The Daily Reckoning PRESENTS: Bennifer. Brangelina. TomKat. If the global asset boom were a celebrity marriage, what would we call it? Chimerican? Americhinan? Or how about…Japanica! Dan Denning looks at the events of the past week and aims to answer the question: is the whole current global asset boom model in jeopardy? Read on…
What’s with all the over-reaction? So a $130 billion was lost in China’s market the other day. It’s not like it was real money. The sympathetic corrections in other global markets were mostly occasions for profit taking by investors and traders nervous about eight months of good times. All those flashing lights and bells and whistles…those just mean we’re in a casino.
There are other explanations. But we’re not buying the theory that China’s crash indicates real concern about the sustainability of its boom. The China boom is happening in the real world. The China stock market boom is largely fictitious.
So is the whole current global asset boom model in jeopardy? No. There are three pillars to the global asset boom, Japan’s easy money, America’s free-spending ways, and China’s appetite for raw materials in order to make things. If this were a celebrity marriage (with a bride and two grooms, or two brides and a groom, or three brides, or three grooms) what would we call it…Chimerican? Americhinan? Or how about…Japanica!
Japanica it is, the new name for the wobbly, triumvirate/mascot for the global super asset bubble. And for the record, since we’re sure history is paying attention to every word we write, our bet is that this asset bubble has miles and miles to go before it sleeps. The unification of global stock exchanges looms in the not-too-distant future. This will facilitate even more rapid global capital flows…and bring even more investment products on-line for surplus savers, be they in Australia, China, or Amer…er…Japan.
Seriously, you can see where all this is headed, a super asset boom. And there’s a simple reason for it. The Boomer’s (or Japanese and Chinese savers) are not ready to leave the gambling table just yet. You, see, they can’t. They don’t have enough money to cash out their blue chips and call it a day. They are still making up for the tech wreck, and still wary of the durability of home price appreciation (and the liquidity in the housing market, which, at least in America, is dropping like a stone.)
Was this week a wake up call for investors that markets are still risky? Of course. But investors already they knew that. They love risk. More importantly, they can’t afford not to take it. Day by day, we are inching closer to the time when the Boomers will have to liquidate. But it’s not that time yet. So the money pours into the market, and the market itself, facilitated by the merger of exchanges, grows larger and ever more integrated.
You know what that means don’t you? The real liquidity crisis, when it comes (18-26 months down the road, we reckon) will be much larger, much more destructive, and impossible to contain. It will represent the end of the post-war, post-Bretton Woods experiment with asset inflation as a means to personal wealth-building. It will be nice to own some gold then, preferably a lot.
The incredible irony of what we’ve seen in the past few days is that most investors almost always do exactly the wrong thing, from a rational perspective, when confronted with “decisions under risk.” This shouldn’t be that surprising, though.
Human beings, under the duress of fast-moving global financial markets with dozens of virtually untrackable variables, are programmed by nature to do two things. First, they freeze, the way our ancestor used to do on African savannah’s thousands of years ago when they saw a big cat on the horizon. You can thank the amygdale, which takes control of the brain at these crucial times, pulling rank on the thoughtful frontal lobes that otherwise makes us distinct as primates.
This temporary coup-de-brain is nature’s way of by-passing the frontal lobes to arrest our action before we do something stupid like running for our lives and attracting a lot of attention from other predators. Panic does not promote survival. It’s this freeze in our musculature that gives us enough time to tense up our muscles and either fight, or flee.
The second thing human beings do when confronted with risk is seek the action which has the largest possible negative effect on them. Yes, you read that correctly. And here we apologize for getting a bit statistically geeky on you. But as this is The Daily Reckoning, we are pretty sure you won’t read this explanation for market behaviour anywhere else. From a novelty perspective at least, it should be worth your time.
The explanation takes us back to that crucially important year in financial history 1979. That was the year Daniel Khaneman and Amos Tversky published the second most cited economics article in academic history, “Prospect Theory: An Analysis of Decision Under Risk.”
The paper was a landmark in the understanding of human behavior because it pointed out the tawdry little lie at the heart of classical economic models about human behaviour, namely that people weigh risks with perfect information and then make rational decisions. Wrong! Homo economicus is a complete fiction.
