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.

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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.

Poetic justice?

From a recent Bloomberg report:

At 80 percent, the proportion of S&P 500 firms exceeding analyst estimates is higher than at any time in the past 25 years. Yet their stocks rose a paltry 0.3 percent on average in first-day reactions. [Link]

Two things to note here:

(1) Beating expectations is a con game. Sequential and annual improvements are the key.

(2) Stocks did not go down much (if at all) in 2014 and in 2015 when profits cratered.

So, this is nothing to wail about.

To be or not in the B-Index

It is difficult to keep up with Andy Mukherjee. At the rate at which he is writing, he might give Amol Agrawal of ‘Mostly Economics’ a complex with his prolificity of writing. In the last twenty-four hours alone, I have counted three Andy pieces – joining the Bond index, on the lone SELL rating on ICICI Bank and on Uber selling out to GRAB in SE Asia.

We shall focus on the column on China joining the Barclays-Bloomberg Bond index with India an onlooker. Andy thinks that India should be less fussy about foreigners holding its sovereign debt issued in Indian rupees. After all, the country runs a current account deficit and it can do with some foreign savings. Once you are in the index, index tracking funds will be invested, no matter what the fundamentals are. Of course, they can go underweight but they won’t sell and scoot fully. That is the sum and substance of his argument, if I understood them correctly.

I do not disagree with the logic. There is something to be said in its favour. Andy’s points are well made. But, on balance, I think India is not ready for it and I am not sure it will be ready in the very near future. India lacks the governance and discipline required for sustained macroeconomic stability. China can and will brazen it out. It is ‘Too big to fail’. India is not.

Whether most investors stay invested or not because of index tracking requirements, what matters to asset prices is the behaviour of the marginal investor.

Whether the debt held by foreigners is denominated in local currency or in foreign currency matters little in the end. If investors whose reference currency is not INR decide that they wish to get rid of INR risk, then the foreign exchange risk comes into play fully, regardless of the currency of denomination of the Indian debt.

India frequently gets into situations in which foreigners would want out. Despite its savings rate at a low 30%  (given its growth ambitions), India has not given up the ambition to become a high growth nation.  Governments feeling shaky politically – that may be a reality after 2019 elections – might want to go for high growth and do so via fiscal populism something that India did, not so long ago (2009 to 2011) and that is recipe for disaster for debt and for the currency because with a savings rate of 30% and low capital and labour productivity, high growth can come only via a ramp-up of aggregate demand and that would blow out the current account deficit.

The bond market – rational as they are with respect to emerging markets (only) – would administer tough love. Sometimes, it is too tough.

Bond markets are far more sanguine with respect to fiscal profligacy and debt accumulation by advanced nations. Indeed, over the last thirty five years, bond investors have rewarded advanced nations’ public debt accumulation with ever-lower interest rates. So much for market discipline!

Therefore, all told, if one is not sure of self-control and discipline and would likely binge, it is better not to look at the plate of delicious sweets.

So, India is better off not regretting missing out on the bond index membership.

The Thiruvadanthai trilemma

Although my friend Srinivas Thiruvadanthai did not mean to pose the question as such, I thought I would credit him with a ‘Trilemma’ that, I hope, will remain for posterity! His blog post triggered the following thoughts:

Another thoughtful and thought-provoking post as usual, Srini. The last paragraph of the post has been the rallying cry of BIS economists from White to Borio (including Cecchetti or not?).

I found the paragraph on the ‘ex-post criticism’ of the Fed not being easy enough in mid-2008 to be particularly insightful. Hindsight is a gift for critics that is denied to policymakers in real time!

The blog post can be considered a formulation of ‘Thiruvadanthai Trilemma’ between free-market finance, financial stability and economic stability. You can have two of the three but not all of them.

Notice that I have taken interest rates out of this trilemma. That is deliberate. In other words, the problem that there is no one single interest rate that stabilises the financial economy and the real economy at the same time disappears if (a) we remove the paradigm that ‘markets know best’ particularly for the financial sector and for financial markets (in a sense, I believe, the comments by Ms. Carolyn Sissoko reflect that) and if (b) the relevant horizon to evaluate the correctness of the monetary plolicy setting was long enough.

Let me take up my point (a) above. The question is whether regulating finance alone is both necessary and sufficient to enjoy both financial and economic stability at the same time. Yes, some would say.

That is what Ms. Caroline Sissoko has said in her coments on his post. But, is that really the case? We will never know because two things were at work in the post-Great Depression period and, in particular, in the post-WW II period. Economic growth was a low-hanging fruit. Therefore, it is possible that, regardless of how the financial sector or financial markets behaved, sustained high growth would have washed away all sins – with or without tight regulation. We will never know.

Therefore, it logically follows that in the era of slower growth that we face now, the case for financial sector and financial market regulation becomes stronger and not weaker.

Critics would object that this would further jeopardise the already lower growth. Well, the IMF has the answer. In a paper that is now a book, ‘Too much Finance’, the authors argue that financial development in advanced nations has already crossed the theshold at which it is beneficial for economic growth.

So, financial sector/financial market regulation will take care of the ‘Thiruvadanthai Trilemma’.

Fortifying that will be a monetary policy setting that chooses its relevant horizon more carefully than what central bankers have done in the last three+ decades. It should be longer than the business cycle so that it encompasses the financial cycle. I am merely paraphrasing the arguments made regularly by BIS economists. That is my point (b) above.

In a long enough time horizon, the dilemma, of fixing a high enough rate that handles financial market exuberance without hurting real economic activity or a low enough rate that allows financial intermediation to repair or to resume while the economy is overheating, solves itself.

In recent times, I beleive that the former dilemma has imposed much bigger long-run costs on the economy and on the society than the latter dilemma, in the above paragraph.

If unelected and technocratic policymakers optimise their decision over a reasonably long time frame, then the need for (or, the impossibility of) multiple policy rates is avoided or obviated.

If they cannot do that in practice that easily, then another approach is to have the domestic economy counterpart of ‘unremunerated reserve requirements’ that is applied to regulate capital flows. There can be a counter-cyclical credit surcharge (or discount) that the central bank, in its capacity as a banking regulator, prescribe for credit allocation, on the top of the policy rate. There can be times when this surcharge (negative or positive) can be zero. In that case, the policy rate works both for the financial economy and for the real economy. This can be on top of (and not in lieu of) countercyclical capital buffers that regulators now want to impose on banks.