The Black Swan Egg

24 Jan 2008

In my earlier posting, I wrote about the Black Swan which is a super catastrophic event. In this instance, the event is the financial market. The sub-prime mortgage problem is like the Black Swan being pregnant while the market upheavals in the past week shows that the Black Swan has laid an egg! When this egg will mature into an adult Black Swan nobody knows.

The sudden drop and the equally dramatic bounce of the stock market world wide reveals two things. First there is nervousness and investors are looking at the slightest opportunity to sell. Second the world acts fast and nervousness spreads from US to the rest of the world pretty fast. The professional investors often need to stay invested .Perhaps they were the ones who sold off fast when prices are high and they are the first ones to buy back when prices are low. For the professional investors or traders, a fortune is made from selling and buying all within two days.

Professional investors act like a herd. This groupie thinking is what allows them to win over the retail investors. When they start selling, prices were high and because of their selling , prices start to drop. The retail investors start to panic and sell their shares which triggers even further drops in the share price. Prices can go almost into a free fall such as the Hong Kong market which dropped 9% in one day.

When prices are low, the pros start to buy and prices started to rise. Retail investors pick up the scent and followed suit. The suckers are the retail investors who sell low and buy high as compared to the professional investors.

Thus the recent stock market gyrations smacked of manipulation, not a pre-planned strategy but one that uses group thinking among professional investors. They can all smell the same thing. All the pros are waiting for is someone to trigger the selling in a big way and soon the herd follow suit creating a global crisis.

You can fool somebody some of the time but not everybody all the time. There will come a time when the professional investors and traders will be caught on the wrong foot. When they start to buy, the retail investors will not follow them leaving them with the baby in the same way as the banks were caught in thier own sub orime mortgage scheme! This tend will be the start of a long bear market!

But as I said the Black Swan has not arrived. It has arrived in the form of an egg. This egg has not hatched but is a matter of time before it hatches. This year will see more of such volatility ie when the egg hatch, when the Black Swan start walking then talk and when it reaches its teenage years.

The size of the US deficit is growing, like the Black Swan. It is a matter of time when the deficit will reach a level where no interest rates cuts, no increase in liquidity can save the lack of confidence in the US dollar. Notice that after the interest rates cuts, gold move up to US$900?
This is a sign that some investors are moving out of paper currencies into gold.

The US dollar now faces a depreciation problem. Who will want to put money in US dollar deposits when Euro deposits gives a higher interest rates with the added advantage of further appreciation against the US dollar? Initially, the US dollar depreciation will stimulate the markets and all appear to be well. But remember the US budget deficit and trade deficit needs billions to support its voracious appetite.What if it cannot find enough international borrowers to finance its deficits? Central banks will have to move in to buy US dollars until they reach a threshold of pain.

When it becomes obvious to the general population that the US dollar is a sinking ship, Governments will find it politically sucidal to continue to buy US dollars. Several events can trigger the speed at which the US dollar depreciates. High oil prices will mean USA have to use its dollar to buy the oil its cars are guzzling. Oil prices is forcasted to reach $160 per barrel in 2009. Another Hurricane Kratina will impose huge recovery costs in the USA. Or perhaps it can be a prolonged drought accompanied by forest fires. Or escalation of the Iraq war to Iran .

Events aside, the more serious problems are systemic. It is the breakdown of institutions and values. The most basic institution the family is resizing. 50% of all marriages end in divorce.31% of children live in single parent or no parent homes.The education system in the USA is crumbling. 60% of high school students cannot read their textbooks properly. One third of graduates cannot pass basic maths. The Enron , WorldcCom and Tyco debacles reveal corporate scandals on a scale never seen before.

The stock market volatility should be seen against this backdrop of institutional breakdowns in the USA and we will understand why it is so hard to fix.

When will the Black Swan arrive?

The Black Swan is an event that is highly improbable but not impossible. Most swans are white and black swans are very rare. Our lives are gretaly affected by unexpected events . These are very rare but of tremendous importance. We have seem to have short memories of tragic events. World War Two arrived to many people unexpectedly although World War One was just a few decades away. Yet with hindsight ( alas everything seems easier with hindsight) they should have seen the war clouds coming as Germany builds up its war machines.

