Fed Flounders as U.S. Dollar Drowns
Exiled from home and hearth, your poor editor lodges in one of the most expensive cities on earth. But what’s this? It’s getting even more expensive! Last night, he took his son out for dinner at a cheap Italian place under the railroad tracks. The bill came to $66 – and we didn’t even have dessert.
“Dollar, in a tailspin, reaches a new low,” reports the International Herald Tribune. Meanwhile, the Dow lost 148 points.
Yesterday, the buck again hit a 26-year low against the pound…and an all-time low against the euro. It now costs $1.37 to buy a euro.
American tourists beware! Be sure to refinance your home before coming to Europe for a vacation.
“The dollar is a basket case,” the paper quotes our friend Peter Schiff. “We are going to pay the piper for years…”
Three years or so ago, we suggested that the dollar would go to $1.50 per euro. The buck promptly went up – making a fool of us. But even the world’s luckiest currency cannot escape the fundamental laws of economics forever. Now it is being hauled before the court and, like a Chinese official, given a harsh sentence.
All the world now works on a paper money system…and all central banks try to debase their currencies to keep up with the dollar. But no major nation has the bad rap of the U.S. monetary brand. The papers tell us that investors are “worried about America’s sub-prime crisis.” But that is only a small part of the story.
Yesterday, Fed chief Bernanke appeared before the people’s representatives and pulled a Greenspan. That is, he spoke in gobbledygook rather than plain English. Americans have “less erratic expectations” for inflation, he said.
Interest rates have not been raised because…”although inflation expectations seem much better anchored today than they were a few decades ago, they appear to remain imperfectly anchored.”
What was that about? Here we offer a translation:
“Yes, I’d like to raise rates to fight inflation and protect the dollar…but I’m like spooked about this subprime mess.”
Hearing this, investors realized that the greenback would get no support from the Fed. And then they got news that China’s trade surplus hit a new record in June – $26.9 billion, half of it coming from the land of the dollar. This number was 87% higher than a year ago…and considerably higher than experts had predicted.
The dollar seems to want to sink with the yen to the bottom of the global currency pool. Japan’s central bankers, like our own Mr. Bernanke, are terrified of recession. Japan is an exporting nation, as is China. A rising yen would make Japanese products more expensive…and possibly doom the economy’s fragile recovery. In Tokyo, as in Washington, financial authorities are desperate to avoid a slump – and ready to sacrifice their currencies to avoid it.
Beyond that, the similarities end. Japan’s economy enjoys a very healthy trade surplus. It has huge foreign currency reserves. Japan is a nation of savers, with an economy that is fundamentally healthy…and coming off a 17-year funk.
America, on the other hand, has the world’s biggest trade deficit, the world’s largest debt, a tiny savings rate, and a boom/bubble economy that is now 25 years old.
And yesterday, when the dollar went down, the yen rose.
What can the dollar do now, but go down gracefully? U.S. assets are already cheap compared to overseas prices. But they are probably going to become cheaper. This will permit foreigners not only to see more of the USA but to own more of it too.
As always, Mr. Market may have plans of his own which he has not shared with us…and it’s no wonder that these recent developments have many market players in a tizzy. But even with all of this noise in the market, some investors have made a pretty penny – take Steve Sarnoff’s Options Hotline subscribers, for instance.
Yesterday, his Intel recommendation hit a high of 108%, his seventh money-doubling opportunity of the year. Over 18 trades, his average is 84%.
Although this service is not for the faint of heart…odds are in your favor that you will make some pretty major profits with Options Hotline – and if you sign up for Options Hotline in the next four days, you can get in before his next recommendation…and take advantage of this offer: if at least 12 of his recommendations don’t gain 100% or more in your first year, we’ll refund your entire subscription cost. No questions asked. Just get in by Sunday, July 15.
The Daily Reckoning
Wednesday, July 11, 2007
Addison Wiggin, reporting from Baltimore…
“Let’s unpack Bernanke’s comments a little: ‘Inflation today isn’t as bad the ’70s, but it’s not perfect either. Today, public fear of rising prices is causing inflation of the money supply. That makes it harder for me and my friends to control prices and the economy.’
