The Mother Black Swan

Months ago I wrote about the possibility of a Black Swan event for the financial industry. A Black Swan is an unlikely event but with severe repercussions and impact. The melt down of the financial industry constitutes such a Black Swan event. The severity of the credit crisis caught everyone by surprise. It seems no one knows how BIG the sub prime problem is . When the Federeal Reserve bailed out Fannie Mae and Freddie Mac, who are severely impacted by the mortgages they backed, everyone thought the crisis is more or less stabilised.

Then Bear Stern started wobbling and was bailed out by the Federal Reserve Board . Then Lehman Brothers was allowed to go bankrupt but AIG started to have serious financial issues and was given $80 billion loans. A more serious look revealed that the credit market was in a kind of seizure and $700 billion was approved by Congress to solve the mess. Central banks got together to lower interest rates and more liquidity was pumped into the market .But stock markets kept on falling, falling, falling.

When investment banks are leveraged thirty times and commercial banks leveraged ten times, there is an absolutely humongous amount of debt that needs to be cleared and eliminated. The Carry Trade has started to unwind as Japanese banks have obviously recalled loans in yen. This is why the yen have strengthened while the high yielding currencies like the Aussie and Kiwis have fallen. The Aussie Dollar fall resembles that of a bungee jump as it was steep beyond belief. There is no fundamental reason to such a steep fall in the Aussie, a country rich in resources , stable government and a highly educated population. It is obvious that many investors have borrowed yen and bought Aussie and now they have to sell the Aussie to redeem the Yen denominated loans. Hence Yen goes up and Aussie goes the other way.

Investors have also borrowed yen to buy shares and this has triggered selling all over the world. No one in his right mind would sell shares at such low prices. They did not want to but HAVE to because they have to return their loans whichever currencies the loans are in. Now assuming the total value of shares worldwide is worth $21Y trillions. Only $Y trillion is bought with cold hard cash .The remaining $20Y trillion is bought with loans, loans which now the banks are asking back. Investors borrowed to buy hedge funds which are extremely highly leveraged themselves. So we have this leveraging upon leveraging. Investors who are leveraged are buying investment products which are highly leverage. The deleveraging process has still some more weeks to go before their positions are unwind .

Central banks seem to see the problem as a credit problem and think that by providing more money at lower interest rates, confidence would be restored . What the Central Banks should do is to follow what Hong Kong did many years ago. The Hong Kong Government went in and buy the shares to prop up the market. Perhaps in time they will recognise this but buying shares seems to be political suicide especially with the Presidential elections around the corner. Shares will continue to fall until the loans have all been redeemed and then the rebound will begin. US and European shares will fall until overseas buyers see value and start buying them up. The first rebound will be Asian shares as they are fundamentally sound and do not have the debt and leveraging issues faced by USA and Europe.

But the Mother of all Black Swan has yet to come. This is the real biggie, the knock-out punch that will floor all but those who have hedge in gold. This is when confidence in the US dollar evaporates. When overseas customers stop buying US Treasuries, or US bonds or even US shares. The Federal deficit needs $2 billion a day. Without this infusion of funds from overseas, the only solution would be to print dollars. The result is extremely high inflation in USA and for a period of time, markets will be even more volatile than what we have seen.

There will be a scramble to find a currency to replace the US dollar. The IMF and World Bank will be expanded to include Asia and will be more reflective of the actual financial strength of each country. Perhaps even majority vote in these two world institutions may move to Asian and Middle East countries for after all they are the ones with the money. He who has the money calls the tune.It will be an irony that now IMF and the World Bank will be assisting developed countries who were previously the ones who provided them with the funds. Now an Asian pied piper calls the tune and it would be interesting to see a Chinese or a Japanese lecturing the Prime Minister of Germany or UK on how to manage his country. The only solution to such a massive crisis is to let the ones with the money decide on how they are to lend to the one who needs the money. The current situation is that the ones in debt are the one who decides how their debts are going to be repaid. China, Japan and Middle East countries are not going to provide loans to IMF or World Bank when they have no control over these institutions.

There will not be a collapse. The world is too sophisticated for that to happen. Central bankers and economist will gather together to find a solution. But it will not be just Western bankers and economists but Asians and Middle Eastern bankers and economists who has to come up with a solution that is palatable to their own citizens as well. A price must be paid for the folly of the past. Just as IMF insisted on strong medicine for the countries in which it provided loans, the same strong medicine has to be given out, this time to Western countries; higher tax, lower Government spending , no agricultural subsidies for farmers and so forth.