The war clouds are coming but of a different kind. It is a financial war cloud. Perhaps the Mother of All Stock market collapse is coming. A financial Armaggedon is on the horizon. If you think I am a Doomsday pessimist , look at the signs. The fall in value of the US dollar is a symptom of a disease, the disease is called Overspending. Decades of overspending by US Government and US consumers have created a huge debt bubble. No one will ever believe anything drastic can happen to the world's only superpower. There is only one solution. The USA has to stop spending more than what they earn.

This will affect companies exporting to the USA and countries with large exports to the USA will be affected. This will create new opportunities as well. US MNCs will become stronger than US companies that have most of their business turnover in the USA. Those with high turnover outside USA will recover to become stronger. The USA's share of the world's market is declining thanks to the growth in Asia and other emerging economies. Manufacturers will be affected but not to the degree as Financial Manufacturers.

These Financial Manufacturers are the creators of the sub-prime mortgage problems. They create Financial Products to market to investors. Initially these Products are good , they provide diversity and protects investors against the market volatility. But greed has taken over and Financial Products now are designed to maximise the size of the wallets of those in Wall Street. The amount paid to Wall Street Executives is staggering. Financial Manufacturers unlike Product Manufacturers can create something out of nothing. They are supported by the huge amount of money that is released in to the markets by Governments all over the world. It is this huge liquidity combined with the excesses of Financial Manufacturers that will create a Black Swan event.

What will happen when this Black Swan arrives? Stock and property markets will be the first to fall. Those markets that rose the highest and the fastest will fall the most and the fastest. Jobs will shrink. The Travel Industry will see dark days. More books will be written with many authors claiming they have seen it coming. The Black Swan will arrive suddenly and unexpectedly. Over spending is like taking drugs. You cannot slowly be weaned off drugs by taking less and less each week. You have to stop, totally and completely. US overspending will not stop until the Black Swan arrives. But when will it comes? That is the six million dollar question that some people will pay billions to know. Since I am not yet a billionaire, I can't tell you.

Beware the Black Swan

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!

The Yen and the Stock Market

The recent dive of the global stock market shocks everyone. Analysts proclaim that the correction is healthy, PE ratios are reasonable and markets will continue to rise. Media focus about the remarks from ex-Federal Reserve Chairman Alan Greenspan who said that it is possible that US will have a recession but that it is improbable. Typical Grenspan's talk that is virtually meaningless and leave you to deduct your own conclusions from the remarks.

One of the primary key to whether markets will crash is not none of the above but the availability of cheap Yen from Japan. In technical jargon, it is called the Yen Carry Trade where you borrow Yen at low interest rates and use it to buy shares or deposit in higher interest rates currencies. It is simple maths. Borrow Yen at 1.5% interest from the banks and put into Australian dollars at 5% and hey presto, you earn 3.5% from the difference. Yen has been borrrow for a wide range of activities to finance stock purchases, buying properties and other investments. It is cheap money that is available in billions.

Where does this cheap money comes from? The Japanese Government wants to keep exchange rates low so that the Yen will not appreciate against the US dollar and hurts exports. Japanese companies sell billions to the US and in exchange gets US dollars. There is a DEMAND for Yen to buy US dollars. This must be countered by a demand for US dollars using the Yen . To do that the Japanese Government buys US dollars and sells Yen. So the equation is balanced at least as far as exchange rates go.

But where do the Japaneses Government gets the yen to buy the US dollars? It is money created out of thin air. In 2003 to first quarter 2004, in 15 months , Japan created 35 trillion Yen which is equal to US$2,500 for very person in Japan. All major currencies have appreciated against the US dollar except the Yen. With such a huge amount of instant money, it is not surprising that the Yen has remained low versus the USD. This unprecedented money creation by the Bank of Japan could be the main reason for the strong growth of the global economy.

The global stock market will not be as sensitive to the US interest rate than to the Japanese interest rate. If Bank of Japan raises its interest rate, and if the Yen suddenly appreciates against the US dollar, it might be the pin that pricks the bubble.

