Australian Property and Dire Straits! How being a contrarian saves you from crazy bad IPO's

Australian Property and Dire Straits! How being a contrarian saves you from crazy bad IPO's
https://www.intelligentinvestor.com.au/heres-proof-property-has-peaked

Property tops.... Australian Economy drops .... Bank default rates increase .... Aus banks cut dividends ....
Aus banks drop.  No saving from China this time!

Macau/China's Fragility

I had not been to Macau in two years even though it's only 50 miles away,  but as evident today, they are still building at their fastest rate including an Eiffel Tower in third or half scale, a Colossus, and a Massive land reclamation. I see probably a dozen mega casinos being worked on still.  Macau loves creating Fragility!

Or is it just another big Gamble!?

8 years ago this was a quant Portuguese - local Chinese mix with great food and meandering back alleys. All gone except a few of the restaurants. 

Where is the Optimism in the economy or stock markets?

Morgan Stanley recently produced a  report saying that there have been net OUTFLOWS in equities from 2010-2015 essentially, EVEN AS THE SPX rose as much as it has.

(see chart of equity flows since 2010 in particular - with few inflow weeks since then).
http://www.businessinsider.com/us-equity-mutual-fund-inflows-2014-8

http://www.morganstanleyfa.com/public/projectfiles/a4da036b-5f43-4891-a27d-ee518764b497.pdf
http://marketrealist.com/2015/04/us-equities-consolidate-current-levels/


Recently the data has included some net inflows into the ETFs and equity market especially when a new high in SPY is hit, but also into high yield bonds!

To me i would ask WHERE IS THE OPTIMISM SO FAR?  I say nil to minimal.

My Reason: Even if the trend of inflows into equities continues we are just at the beginning of optimism, but there is still
a search for yield/risk aversion leading to bond inflows at the same time somewhat negating that.

I think it will be interesting if this trend is a crossover point ... TBA i guess?  But I am still bullish stocks, and bearish bonds.

Will the Chinese RMB replace the USD as reserve Currency?

blog.mpettis.com/2015/04/will-the-aiib-one-day-matter/

An excellent, though long post by Michael Pettis from his blog, where he begins to look at the new AIIB, and continues with a review of past challenges for reserve currency status.  Particularly the section from the following paragraph through to the end is an excellent review of history, and likely modern parallels. 

"There have been four times in the past 100 years, in other words, in which we were more or less certain (absolutely certain in the cases of the US in the 1920s and Japan in the 1980s, very certain about the USSR in the 1950s, and arguably certain about Germany in the 1930s) that a country would become the dominant economic and geopolitical power, and only once did this turn out to be true. Anyone old enough to remember the 1980s will remember that we were even more certain about Japan’s rise in the 1980s than we are about China’s rise today, but in the Japanese case, as in every other case, we were flabbergasted by how difficult the economic adjustment turned out to be, which suggests at the very least that we might want to wait to see how Beijing manages China’s rebalancing before we insist that this time is indeed different." (continues to the end of the blog).

The question is not whether China can force this to occur, or even when.  But there are serious challenges that they must face for quite some time before the RMB can even vie for equal footing with the USD.  The only time in history where reserve currency status actually changed, essentially took 40 years of USA economic leadership first, and 2 World Wars with the resulting economic decline of England.

It reminded me of a blogpost I made comparing Japan in their bubble years to the US.
http://investingpsychologyblog.blogspot.com/2014/11/kamikaze-capitalism-its-correlation-to.html

Back then, claims were made of the Yen replacing the USD too.

China & Hong Kong - Property Bubbles and Euphoria.

Recently I noticed that a long established photography shop in Central HK had closed down, and within a week had been replaced with a fully functioning new……
shock horror…. real estate agency!  (I was not at all surprised).

This is in an area where there has to be at least one retail real estate agent every 60-70 metres along all the main roads of Midlevels, Central, Sai Ying Pun, Pokfulam, The Escalator, and Causeway Bay (well - all of the north of HK Island actually).

