How much more recklessness?

Just yesterday, I wrote that the argument by Martin Sandbu that central bankers missed a trick by not being more reckless in the years following 2008 than they already were was monstrous non-sense.

See these blog posts by Jesse Felder. How can one argue, even after seeing these posts, that central bankers were not responsible for this recklessness on the part of investors? How much more reckless would investors have been, had central banks become been even more reckless?

Callous arguments such as those are simply astounding and mind-boggling.

One more sample of bond market ‘efficiency’

Despite tight restrictions on foreign exchange, Chinese investors have spent $30.4bn on US residential real estate in the past year, according to the US National Association of Realtors, while our monthly consumer survey shows that household demand for foreign exchange has only increased since the turmoil of early 2016.

Outflows have been balanced by record inflows from foreign investors, particularly into the onshore bond market. June data suggested these investors took the depreciation at the end of that month in their stride, but growing signs of currency risk could convince them to sell. [Link]

Why would anyone with a good awareness of risk and return buy Chinese onshore bonds? The yield pickup is not great and the risks are high. Unless, they were so confident that China would not really deleverage and would not allow defaults. Otherwise, it makes no sense investing in China bonds when the country’s non-financial debt to GDP ratio is already too high, when growth is slowing and trade tensions are escalating.

So much for investors’ ability to balance return considerations with risk.

That extract was from an article on RMB risk published by FT Confidential Research. Against America, China is indeed very keen to retaliate with RMB depreciation. But, they know very well that it is a double-edged sword. Capital outflows will accelerate. Same problem with their holding of US Treasuries. If they dump it, they face capital losses. The dollar will weaken, everything else being equal.  Rising US interest rates will push up Chinese cost of capital too. Yields on China bonds will rise too. It will be a self-defeating exercise too.

The best 30-minute investment of your time

I am a regular reader of Tim Price’s blog. I catch up with it in spurts. Towards the end of June, I had chanced upon his blog post recommending a talk by Morgan Housel in the microcapclub in September 2017. I had bookmarked to watch the video but the video is gone now. Taken off the internet.  Sad. But, luckily, a transcript is available. It might take 30-35 minutes to read and absorb the 19-page transcript. But, it is probably a very good investment of your time. The title of the talk is ‘what other industries teach us about investing?’.

I would draw three lessons from his talk:

(1) One is on the Wright Brothers’ invention. The lesson he draws from it is this:

when innovation is measured generationally, results shouldn’t be measured
quarterly.

I am not disputing it. I am adding another lesson. If you notice, the Wright Brothers’ invention of the flying machine was ignored for a few years. But, it was happening. Therefore, the best inventions and scientific breakthroughs are the ones that are happenign off the prying eye. Most invesment value lurks there. It does not lie in the investments that are brought to your mailbox through investment newsletters.

Second lesson is finding that one investment is easier in hindsight! That is, one may have to invest in ten such ideas to find one that succeeds tremendously. Luck, diversification and an awareness of one’s maximum loss absorbing capacity are needed.

(2) Timing in investment matters. Looks like American Presidents’ ‘State of the Union’ addresses are great contrarian indicators. Buying in the years 1999 or in 2000 and holding the stock(s) or the Fund for ten years would have yielded a very different annual return than buying them at the beginning of 2003. See this tweet for some statistics on the best and the worst ten-year returns. In other words, buying with a margin of safety matters. That is a great insight, attributed to Ben Graham, from the talk:

The purpose of the margin of safety is to render the forecast unnecessary.

(3) The final lesson from his talk:

Since most of what he says is simple, they will also be the hardest for us to do. That is one of the early lessons from his talk itself – from the discussion of the episode on cancer treatment vs. cancer prevention.

Risk axioms

A good article by Gillian Tett on where risks lurk. She concludes that it lurks in places where we don’t look. Quite. It has been that way and it will always be that way. We are simply not wired to anticipate risk. We are poor predictors. Recall the post I had written two days ago from Sir Martin Rees’ book as to how little we were able to predict in 1937 about the things that actually materialised in the remainder of the century.

From the article flows the following ‘risk’ axioms:

(1) No crisis is, by definition, anticipated. If it is anticipated, it will be handled, very likely, before it becomes a crisis.

(2) There are no catalysts to a market crash that is known ex-ante. It is actually a corollary of (1) above. All catalysts are clearer only in hindsight.