Sounds impossible but think it through!

Imagine all the banks in a country which we call Happy has $5 billion in fixed deposits. The bank keep 10% and loan out the balance of the $4.5billion. There is only $500million that is not lent out. There is a property market boom.There is a surge in property loans and $1.0 billion of new loans is needed. But the bank has only $500 million which it by law has to keep in reserves to maintain the Capital Adequacy Ratio. As all the available money has been loaned out, the banks has nothing to lend. All its $4.5 billion has already been loaned out. There is no money in the bank to lend to its new customers.

This is where the incredible magic occurs. Out of thin air, the Government provide a deposit of $1.0 billion to the bank. The bank then use this $1.0 billion deposit to lend to its new customers who needed the loans to buy property. Amazingly the bank has to pay interest to the Government for this $1.0 billion deposit which is an accounting entry created from nothing. Everyone is happy. The banks earn from the spread between what it pays the Government and what it collects in interest from its customers. Customers are happy since they are able to secure loans to buy their properties and the Government is smiling all the way to the bank earning interest from nothing!

When a recession occurs, there is too much money or liquidity and so the Government takes back its deposit and the $1.0 billion it created out of nothing is withdrawn from the market. So far so good as we are back to zero as far as money creation is concerned. This is one reason why recessions are good for they keep the money supply in balance.

But what happens if we have a boom year, year after year. In the second year, property prices rises and now customers want to borrow $2.0 billion. There is no money in the bank and so the Government repeats its miracle and deposit $2.0 billion into the banks .The banks used this money to loan to its customers. Now there is $3.0 billion of additional money in the market, money which never exists before.

If the boom continues for the third, fourth, fifth and sixth year, one can imagine how much new money is injected into the market. This huge supply of money creates inflation as with more money floating around, prices have nowhere to go but up. The money has depreciated simply because there is so much more money chasing after the same assets.

If initially in the country called Happy there is $100 billion of money. After six years, $20 billion of new money has been created. The total money supply increased from $100 billion to $120 billion. One dollar is now worth 83 cents of the one dollar six years ago. $120 billion times 0.833 is $100 billion. This is how our money gets smaller as the years go by. The main beneficiary is the Government who has created $20 billion from nothing and the citizens of Happy find after six years that their hard earned savings is now worth 17% less than before.

In a nut shell, that is how the modern economy works. The lesson is to put your money in hard assets such as gold, properties and stocks. Never leave your money in fixed deposits. The money will devalue year after year.

Where is the breakdown point?

The breakdown point is the percentage of national debt to GDP which is seen to be unacceptable by the financial community. To join the Euro, member states must show that their national debt has to be below 60% or fast approaching that level. This 60% is seen to be the sustainable ratio and Governments whose spending exceeds this ratio will be told to rein in thier spending. It would be interesting to see how many of the countries in Euro has national debts below the 60% level.

The same ratio in USA is 66%. The last time this level was reached was after World War 2 and money was needed for the rebuilding of Europe and Japan. After WW2, the only major developed country that was not bombed was the USA and so it was in a position to capitalise on the development of the bombed out countries. Today the world is competing on a global basis.

It seems governments throughout the world is in debt.The two Asian giants China and Japan has national debts . USA leads the charge followed by Europe and Asia. Only the oil rich countries have no national debts. China intends to spend $160 billion on the 2008 Olympics and need to spend even more to improve its infrastructure in the poorer provinces.

The problem is that there is no universal worldwide standard or agreement as to what level of debt is acceptable. Today banks have to have reserves that meet the capital adequacy ratio to protect them from potential financial crisis. Countries need to have a similiar capital adequacy ratio to protect them from over spending. The reserves would be kept in gold.

Indications of worry of excessive national debts can be seen in two indicators. Rising interest rates and gold prices. If investors see paper currencies as losing their value , they will want high interest rates to cover the risk of currency devaluations. The most obvious choice would be higher gold price . As national debts keep on rising, there will be a pulpable tension in the financial markets as everyone will be watching for the breakdown point. A lack of confidence in currencies could cause gold to spike to beyond the US$1,000 level.