For those that live there, this is often so annoying as to draw comments along the lines of; “That could have been a nice coffee shop/martket/restaurant/creche/<insert a desirable alternative> instead.”

In fact, it seems that real estate agents are competing to rent the spaces that they should be trying to rent out to good shop tenants!

Is this the proof that there is a property bubble in HK/China?  Not necessarily I think.
Is this proof that there has been bubble like behaviour occurring with respect to property, and the marketing of property to as many people as possible?  Yes I believe so, and its been occurring for years.

Too many times discussing HK property with colleagues, I have heard the standard response of “HK property always goes up” / “It will stay up as long as the Mainlanders are buying, and have so much money,” etc.
But people have already forgotten (unless they were hurt), by the huge reduction of prices when SARS hit HK in 2003, and it took Ten Years for their equity to be regained.

Why?  Because SARS caused a surge of fear that was unheard of previously.  Were they scared of SARS destroying their property though?  I don’t think so - they were scared of the collapse of the property market that was occurring due to Fear becoming contagious in HK.  SARS after all is a respiratory illness that cannot hurt a property itself.

So can HK property collapse again as much as it did in SARS?  Sure, just add fear.  Fear of recession, fear of a hike in interest rates and loan servicing ability (we are pegged to the USD and their low rates in HK), fear of a pullout of money from Chinese Mainland investors, fear of job losses, fear of currency devaluation or depeg,  But one thing is for certain, there will be less real estate agents after that, and maybe a few good coffee shops finally.

I don’t know if it will happen or when, but its certainly interesting walking around HK, looking in agents windows, were a tiny unit can cost as much as several dozen acres in the USA, and where rent can easily outpace the actual full salary of a professional employee.

{My main road up the right hand side - 7-8 agents in three minutes walk}
http://postimage.org/][img]http://s16.postimg.org/4wgf7hm7p/HK_Caine_Road_60405_ppt.jpg


{$6-10 Million HKD for 830 square feet - any takers?}
http://postimage.org/][img]http://s14.postimg.org/bj93zq8ld/130821091829100311_676x450.jpg


{Competition among agents for a rental placement is fierce}
http://postimg.org/image/inutzkhjf/full/][img]http://s1.postimg.org/6lzg5f8b3/17228536.jpg

Physical Gold – Why Bother?

Below is the sad story of the pensioner in France that has his Gold bars stolen by well-informed thieves.

It begs me to ask, Gold – Why Bother?

I don’t disagree with the value of holding some physical Gold, either in the home or elsewhere.  But certainly, if in the home, not too much that you are destroyed by its loss.

The reasons for this, to me are simple:

1. Holding Gold to me is cataclysm type event protection.  If it’s just as an investment, or to hedge inflation, buy GLD the ETF.

2. In a cataclysm type event, any Gold you own will be ripe for the taking as soon as it is known that you have it.  So you better have it well hidden and protected with security. (i.e. guns and bullets).  You will need them!  (The most amusing thing about “Doomsday Preppers”, is that they go on TV, showing us what they have and often where.  This is totally is defeatist in intent).

3. Big value, one kilogram Gold bars are next to useless when you need to live on them.  Coins are definitely better.  I would argue Silver coins are better again, as they have lower value per coin.  Gold coins if you needed to travel would work fine however to move wealth.

4. In a cataclysm type event, Gold ownership is likely to be made illegal, as during the Depression era of the 1930’s in the USA.  (In this case physical Gold in vaults is even more at risk.  Penalties after the fact of hoarding it could be severe too.

http://en.wikipedia.org/wiki/Executive_Order_6102

5.  You can’t eat Gold, meaning that someone with land, water, defense, crops, and some source of power is more likely to be useful and thrive.  They simply wouldn’t need your Gold necessarily.

