The Black Swan is a highly unlikely but catastrophic event. Assume you are a pig and for one thousand days a human fed and took care of you. You could conclude based on past events that this trend will continue and you do not see anything that could point to a change in the trend. Each day you are given the same amount of food and bathed at exactly the same time. Same food, same time, trendline is the same. Based on past events, there is no reason to forcast a drastic change. But on the 1001 day, something drastic happen. You ended up as a roast pig on someone's wedding dinner.
In investment, we follow the same thinking as the unfortunate pig. We try to use past events to predict the future. Black Swan events can occur swiftly, with no notice and with everyone taken by surprised. All financial crisises are surprises. If they were not unexpected, they would not have been a crisis as everyone would have taken precautions and hedge their investments. But Black Swans events are not totally invisible. The signs are there but we do not see it.It is how we think that makes Black Swans invisible.
Most people would like to believe that they are thinkers but very few actually think. Consider this puzzle:
You are in a room with two doors. Behind one door is a lion that will eat you .In the room are two men who know which is the safe door. One of the two men always tells the truth and the other always tells lies. If you can ask ONLY ONE of the two men , ONE question, what would you ask to choose the correct door. This is not a trick question like asking the men to follow you and so he will be forced to tell the truth. It is a pure logic puzzle.
We don't think because it is hard work. Try and get the answer to the above puzzle and time how long it takes for you to give up! 5 minutes is about the average time someone spends trying to solve the above before he gives up. Let me assure there is an answer and it is no trick so try hard, real hard.
Thinking is never done in isolation. It is surrounded by events. The events cloud and prejudice our thinking. high end condominiums are now selling for S$4,000 psf. It is hard to imagine that very same condo selling for $1,000 psf. A few years ago, we woudl be crazy to think prices would be $4000 psf and $1000 psf is deemed a high price. So why could the same condo that suddenly shot up to $4000 psf not drop to $1000 psf? List down the logical reasons such as construction costs, income earned, supply and demand and so forth.
Is making money so easy these days? If you are a businessman, a restaurant owner, a retail shop owner, you will know that competition is tough and huge profits are not easy toc ome by. Of course there is the occasional Bill Gates who made billions but even Bill Gates's wealth compared to the TOTAL WEALTH in the world is small. Are thousands making easy money as implied by the story of someone who paid $31 million for a penthouse? Our thinking is heavily influenced by narratives and not statistics. We don't know the statistics behind these purchases. Did the buyer paid cash or he took a loan?
True wealth is when a person buys with cash. Virtual wealth is when he takes a loan to buy. If I paid a $1 million in deposit and borrowed $9 million, suddenly $9m is released to the seller. The seller may take that $9 million and splurge creating a wealth effect but someone actually owes a bank that same amount of money. We are spending what someone has borrowed. The total amount of sub prime mortgages outstanding in USA is US$1.5 trillion or US$1,500 billion or US$1,5 million million. Assuming a super airport costs US$1.5 billion to build, that is 1,000 new super airports! 75,000 people earning US$1 million a year will take 20 years to pay off that amount assuming every cent they earn goes to the payment of the debt.
This is just the amount ONE sector of the world is borrowing. We are just talking about sub prime mortgages in USA. What about sub prime mortgages in UK and Europe? Huge mergers and acquisitions requires billions. In 1998 Daimler Benz paid US$36 billion to "merge" with Chrysler. Daimler is selling away its Chrysler investment at a fraction of what it paid to a private equity firm Cerberus Capital Management. In 2000, America Online paid US$182 billion in stock and debt to acquire Time Warner. M&A oftens ends up in negative territory for the combined entity.
Facts can be very misleading. In one financial report, it says that global M &A will reach an all time high in 2007. Last year it totalled a massive US$2.9 TRILLION. But the report went on to say that this M &A is healthy because companies are using cash instead of shares to finance the deals. But is it cash from profits earned and hoarded or cash from borrowings. It goes on to say that Leveraged Buyout Firms using borrowings have US$1.4 TRILLION of buying power. If we add M&A borrowings to sub-prime borrowings, we reach the US$2 TRILLION mark. That is US$ 2 TRILLION of BORROWED MONEY.
No one really knows how much is the Carry Trade borrowing where investors borrow low yen at low interest rate to invest. Maybe it is another US$1 Trillion. What about Hedge Funds that use leverage to enhance yields. We can see that total global borrowings can easily reach a massive US$5 TRILLION dollars. In 2003, the market capitalisation of the US market is US$14 trillion. With estinated borrowings at 35% of total US market capitalisation, one can say the mother of all bubbles is in the works.
With stock markets at record levels, the lessons of the past are forgotten or explained away. The Asian Financial Crisis will not happen as Asian countries have huge savings. But who is talking about an Asian Crisis? What if there is a USA Financial Crisis and Asian countries find that their investment in US Treasuries is now a small fraction of their value due to the exchange rate between the USD and their own currencies. If we had asked Mr Pig whether he could end up as a roast pig, he would give a dozen reasons why that was an impossible event. It seems the same emotions are expressed when I asked if the US dollar could devalue by 50% or more! Impossible ! No way! Can never happen! Central Banks the world over will never let it happen! Really? The sinking of the Titanic is a Black Swan event. The coming financial crisis is a Black Swan event. Watch out!