What Khaneman and Tversky showed is that people make two kinds of decisions with respect to risk and reward, and that neither decision is rational. One the reward side, investors tend to overweight certain outcomes, choosing lower returns with higher probabilities over higher returns with lower probabilities. Or, in layman’s terms, most investors prefer the appearance of certain, predictable, single-digit returns from blue chip stocks or bonds than the higher but lower probability returns from say, small cap stocks or emerging market bonds.
That investors would over-weight outcomes that are considered certain isn’t that surprising. It suggests that capital preservation is psychologically (and financially) more important to investors, than capital growth. The difference today may be that investors-at least the retiring Boomers in the West who make up the bulk of the market-need big capital gains in the next few years to increase their retirement income. This may cause them to take more risk (to make up for past losses) than would ideally be appropriate at this stage in their investment career. But you go to war with the Army you’ve got, don’t you?
What’s really shocking from Kahneman and Tversky’s paper is how investors approach losses. And the conclusion is inescapable: investors seek it. Or, as the paper puts it, “This analysis suggests that a person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise. The well known observation that the tendency to bet on long shots increases in the course of the betting day provides some support for the hypothesis that a failure to adapt to losses or to attain an expected gain induces risk seeking.”
And here we thought investors were seeking alpha, and that global risk premiums were converging toward zero. But no! What you’re really seeing is more bets on long-shots. This is, in the paper’s own terms, a failure to adapt to the very risky world we invest in. But then again, investors are only people. And this means that in the coming years, we can expect investors not to avoid wealth-destroying beahviours and investment decisions, but to greedily seek them out.
Incidentally, Bill Bonner has a theory about this, which he hasn’t given an official name to. His theory is geopolitical, that it is the nature of large institutions (like empires) to find a way to destroy themselves, that they must do so. Surpluses of any sort (financial, political, caloric) are un-natural. Human beings, as every good student of Greek and financial tragedies knows, find spectacular ways to squander their good fortune.
Tversky and Khaneman show that faced with a choice between a low-probability but high-magnitude loss on the one hand, and higher-probability but lower magnitude loss on the other hand, human beings tend to choose the higher magnitude loss with the lower probability. Or, in layman’s terms, that means if you were faced with the choice of a certain loss of $20 or the 30 percent probability of losing $60, you, if you were like most of the other featherless bipeds on the planet, would choose the 30 percent probability of losing $60.
It does make sense with a weird kind of emotional logic. Faced with the certain loss of $20 or the possible loss (one chance in three) of losing three times as much, investors take the lower probability, higher magnitude event.
But when you apply this statistical, empirical, and psychological finding to the markets-and here we mean equity markets writ large on a global scale, reacting to one another in real-time-the result is stunning. It means you can expect to see people engage in riskier and riskier behaviour, nearly always choosing bigger losses over smaller losses.
“But wait!,” you shout. “You’re forgetting about probabilities. Why choose a certain loss over a probably loss?
Good question. But perhaps our notion of probable losses is wrong as well. Investors are operating under the assumption that larger losses in today’s markets are lower probability events. There is also a wide-spread believe that the larger the markets get and more integrated they become, the lower probability of really gut-wrenching losses. The problem with this academic theory is that it is exactly, emphatically, categorically, wrong.
The theory we refer to is that market crashes are statistically rare and can be modeled on a bell curve, with a standard distribution of price movements. Most movements, in a classic bell curve, would be within one or two standard deviations of the mean. Or, in stock market terms, there would be only a few instances when the market produced dramatically above average or below average returns. Most returns would be rather mundane, and rather predictable. There would be few crashes and fewer still triple digit gains. But the evidence suggests otherwise.
“From 1916 to 2003,” Benoit Madelbrot writes in The Misbehaviour of Markets, “the daily index movements of the Dow Jones Industrial Average do not spread out on graph paper like a simple bell curve. The far edges flare too high: too many big changes. Theory suggests over that time, there should be fifty-eight days when the Dow moved more than 3.4 percent; in fact, there were 1,001. Theory predicts six days of index swings beyond 4.5 percent; in fact there were 366. And index swings of more than 7 percent should come once every 300,000 years; in fat, the twentieth century saw forty-eight such days. Truly, a calamitous era that insists on flaunting all predictions. Or, perhaps, our assumptions are wrong.”
And what about this new era, dear reader? When you combine Mandelbrot’s observation with Kahneman and Tversky, you get a picture of increased volatility and risk-seeking behavior. People, faced with more to lose, risk ever more.