“We’ve already seen record high fuel and food prices this year. But why should that bother anyone? For now, Bernanke and company are sticking to the ‘close your eyes and picture lower inflation’ technique.”
For more on this story, and for more market insights, see today’s issue of The 5 Min. Forecast
And more views…
*** The U.S. housing slump is not likely to end any time soon. Unlike stocks or bonds, houses do not get “marked to market” overnight. Owners drag their feet. They look for other solutions. They reject good offers, hoping prices will go back up.
So, a correction in housing takes time.
Why? Because, among other things, resetting ARMs higher takes time. Some monthly payments will go up by more than 35%. There are two million mortgages to be adjusted upward in the next few months, according to CNN and a total of $50 billion worth of ARMs scheduled for reset in October alone.
It was two years ago that the quality of mortgage credit began to go down sharply. Lenders had made a lot of money on mortgage contracts; they didn’t want to slack off just because the pool of credit-worthy buyers was drying up. Instead, they lent to increasingly wobbly borrowers. Now, those teaser-rate loans are being reset. A typical monthly mortgage payment might be $955, says CNN; soon, it will be $1,331.
How many of these marginal borrowers have an extra $400 to spend per month? We don’t know, but we think we’re going to find out.
Moody’s and S&P are downgrading subprime-backed securities. Junk rated loans, not necessarily associated with subprime, fell to their lowest prices in four years. But the whole credit structure is getting a little fidgety. And look out central Florida and Las Vegas – two areas where subprime lending ran wild in ’05 and ’06.
Clearly, investors have every right to be concerned about the subprime debacle – but the smart ones will do something to protect their portfolio – will you?
*** Oil is selling at $72 a barrel.
Our friend James Ferguson believes that one of the best ways to get rich now is to do what Jean Paul Getty did in the 1930’s – buy oil in the ground. The basic idea is that oil has become a lot more expensive than it was in the Clinton years – nearly seven times more expensive. But the price you pay for a major oil company stock may not be seven times higher. Some large, high-yielding, blue chip stocks are actually trading below where they were seven years ago, says James, “even when some of them have more than doubled earnings since then.”
Royal Dutch Shell is currently trading around $40 a share. If you bought the whole thing, plus net debt, it would cost you about $287 billion. But the “downstream” business of Shell – refining, marketing, transporting, power, etc. – is worth about $174 billion according to Morgan Stanley. That means that the rest of the business – the oil in the ground – is worth $113 billion. Let’s see, the company has proven reserves of 11.8 billion barrels. That’s $9.58 each. And with oil at $70 above ground, these reserves are worth a lot of money.
But keep in mind that there are rules for reporting “reserves.” The SEC tells Shell what it can call a proven reserve and what it can’t. It also has “2P” and “3P” reserves – probable and possible. Altogether, it could have 30 billion barrels of 1P, 2P and 3P oil. That works out to $3.76 a barrel. And Shell’s private estimates of what it owns is even more optimistic – it believes it has proven, probable and possible reserves of 60 billion barrels. At today’s share price, they’re available now…at less than $2 a barrel.
If J. Paul Getty were alive today, says James, he’d be buying.
*** “Live Earth,” a series of eight simultaneous concerts worldwide developed by Al Gore and meant to raise awareness about global warming, proved a bit of a flop. More than 100 artists performed in the trendy extravaganza on Saturday in New Jersey; London; Johannesburg, South Africa; Rio de Janeiro, Brazil; Tokyo; Sydney; Shanghai, China; and Hamburg, Germany, but it turned out that TV audiences, especially, were more interested in Princess Di and Harry Potter than in global meltdown.
It snowed in Buenos Aires yesterday. Argentina is having its coldest winter in 89 years. And here in London, we could use a little more carbon in the air, too. It is cold again…after only two days of real summer, it feels like November.
The Daily Reckoning PRESENTS: When is luck not really luck at all? Is anything in this world truly random? Nassim Nicholas Taleb examines these questions and more…Read on…
IT’S NOT SUCH A SMALL WORLD AFTER ALL
You get an anonymous letter on January 2nd informing you that the market will go up during the month. It proves to be true, but you disregard it, owing to the well-known January effect (stocks have gone up historically during January). Then you receive another one on Feb 1st telling you that the market will go down. Again, it proves to be true. Then you get another letter on March 1st – same story. By July you are intrigued by the prescience of the anonymous person and you are asked to invest in a special offshore fund. You pour all your savings into it. Two months later, your money is gone. You go spill your tears on your neighbor’s shoulder and he tells you that he remembers that he received two such mysterious letters. But the mailings stopped at the second letter. He recalls that the first one was correct in its prediction, the other incorrect.