What could cause this lack of confidence? A sudden disaster which would require billions to recover such as an earthquake in California or Tokyo. A tsunami in USA and Europe .Imagine Nice, Florida and the expensive resorts being hit be a tsunami. The cost of the tsunami in Asia is in human cost while the cost of the tsunami in Europe and USA will be more in economic costs. Imagine a tsunami several times more powerful than Hurricane Katrina.

Without a natural disaster, it will take another seven years for perhaps the national debt to exceed 100% of the GDP. No one can tell what this breakdown ratio is but perhaps 100% is a figure we can for now assume is the breakdown ratio. And when this happen buy gold and more gold!

Money from thin air?

My friends usually react with horror when I tell them that Government can and do print money out of thin air without zero asset or collateral to back what they have printed. A few still think that the good old Government must have an equivalent amount of gold to back the new money they have printed. Yes that was true, a few decades ago. We all know that the same one dollar buys much less than the same dollar twenty years ago. Assuming that the Government prints 6% more money each year, in twelve years, the amount of money would have doubled which has the effect of halving the value of money. Thus one dollar twenty years ago buys the same amount as what $2 buys today. This depreciation of our money is simply the result of Government printing money year after year.

This is great for the spending Government since twenty years later they effectively pay you less than what they borrowed from you after deducting the effect of inflation. If the inflation is larger than the interest, it means that the Government is paying a negative interest rate! China and Japan are the willing suckers buying the US bonds knowing full well that they may end up with less than what they paid. Who cares about the value twenty years from now on? What the politicians care is to keep exchange rates low , so their goods remain competitive, and jobs remain available.

Printing money is easy to understand. The Government just tell the printers to print x billions more cash and all it cost them is the printing cost. Government do have that right to just print cold hard cash. But an easier way will be to ask the central bank to add a figure to their ledger and hey presto , suddenly the Government has an extra billion to spend! Central banks in mnay parts of the world are literally forced by the USA to print money. Let us examine why.

The US Government borrows US$$413 billion in 2004 as this was the amount of the federal budget deficit. A large part of this borrowing is from other Central Banks who buys the US Treasury bonds with their local currency. The Central Banks do this to keep their exchange rate low vis a vis the US dollar. If US borrows, it sells US dollars which means there is a lot of US dollars in the market. If there are less Chinese Yuans available , then the exchange rate of Chinese Yuan to the US dollar will increase. One Yuan will buy more dollars since there are more dollars than yuan.

The Chinese Central Bank reverses this effect by buying US bonds which means it buys up the US dollar and releases more Yuan into the system. Now everything is in equilibrium. There are equal amounts of additional US dollars and Chinese Yuans and so the exchange rate remains stable. But wait a moment. The Chinese Government also has a budget deficit although it is much smaller than the US budget deficit. It means that the Chinese Government spends more than it has collected from taxes. If so where did the Chinese Central Bank get the Chinese Yuans to buy the US Treasury bonds? So the six million dollar is whether the Chinese Central bank and indeed other Central Banks print money to buy the US Treasury bonds?

The two biggest exporters to the USA are China and Japan and both these central banks buy huge amounts of US Treasury bonds to keep their exchange rates low. The total amount of money in the world is increasing leading to higher stock and property prices. The amount of stocks and properties in the world does not increase as fast as the increase in the supply of money. When you have more money chasing after the same goods, the price of these goods increases.

A stock is priced by what we call the PE or Price Earning Ratio. That is the price of the stock divided by the profit earned per share. In the US, the PE ratio has gone from 10 to 20. In other words, with exactly the same amount of profit, the price of the share has doubled! But the money does not get absorbed into the shares. The money goes into someone's pocket and he will use the gains from selling his shares to buy more shares , buy a bigger house, buy more goods, eat better and so forth. There is a wealth effect as the money goes around generating more profits and jobs for everyone. Money does not disappear but goes round and round and even from country to country.

After spinning around the USA, some of the money goes overseas inflating the oversea stock markets! The whole world is pumped with more and more money year in year out. The term for this is liquidity. The world is awash with liquidity. So when will the bubble end? The key to making a good investment lies in your understanding of money. Stay tuned.