(3) ‘Early warning’ indicators anticipate the last crisis well.

A lucid master-class on bubbles

Rob Arnott (and his colleagues) of Research Affiliates had written a rather lucid paper on stock market bubbles in April 2018. You can find it here. If you are either an investor or a student or, perhaps, importantly, a teacher, it is a MUST-READ.

They brilliantly shred the arguments that somehow painfully try to prove that stock markets were efficient. They are nothing but pathetic attempts at post-hoc rationalisations or rationalising a conclusion that the authors had already arrived at. Such papers should ideally be classified under ‘propaganda’ rather than under ‘research’, notwithstanding all the geeky mathematics deployed.

On market efficiency:

The efficient market hypothesis has been stretched to fit observed market behavior, by allowing cross-sectional and intertemporal variations in risk premia. Prices adjust until the marginal investor becomes willing to assume both market risk and assorted factor-related risks. The market’s willingness to bear these risks varies over time. In this view, high valuation levels don’t represent mispricing; the risk premia just happen to be sufficiently low so as to justify the prices.

These models benefit from being constructed on a post hoc basis to be consistent with market events. Fair enough, because a useful model needs to be consistent with observable data. But the models often shift problems in the observable data, such as puzzlingly high volatility in price-to-dividend ratios, into unobservable nooks and crannies. In other words, perhaps bubble-like prices can be perfectly rational as long as we accept curiously high volatility in the curvature of investors’ utility functions. Sadly, these hypotheses and models lack a key attribute of scientific method: they are unfalsifiable. No practical difference exists between an inefficient market and an efficient market in which risk premia vary in this fashion.

All students of finance must memorise these two paragraphs.

On market timing:

At the beginning of 2000, the 10 largest market-cap tech stocks in the United States, collectively representing a 25% share of the S&P 500 Index—Microsoft, Cisco, Intel, IBM, AOL, Oracle, Dell, Sun, Qualcomm, and HP—did not live up to the excessively optimistic expectations. Over the next 18 years, not a single one beat the market: five produced positive returns, averaging 3.2% a year compounded, far lower than the market return, and two failed outright. Of the five that produced negative returns, the average outcome was a loss of 7.2% a year, or 12.6% a year less than the S&P 500.

Lesson: Timing matters. If you buy high, you reap lower returns unless you were lucky to flip the stock quickly and find a greater fool to buy it off you.

On Tesla:

Over the first quarter of 2018, Tesla has been an excellent example of a micro-bubble. Tesla’s current price is arguably fair if most cars are powered by electricity in 10 years, if most of these cars are made by Tesla, if Tesla can make those cars with sufficient margin and quality control and can service the cars properly, and if Tesla can raise additional capital sufficient to cover a $3 billion annual cash drain and another billion to service its debt. To us, that seems an unduly optimistic array of assumptions, especially given the magnitude of Tesla’s debt burden. Such an argument ignores the deep pockets of competitors and the common phenomenon of disruptors being themselves disrupted by newcomers.

On cryptocurrencies:

It boggles the imagination to hear people speaking of “investing” in bitcoin, an electronic entity that offers no hope of future operating profits or dividends, is little used as a surrogate for money in transactions (trading volume is well over 100 times as large as spending volume), offers an uncertain longer-term use case, and has no objective basis to determine fundamental value.

Will bitcoin and a handful of other cryptocurrencies settle in and become a stable store of value, akin to gold or sovereign currencies? Perhaps.

Those of us who are libertarians, wary of government control of the money supply, are rooting for that outcome.

That said, how many investors are holding cryptocurrencies for any purpose other than the expectation that someone else will pay a higher price at some point in the future?….

Even if we assume that bitcoin has merit as a libertarian alternative to government-sourced fiat currency, it’s hard to justify today’s 1,500 different cryptocurrencies. Many of these were launched with the singular goal of making the originator of the cryptocurrency wildly wealthy in an ICO (initial coin offering).

On the ‘costs’ and distortions of the crypto bubble:

The bitcoin bubble also serves as a wonderful example of how bubbles create harmful distortions in the real economy. The website Digiconomist estimates the run-rate annual electricity utilization of the bitcoin network at 56 billion kilowatt-hours. That’s more than enough to power all the households in Los Angeles for a year, and nearly enough to meet all of Israel’s power demands. Bitcoin already consumes about 0.25% of total global electricity consumption! All just to “produce” new coins on a nonphysical ledger and move these coins around on electronic exchanges….