What happened? The trick is as follows. The con-operator pulls 10,000 names out of a phone book. He mails a bullish letter to one half of the sample, and a bearish one to the other half. The following month he selects the names of the persons to whom he mailed the letter whose prediction turned out to be right, that is, 5,000 names. The next month he does the same with the remaining 2,500 names, until the list narrows down to 500 people. Of these there will be 200 victims. An investment in a few thousand dollars worth of postage stamps will turn into several million.
It is not uncommon for someone watching a tennis game on television to be bombarded by advertisements for funds that did (until that minute) outperform others by some percentage over some period. But, again, why would anybody advertise if he didn’t happen to outperform the market? There is a high probability of the investment coming to you if its success is caused entirely by randomness. This phenomenon is what economists and insurance people call adverse selection. Judging an investment that comes to you requires more stringent standards than judging an investment you seek, owing to such selection bias. For example, by going to a cohort composed of 10,000 managers, I have 2/100 chances of finding a spurious survivor. By staying home and answering my doorbell, the chance of the soliciting party being a spurious survivor is closer to 100%.
The same logic that applies to the spurious survivor, also applies to the skilled person who has the odds markedly stacked in her favor, but who still ends up going to the cemetery. This effect is the exact opposite to the survivorship bias. Consider that all one needs is two bad years in the investment industry to terminate a risk-taking career and that, even with great odds in one’s favor, such an outcome is very possible. What do people do to survive? They maximize their odds of staying in the game by taking black-swan risks; those that fare well most of the time, but incur a risk of blowing up.
The most intuitive way to describe the data mining problem to a non-statistician is through what is called the birthday paradox, though it is not really a paradox, simply a perceptional oddity. If you meet someone randomly, there is a one in 365.25 chance of your sharing their birthday, and a considerably smaller one of having the exact birthday of the same year. So, sharing the same birthday would be a coincidental event that you would discuss at the dinner table. Now let us look at a situation where there are 23 people in a room. What is the chance of there being two people with the same birthday? About 50%. For we are not specifying which people need to share a birthday, any pair works.
A similar misconception of probabilities arises from the random encounters one may have with relatives or friends in highly unexpected places. “It’s a small world!” is often uttered with surprise. But these are not improbable occurrences – the world is much larger than we think. It is just that we are not truly testing for the odds of having an encounter with one specific person, in a specific location at a specific time. Rather, we are simply testing for any encounter, with any person we have ever met in the past, and in any place we will visit during the period concerned. The probability of the latter is considerably higher, perhaps several thousand times the magnitude of the former.
When the statistician looks at the data to test a given relationship, say to ferret out the correlation between the occurrence of a given event, like a political announcement, and stock market volatility, odds are that the results can be taken seriously. But when one throws the computer at data, looking for just about any relationship, it is certain that a spurious connection will emerge, such as the fate of the stock market being linked to the length of women’s skirts. And just like the birthday coincidences, it will amaze people.
What is your probability of winning the New Jersey lottery twice? One in 17 trillion. Yet it happened to Evelyn Adams, whom the reader might guess should feel particularly chosen by destiny. Using the method we developed above, researchers Percy Diaconis and Frederick Mosteller estimated at 30 to 1 the probability that someone, somewhere, in a totally unspecified way, gets so lucky!
Some people carry their data mining activities into theology – after all, ancient Mediterraneans used to read potent messages in the entrails of birds. Michael Drosnin provides an interesting extension of data mining into biblical exegesis in The Bible Code. Drosnin, a former journalist (seemingly innocent of any training in statistics), aided by the works of a “mathematician,” helped “predict” the former Israeli Prime Minister Yitzhak Rabin’s assassination by deciphering a bible code. He informed Rabin, who obviously did not take it too seriously. The Bible Code finds statistical irregularities in the Bible; these help predict some such events. Needless to say, the book sold well enough to warrant a sequel predicting with hindsight even more such events.