China , Japan and Asia will have to find new markets for their products. The emergence of countries like Brazil, Russia , Poland and others plus China's potentially huge domestic markets will take up the slack from the US. After all the US contributes only 20% to the global economy and this can be taken up by the emerging countries. Japanese consumers have not been spending but will be encouraged to do so when their Yen becomes so strong that going overseas and buying overseas products become very cheap. Will Japanese consumer take over from the American consumer? Not totally but together with Chinese, Brazilian, Russian and Korean consumers , they will take up the slack that the American consumers have left behind.

A reverse brain drain will occur when top talents and professionals now flow West to East , increasing the competitiveness of Asian companies. The West becomes a less important market .Already we see this in China where there are products catering solely to the Chinese market.Likewise we will see products tailored to Japanese taste which means smaller products to taken up less space and more functionality as well. The lack of funds by Western countries will lead to Asia becoming more dorminant in Africa and even Latin America.

In time to come , Latin America will become the next Asian tigers. America will be too pre-occupied and too poor to interfere with its southern neighbours. It would be interesting when educated Latinos and Mexicans start returning home from USA to their home countries and start new companies. Many Chinese and Indians have done the same in the past decade. It will be a different world but still a rich world where knowledge will continue to grow and new products , new services will sprout.

The long term value of gold

13 September 2008

How do we make sense of the sudden strengthening of the US dollar and the drop in commodities and in particular gold prices? This article tries to give some logic as to how the long term price of gold is being derived. We will first look at the growth in money supply. How much money is being created out of thin air year after year? I am still amazed that some friends still think that Governments cannot create "fiat" money and that any money created have to be backed by gold. This was abandoned since the early 1970s and Central Banks have the power ot create money at will. So let us look at what some journalists say about this money suppy growth.

This was reported in the Economic Times on 12 Septembr 2008:
BEIJING: China's broad measure of money supply rose 16 per cent year-on-year at the end of August, level with the government's annual target, the central bank said on Friday. Here is an excerpt from the Press Release of the European Central Bank on 27 Feb 2008:The annual rate of growth of M3 stood at 11.5% in January 2008, compared with 11.6% in December 2007.

China has pegged its currency to the US dollar which means that as the US expands its money supply, China has to follow suit. The increase in China's money suppy gives us an indication of the US money supply as well as described in the article below:

Financial Senses University wrote on 28 Feb 2008:
In a story published in July, 2006 by the China Daily newspaper titled “Money supply growth unlikely to slow” we were told that, "the ballooning forex reserve is a major factor behind the dynamic growth of the money supply," by Li Yongsen, an economist at Renmin University of China. "The central bank has to release new money to mop up the excess US dollars in the marketplace and enforce a floating band for the renminbi, which is driving up money supply growth," he said. So we ask again. How can there be negligible money supply growth in the US and 2-3% inflation, when China, a country with a pegged currency to the $US, is experiencing money supply growth in the mid-teens and 6.5% inflation in December?The answer should be obvious.That is what the continued rise in the $US prices for precious metals and commodities is telling us."

FXStreet.com wrote on 31 July 2008:
SINGAPORE (Thomson Financial) - Singapore's broad money supply, or M3, rose 7.9 percent to S$325.08 billion ($239 billion) in June from a year ago, data from the Monetary Authority of Singapore showed on Thursday.
M2 edged up to S$315.70 billion from S$293.61 billion a year earlier.

Prices are dependent on two things. Supply and demand and the value of money. We have often think of prices only in terms of supply and demand. If demand exceeds supply, then the prices will go up. What we have often not looked at is the value of money. There is $X amount of money in the world available to buy $Y amount of assets whether it is gold, stocks, properties or bonds. Over time , on an average basis Y must equal to X. Of course there are different asset classes within Y which may move in the opposite directions but over the long run, when we look at prices over one or two decades, then Y generally follows X. Let us take gold as an example. There is the supply and demand issues. On the demand side gold is bought mainly as jewelry with some industrial uses but mainly it is kept by Central Banks and investors as a store of value. Due to its limited supply, gold tends to hold its value better.

As more and more money is being created, then the price of gold goes up , not because there is a great demand but because there is simply too much money chasing after too little gold. Now gold is not an interest bearing investment and so when stocks and properties are going up, few would want to hold gold. Still over ten to twenty years, gold will show its ability as a store of value. Let's look at how gold retain its value over the past ten and twenty years

In September 1998, gold was selling at US$300 per ounce. today it has dropped to US$763. That is an annual increase of 9.78%. However based on money supply growth ,here is what gold prices should be:
1.If it follows a 16% increase ( see quote on China),: US$1,323.
2. If it follows a 11.5% increase (EU) :US$890
3.If it follows a 20% increase ( my guess for USA): US$1,857

Based on money supply growth rates, gold should be valued from US$890 to US$1857.
Let us go back twenty years to 1988. Gold is priced at US$485. Based on today's price of US$763, that is an annual increase of a miserly 2.29%. Assume different average growth rates in the money supply will show that gold is indeed undervalued:
1. 5% growth in money supply, gold should be US$1,286
2. 7.5% growth in money supply, gold should be US$2,060
3. 10% growth in money supply, gold should be US$3,262.

The recent drop in the price of gold is due to a recent contraction in the money supply and other factors described below.
The Telegraph on 19 August 2008 wrote:
"The US money supply has experienced the sharpest contraction in modern history, heightening the risk of a Wall Street crunch and a severe economic slowdown in coming months.Data compiled by Lombard Street Research shows that the M3 ''broad money" aggregates fell by almost $50bn (£26.8bn) in July, the biggest one-month fall since modern records began in 1959. "

This $50billion is a drop in the bucket compared to the amount of funds available world wide for investments. The drop in commodities and equities is most probably caused by hedge funds liquidating their positions probably due to the credit crunch, the sudden contraction in money supply and a herd mindset. The hedge funds managers that want to bet on commodities going up may not be able to borrow to leverage their positions. The sudden contraction in money supply reduces the ability of fund managers to increase their leverage which means if a large investor shorts or sell, the other investors are less able to balance them out.

Wall Street Journal on 9 September 2008 wrote:
“Hedge funds have delivered their portfolios and become defensive, and are now sitting on a lot of cash,” says Mary Ann Bartels, chief U.S. market analyst at Merrill Lyncht Journal Macro-oriented hedge funds, those that invest across a number of sectors and asset classes, were hit particularly hard in August, a result of weakness in widely-held technology shares and resource stocks.

The $155 billion in cash is equivalent to about 8% of hedge fund assets, according to Ms. Bartels, a bullish signal, for hedge-fund managers do not tend to stay in cash for long. With seasonal factors soon turning in favor of stocks (the last three months of the year are generally among the strongest for equities), investors aren’t likely to remain on the sidelines for long. “They’re going to want to participate to boost their numbers,” Ms. Bartels says.

The Wall Street Journal Market Watch on 29 August 2008 wrote:
"Three unidentified U.S. banks held 86,398 short positions, or bets that gold prices will fall, in the COMEX gold market as of Aug. 5 -- 10 times more short positions than a month earlier, a government report showed.The report by the Commodity Futures Trading Commission, which regulates U.S. futures markets, also showed short positions held by three U.S. banks in silver futures had increased more than four times during the same period." The data in the bank participation report is so clear and compelling that it is hard to conclude anything but manipulation," said Theodore Butler, a precious metals analyst, in a note.

The sudden jump in short positions coincided with a slide in silver and gold prices, which fell $12.30 an ounce in July and another $89.20 in August, their biggest monthly loss since at least 1984, according to Factset. Silver has slumped more than $4 an ounce in August, also the biggest since 1984. As for the banks involved in the recent short selling of gold, they are only market makers, taking orders from large money players, such as hedge funds, said Jeffery Christian, founder of commodities research firm CPM Group. "What you have here is the footprints of hedge funds exiting the commodities markets en masse," said Kitco's Nadler.

Bullion Vault on 14 August 2008 wrote:
IN THE WEEK ENDING the 25th of July, a decrease of €578 million in "gold and gold receivables" – reported by the European Central Bank – reflected the sale by two Eurosystem central banks roughly equal to the sale of just over 30 tonnes of gold, notes Julian Phillips of the Gold Forecaster.

The above articles seem to indicate that the drop in gold prices are caused by hedge funds exiting their positions and Central Banks selling of part of their gold reserves coupled with a contraction in money supply. But these are short term events and eventually $X and $Y has to come to some form of equilibrium. THE PRICE OF GOLD WILL BE DETERMINED BY ITS ABILITY TO HOLD ITS VALUE AGAINST PAPER CURRENCIES.

If the US dollar reverts to his previous exchange rate at the beginning of the year, gold will rise to US$806 based on this devaluation of the US dollar alone. However if the money supply growth over the decade is factor in, gold could easily exceed the US$1,000 mark. With the current Federal Deficit in the US , the poor performance of its economy, the large household debts, the depreciation of the US dollar is inevitable.

Gold has reached its fair value

Gold is a store of money and so is paper money. The one exception is that gold has a limited supply while money can be created at will. Many people still think that money is somehow pegged to gold and that Government must have some gold to back up their currency. No the gold peg was removed decades ago and money can now be created almost at will. The key to the possibility of gold reaching US$2000 per ounce is dependent on how much money has been created.

On March 23, 2006, the US Government stopped publishing the M3 money supply data. A reason for doing so is that it wants to hide the amount of money it is creating . The rate at which this M3 money supply increases annually could raneg from a low of 6% to a high of 9%. This means the value of money will decrease. Using the rule of 72, this means the value of the US dollar will drop by half in 12 years using a 6% increase in money supply or just 8 years if we use the higher 9% figure. Thus when gold hits the US$2000 level, it is not that gold prices have risen but that dollar has devalued.

The well known US trade deficit has hit the US$800 billion level which means they buy more than what they exported. We do not know how this trade deficit is computed and whether services are excluded or not. A printer may be made by Hewlett Packard in China and exported back to the USA creating a deficit . But profits made by Hewlett Packard worldwide will be used to pay for the cost of its staff in the US and so this sort of offset the trade deficit. Assuming that somehow three quarters of the trade deficit somehow returns to the US, it leaves an annual deficit of US$200 billion.

But this is part of the overall debt. The Federal , State and Cities in the USA has substantial debts as well. The Federal Debt at at 25 July 2008 is US$9,528 billion dollars. At a 4% interest rate, it has to pay $240 billion just in interest alone each year! This Federal Debt is growing at the rate of $1 million a minute. Scary though it sounds, the pciture can get worse.According to the Institute of Truth in Accounting, the true federal debt is $55,146 billion of off balnce sheet items are included such as Social Security and Medicare. These are "promises" that have to be fulfil in the coming years!

All the increase in money supply goes to fund these debts. When someone incurs a debt, it also mean the other party has money to spend. When the US Government incurs a debt, its employees would be paid and hence have money to spend. When the US Government spends on buying military hardware, defence contractors make a pile and this money goes to its employees and shareholders. So as the US Government goes on a borrowing spree, everyone is happy and the party continues. The question is when will this party end?

Amazingly even more debt is created by the past housing boom fueled by easy credit .These housing mortages are the no questions asked, 100% loans called subprime mortgages. The two institutions that provide mortgage guarantees , Freddie Mac and Fannie Mae, have provided $4.8 trillion worth of mortage guarantees. They owned half the housing mortgage which puts the total US housing mortgage at $10 trillion. The loans benefited housing contractors, real estate agents, interior decorators, furniture and appliance suppliers and a whole gamut of businesses that benefitted from a housing boom! Now all these money spent and earned have to be repaid, somehow.

US Government may step in to bail out Freddie Mac and Fannie Mae but where does it gets the funds from? It is already in deficit which means it either prints more money, borrow more or do both. The end result is the same, an increase in money supply which will cause the US dollar to devalue over time and increases the price of gold! The price of gold in US dollars is meaningless and perhaps more meaningful to compare it with say a house.

In 1970, a terrace house in Singapore can be bought for S$70,000 and gold prices was US$35 per ounce . Based on an exchange rate of $1.8, the terrace house would cost 1,111 ounces of gold. Today the same terrace house cost $1.2 million and gold is at US$930 an ounce with an exchange rate of 1.36. The cost of the same house in gold is 945 ounces. Thus we see that based on gold prices, the cost of the house has indeed dropped rather than increase! Based on this analogy, we see that gold at US$930 per ounce has reached its fair value based on current exchange rate and property prices in Singapore.

What on earth is CDS?

Many people are anxious whether the sub prime mortgage issue is over. Have all the banks written off their bad debts due to the sub prime mortgages. But the question is partially irrelevant because that is not the only issue facing the financial markets. Credit Default Swaps or CDS is a massive US$62 trillion dollar market.

Credit Default Swaps is like an insurance policy, used by debt owners to hedge, or insure, against a default on a debt. There is no assets or collateral involved and hence it can be speculative.Warren Buffett once described derivatives bought speculatively as "financial weapons of mass destruction." In his Berkshire Hathaway annual report to shareholders he said, "Unless derivatives contracts are collateralized or guaranteed, their ultimate value depends on the creditworthiness of the counterparties. In the meantime, though, before a contract is settled, the counterparties record profits and losses -- often huge in amount -- in their current earnings statements without so much as a penny changing hands.

The CDS market is said to be more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association and is far larger than the size of the U.S. stock market (which is valued at about $22 trillion and falling) , the $7.1 trillion mortgage market and the $4.4 trillion U.S. treasuries market according to Harvey Miller, senior partner at Weil, Gotshal & Manges. The effect of CDS's collapse would be even lower liquidity and signals the end of low interest rates. The higher interest rate would have serious impact on an already declining US economy.

CDS is an unregulated market and is used by banks to cover losses when companies fail to repay their loans. If CDS are priced low, then the bank can afford to lend relatively "risk free" at lower interest rates. Without CDS or higher priced CDS, banks would need a higher interest rate to cover the potential loss on a loan. With a slowing economy, risk to loans will increase and with problems from past CDS issued, banks may be very reluctant to lend with collaterals.

Subprime is about MBS or mortgage backed securities but how much CDS based on MBS has been issued? More curious is who are holding these MBS? In the following weeks, we may hear more about CDS and CDS may be as familiar a term as subprime. So hold on tight, the financial tsunami is on its way

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!