The only question now is how large the stakes will get. And our observation on that is that the global equity and asset pot has room to grow. Volatility has been ominously quiet the last few years. It may have returned this week through the backdoor in Shanghai. But don’t expect it to make investors more conservative and trigger a rally in fixed income and bonds.
Rather, we may be seeing a whole new level of global speculation, an order of magnitude larger than anything that came before it. This game, the world series of speculation, is the end-game of the experiment with fiat money, money not backed by a real asset. But it would be a mistake, we think, to imagine that the end-game is now.
The tragedy/comedy has at least one more act and a few years to go. And in that time, we recommend you pull up a chair, pop some corn (if you can afford it at today’s prices), and enjoy the spectacle.
for The Daily Reckoning
March 1, 2007
P.S. We do, however, advise against over-weighting expected certain outcomes…that stock prices always go up, that sovereign governments don’t default on their debt…and that investing for the long-term is your best bet.
Just what is your best bet? Cash in while you can, perhaps. Peace of mind makes being a spectator more pleasurable. But, if you’re in the markets, or must be in, our focus will continue to be on the higher-magnitude returns that are priced as if they have lower probabilities.
Or, of course…you could always buy gold.
Yesterday evening, we sat on the edge of our seats.
What was going on? We tried to explain it over dinner to two teenagers:
“It could be the beginning of the end. Central banks and the financial industry have made money very easy to get. People took the money, and naturally, they spent it; they invested it.
“But sooner or later, the lenders will want it back. When that happens, the borrowers will have to scrape around…you know, looking under seat cushions and selling stuff on eBay…to get the cash. And when everyone is trying to raise cash – by selling things – the things they are selling will go down in price, because there are so many of them for sale.
“This makes it harder for the people who are trying pay off their loans to get the money they need. Some of them won’t be able to, so the loans themselves will go bad; they’ll become worthless because they will never be repaid. And so, the lenders themselves will be hurting, because they won’t be getting the money they lent out back. It’s been spent. Or it’s been poorly invested.
“The whole thing gets to be a big mess…because people discover that they don’t have as much money as they thought they did.”
We interrupt the dinner-table conversation with a little more precision. You might have found Tuesday’s worldwide stock market slump shocking or unnerving. But you shouldn’t have found it surprising. There are some threats to your money that are unpredictable – wars, natural disasters, thefts. But there are other menaces that are inevitable, and the inevitable result of a big bubble is a big pop.
Anyone who says he was ‘surprised’ by the big drop in stock prices just wasn’t paying attention.
When was the last bubble that didn’t pop? Never. It has never existed. All bubbles pop. All living things die. All paper currencies become worthless. All empires are destroyed. All politicians lie.
But let us pull away from these eternal verities and look at what has been going on recently. The quantity of money is increasing at a rapid pace. Just this week we discovered that the euro money supply is now going up at its fastest rate in 17 years – nearly 10% per annum. Dollars are increasing at about the same rate. And in India, the money supply is going up at a 21% rate. And yuan? We don’t know, but we bet it would take our breath away.
Why so much money? Because we are in the bubble phase of a credit expansion. And one of the highlights of this period is that the Bank of Japan will lend money at less than 1%. This tempts speculators to enter the ‘carry trade,’ in which yen are borrowed…carried over to dollars or other currencies…and invested in higher-yielding assets.
Anyone with any sense could see that all this fresh and eager money was going to get a lot of people in trouble. And anyone who bothered to read the headlines could see the trouble coming in fast.
Just a couple of days ago, even our erstwhile Fed head, Alan Greenspan himself, warned that the nation could be in recession by the end of the year. Why? Because the housing market was going soft.
Manufacturing is already in recession. Housing looks like it is headed for recession too. January new house sales, for example, were down 16.6% – the sharpest decline in 13 years. Subprime lenders are going broke. And the LA Times says, ‘Mortgage Delinquencies [still] Rising.’
And now the central banks are threatening to pull the plug on this tub of liquidity.
“There is a bubble going on. Investors should be concerned about the risks,” said Cheng Siwei, vice-chairman of China’s National People’s Congress in a January 30th interview with the Financial Times. “But in a bull market, people will invest relatively irrationally. Every investor thinks they can win. But many will end up losing. But that is their risk and their choice,” Cheng warned.
The Bank of Japan warned speculators, too, that they had better watch out. It doubled its puny overnight rates. The Swiss National Bank offered the same warnings: Borrowing was easy, it said; but paying back may not be so easy. The European Central Bank raised rates and said it would raise them again.