The same mechanism is behind the formation of conspiracy theories. Like The Bible Code, they can seem perfect in their logic and can cause otherwise intelligent people to fall for them. I can create a conspiracy theory by downloading hundreds of paintings from an artist or group of artists and finding a constant among all those paintings (among the hundreds of thousand of traits). I would then concoct a conspiratorial theory around a secret message shared by these paintings. This is seemingly what the author of the bestselling The Da Vinci Code did.
My favorite time is spent in bookstores, where I aimlessly move from book to book in an attempt to make a decision as to whether to invest the time in reading it. My buying is frequently made on impulse, based on superficial, but suggestive clues. Frequently, I have nothing but a book jacket as appendage to my decision making. Jackets often contain praise by someone, famous or not, or excerpts from a book review. Good praise by a famous and respected person or a well-known magazine would sway me into buying the book.
What is the problem? I tend to confuse a book review, which is supposed to be an assessment of the quality of the book, with the best book reviews, marred with the same survivorship biases. I mistake the distribution of the maximum of a variable with that of the variable itself. The publisher will never put on the jacket of the book anything but the best praise. Some authors go even a step beyond, taking a tepid or even unfavorable book review and selecting words in it that appear to praise the book. One such example came from one Paul Wilmott (an English financial mathematician of rare brilliance and irreverence) who managed to announce that I gave him his “first bad review,” yet used excerpts from it as praise on the book jacket (we later became friends, which allowed me to extract an endorsement from him for my book).
The first time I was fooled by this bias was upon buying, when I was 16, Manhattan Transfer, a book by John Dos Passos, the American writer, based on praise on the jacket by the French writer and “philosopher” Jean-Paul Sartre, who claimed something to the effect that Dos Passos was the greatest writer of our time. This simple remark, possibly blurted out in a state of intoxication or extreme enthusiasm, caused Dos Passos to become required reading in European intellectual circles, as Sartre’s remark was mistaken for a consensus estimate of the quality of Dos Passos rather than what it was, the best remark. (In spite of such interest in his work, Dos Passos has reverted to obscurity.)
I am frequently asked the question: When is it truly not luck? There are professions in randomness for which performance is low in luck: Like casinos, which manage to tame randomness. In finance? Perhaps. All traders are not speculative traders: There exists a segment called market makers whose job is to derive, like bookmakers, or even like store owners, an income against a transaction. If they speculate, their dependence on the risks of such speculation remains too small compared to their overall volume. They buy at a price and sell to the public at a more favorable one, performing large numbers of transactions. Such income provides them some insulation from randomness. Such category includes floor traders on the exchanges, bank traders who “trade against order flow,” moneychangers in the souks of the Levant. The skills involved are sometimes rare to find: Fast thinking, alertness, a high level of energy, an ability to guess from the voice of the seller her level of nervousness; those who have them make a long career (that is, perhaps a decade). They never make it big, as their income is constrained by the number of customers, but they do well probabilistically. They are, in a way, the dentists of the profession.
Nassim Nicholas Taleb
for The Daily Reckoning
July 11, 2007
Editor’s Note: You can hear Mr. Taleb (along with all of your favorite DR editors) speak at this year’s Agora Financial Investment Symposium in Vancouver, British Columbia. This year’s theme is “Rim of Fire: Crisis & Opportunity in the New Asian Era” – and it’s your first look at investment opportunities, global market concerns, and the best investment bets across the globe.
Nassim Nicholas Taleb is an essayist principally concerned with the problems of uncertainty and knowledge. Taleb’s interests lie at the intersection of philosophy, mathematics, finance, literature and cognitive science, but he has stayed extremely close to the ground, thanks to an uninterrupted two-decade career as a mathematical trader. Specializing in the risks of unpredicted rare events (“black swans”), he held senior trading positions in New York and London, before founding Empirica LLC, a trading firm and risk research laboratory.
The above essay was taken from his book, Fooled by Randomness. His latest, highly acclaimed book, The Black Swan: The Impact of the Highly Improbable, was released in April of this year. Purchase your copy by clicking on this link: