is a change in policy for the G10 country with the highest debt to GDP ratio at over 200%. The demographics are working against Japan as the population ages. The savings rate has declined with the change in population which make sit harder to fund the deficit. The savings rate has been declining since the the early 1980's form well over 15% to no only 3.3%. This up form the low of 1.7% last year.

There are problems with mechanics if the deficit is to be cut. Monetary policy will have to b used to purchase debt. Quantitative easing will have to be used because it will be be hard to close the deficit gap through conventional means.