From the footnotes: One aspect of bitcoin-related energy consumption that won’t disappear so easily is the residual carbon footprint left by bitcoin mining, which is currently dispensing as much CO2 a year as 1,000,000 transatlantic flights.

On the bubble in current technology stocks:

At the end of January 2018, the seven largest-cap stocks in the world were all tech fliers: Alphabet, Apple, Microsoft, Facebook, Amazon, Tencent, and Alibaba. Never before has any sector so dominated the global roster of largest market-cap companies. At the peak of the tech boom, four of the top seven companies by market cap were in the tech sector, and at the peak of the oil bubble, five of the top seven were in the energy sector. Only the Japanese stock market’s bubble at yearend 1989 has matched today’s tech sector dominance of the global market-capitalization league tables. Not only do we have the FANGs, we have FANG+ futures, affording investors a chance to buy the world’s trendiest tech stocks with almost no collateral, and the list is amended quarterly to make sure only the trendiest are on the list.

Yet, how shorting can be perilous:

During the three months August–October 2008, the Zimbabwean dollar plunged from 10 to 1000 per the US dollar, a 100-fold currency collapse. At first, the Zimbabwean stock market was unfazed, rising 500-fold in just eight weeks, while the currency fell 10-fold. Thus, in US dollar terms, the stock market rose an astounding 50-fold over those eight weeks. In the next two weeks, however, the stock market toppled 85% and the currency tumbled another 3-fold. Adjusted for the plummeting Zimbabwean currency, the nation’s stock market plunged 95% in two weeks.

There is really no cataylst that trigger a bubble collapse. I keep saying that to my students and clients:

The all-too-common question—“What’s the catalyst that will cause the market to turn, the bubble to burst?”—is simply a distraction because a catalyst is, by definition, a surprise to most of the market.

What, for example, was the proximate catalyst that ended the tech bubble in March 2000? We have yet to hear a persuasive answer. Yet, the quest for a catalyst is fun and potentially profitable; after all, a few people will identify the catalyst, if there is one, in advance.

You can see why I was very excited about reading this paper and very excited to share it here too. It is a treasure trove of common-sense, practical and valuable wisdom.

Many, many thanks to Rob Arnott and his co-authors.

The Fed and stock prices

On May 2 when the Federal Reserve concluded its two-day meeting, the Dow-Jones Industrial Average was around 24100 points. Some five weeks later, it is up 4%. The Federal Reserve Open Market Committee (FOMC) emphasised the symmetric nature of its inflation target. In plain English, it will overlook an overshoot of the inflation rate above 2% for some time. How much of an overshoot will be overlooked and for how long have been left undefined.

This was their reassurance to bubble-investors and speculators even as their research staff warned off elevated vulnerabilities in two areas: asset prices and non-financial sector leverage.

As long as the Federal Reserve is obsessed with asset prices when they are on their way down and indifferent to them when they are rising, long booms and short but severe busts will be the feature of financial capitalism. Peering long into the future, it may well be the deathknell of modern capitalism.

This may sound over the top or too prescient or too late. Take your pick.

On crypto currencies and the financial trilemma

(1) Robert Skidelsky has a good piece (ht: Rohit Rajendran) on why the crypto currencies will die a short death. He says that central bankers have done a better job with preserving the ‘store of value’ function of currencies and that past such experiments have failed. The article is inadequately critical of the job that central banks in advanced nations have done that has led to the emergence of crypto currencies.

(2) In the Asian Bureau of Financial and Economic Research (ABFER) conference in Singapore last week, I heard ‘financial trilemma’ mentioned more than once. I think it is flawed. It is a variant of the ‘Impossible Trinity’ that is associated with Fixed Exchange Rates. But, financial trilemma falls well short.

What is the ‘Financial Trilemma’?

The financial trilemma states that financial stability, financial integration and national financial policies are incompatible. Any two of the three objectives can be combined but not all three; one has to give. [Link]

It is flawed. There is no trilemma when there is global financial integration. In the presence of financial integration with the rest of the world, it is not possible to obtain both financial stability and national policies or even one of them. If there is a high degree of international financial integration, there is frequent financial instability and national polices are pegged to the anchor country.

One can have financial stability, national policy autonomy with financial fragmentation. With financial integration, both are impossible.