If we’re right about things, speculators should be looking to the price of yen like the passengers on the Titanic looking for lifeboats. They borrowed yen. Now they must pay back yen. As they grow worried, we’d expect the price of yen to rise…because they must buy yen in order to pay back their loans. That is exactly what is happening…perhaps only slightly and furtively so far. And that is why we continue to think that yen-based investments will prove surprisingly strong as the credit bubble deflates.
But we are still watching and waiting. Today, the Dow bounced…a modest 50 points. Emerging markets were mixed. The yen rose. If this is not just a pop…but The Pop…we’ll see more speculators run for cover in the days ahead…and the yen will rise.
“But Dad,” said Henry, “if you’re right, there’s a big mess coming and people are going to lose a lot of money. But if people knew there was big mess coming, they’d sell their investments, right?
“But the price of investments hasn’t gone down. So most people must not think you are right. They think you are wrong. So they’re not selling. They’re buying. And if they think you are wrong…and if they are buying…won’t investments continue to go up…?”
“Yes…as long as the money keeps flowing. But there always comes a time when the money gets pinched…or investors get nervous…or the stars enter a new phase – we don’t know exactly what triggers a sell off. But when it comes…you want to be sure you sold off before everyone else.”
Chris Gaffney, reporting from the EverBank world currency trading desk in St. Louis…
“These deficits are going to jump up and bite us, and soon! When they do, we won’t be able to say we weren’t warned. But without pressure from we the people, do you think Congress is actually going to do anything about them? What is wrong with us?”
For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig
And more views…
*** Oh woe…today we had to leave our beach shack and head back to the real world of meetings, deadlines and term papers. Sob…sob…
We were just getting into a nice routine.
We would wake up at 6AM…open up the shutters and watch the sun rise across the bay. Then, down to the sand for a walk along the beach…followed by a quick swim in the ocean. By then, our Nicaraguan cook had the breakfast on the table. We could never decide whether to have a North American-style breakfast or to go local with a native desayuno. So, we ended up with both – an elaborate morning meal with pancakes, bacon, eggs, fruit, beans, rice, tortillas and a few other things we could never identify.
After breakfast, the boys would go surfing while we took out our laptop to write to you, dear reader, and answer our mail. We kept at it until noon, when it was time for lunch. Again, we were so well looked after by our cook that all we could do in the afternoon was lie around, reading…often dozing off in the heat of the day.
Our reading was a book of classical sources on the life of Caesar, including Caesar himself. Battles, blood feuds, civil wars, murders…you have to like Julius. At a tender age he was captured by pirates, who held him for ransom. When the pirates told him they wanted 25 talents to let him go, Caesar replied that they didn’t know what a prize they had…they should ask for 50 talents.
He added that after he was ransomed he would catch them all and have them crucified. The pirates laughed. They thought it was a joke. But no sooner was the ransom money paid and the future emperor liberated than he put together a naval force to chase down the pirates. When he had them he followed through on his promise – he crucified them. But Suetonius tells us that he was such a nice guy, he had them strangled first.
“It’s too bad our president does not read the classics,” we said to our self many times.
Americans celebrated the 275th birthday of George Washington, last week. President George W. Bush compared the War on Terror to the American Revolution: “General Washington understood that the Revolutionary War was a test of wills, and his will was unbreakable.”
We have thought about it for hours…straining to find a single way in which the American Revolution is similar to the War on Terror. Finally we had to give up.
Roman history, on the other hand, is full of useful tips and insights for emperors. Caesar’s account of how he subdued the insurgents in Gaul, for example, is genuinely entertaining and helpful. It took 10 years of war…in which Caesar’s forces took 800 towns by armed force, conquered 300 tribes, fought 3,000,000 enemies in different battles – he killed 1 million and took another million prisoner.
Whenever danger threatened, Caesar himself was in the heat of the action…rushing to support on garrisons, encouraging defenders on another, besieging a fortress here, breaking a siege there. Caesar kept at it until he was able to return home in triumph… ‘Mission Accomplished,’ he said. And then, he set himself up as a tyrant…an emperor…a dictator – and after dodging the spears of 3 million enemies, he was finally cut down only a year after coming back to Rome…by his own people, one of whom was said to be his own son.
Good reading for a beach vacation.
By 4 PM the sun was well past its peak. We all went back to the beach for more splashing in the waves…walks along the rocks…laying on the sand…followed by drinks, dinner, and not long after, bed.