6. If I need Gold THAT badly, in an end-game scenario, without the things listed in point 5, I am not sure I would even want to be around!

7.  Finally there is an opportunity cost in holding large amounts of Gold.  What is the probability that the world will put us in a position to NEED it?    I am certain there will come a time of high inflation where owning Gold as an investment makes sense again.  I am not certain that I will ever need it as a physical asset to trade to live.  (But it’s pretty and nice to have a bit – until the thieves come).

Below the article on the theft:

http://www.zerohedge.com/news/2015-02-19/gold-bars-france-worth-500000-robbed-pensioner-fake-cops

The U.S. Economy and Oil

Very interesting historical perspective on the "common job" in each state over time.  But what got to me was the dependence on trucking and delivery as an industry, vocation, and owner-driver type of career.

How can the US NOT benefit from lower oil prices when so many rely on it as a major necessity and also a liability in their business?  The stock market can go do whatever it wants, but consumer confidence is likely to keep on rising as the cost of transport falls, and ALL those truck drivers out there benefit.


http://www.npr.org/blogs/money/2015/02/05/382664837/map-the-most-common-job-in-every-state?utm_source=facebook.com&utm_medium=social&utm_campaign=npr&utm_term=nprnews&utm_content=20150205

USA - Keep on Truckin!

Ka-Boom!!! The Swiss go to War on Currency - CHF

Recently I wrote a post looking at Leverage and Trading success that I came across, and the observation that the best performers limited their max drawdown percentage risk to less than 50%.  Further the greatest number of net profitable traders held less max drawdown percentage risk at around 30%.

http://investingpsychologyblog.blogspot.hk/2014/12/leverage-bringer-of-destruction-risk-vs.html

"Humans have a great awareness of risk through survival instincts, but this does not seem to translate into the markets!"

I certainly didn't predict the move the SNB made to unpeg, but the observations seem to be borne true, especially when you consider that FXCM users owe FXCM over $300 Million, forcing FXCM itself to seek a bailout to satisfy their fiduciary obligations.

FXCM had even been one of the champions of allowing greater leverage use by traders to the US Commodity Futures Trading Commission review.

http://www.bloomberg.com/news/2015-01-16/fxcm-lobbied-against-leverage-limit-before-franc-trades-went-bad.html

I had a bit of a loss on the USDCHF move, saved largely by stoplosses limiting my risk, but I also learnt a couple of lessons as a result of the "close-call."

1. I will from now on keep my option and any spot positions separate in another account.  Whilst I didn't suffer any option liquidations, I would have been VERY annoyed if those long term options had been closed on me.

2. EVERY Spot position needs a solid stop loss.  Fortunately I had that.  The danger with Risk, is that is is unknowable until you suffer its effects.

3. Forex options are a better alternative to Spot.  These are still alive at least, and not subject to leveraged margin calls.

4. Leverage must be watched like a Hawk, and controlled to levels that allow survival in surprise events, as proven in the chart of trading success and leverage above.

5. VOLATILITY + LEVERAGE = DYNAMITE

Stock Market Noise and B-S.

It took me a few days to finally decide on my New Years Financial Resolution for 2015.

Just one, its pretty simple – “Avoid listening/reacting to all the Noise and BullS$@t.”

Jan 9^th and the market is in an uptrend, booming strongly again, despite fears just days before in the media of the Greek Exit from the Euro (Grexit - stupid catchcry legitimizing media name for something that hasn’t ever happened), more of Putin’s games, unrest in the USA, Oil up or down a dollar today,  etc etc.

It doesn’t really matter if you think that the market is manipulated or not, but its very easy to believe that retail investors are heavily manipulated. 

“They”, whoever “they” are, those men in dark suits, the Fed, Politicians, Wall Street etc, have that mastered to an art form.  Washington DC and most political centers around the globe operate on a 24-hour news cycle.  That keeps the public listening to what the politicians have to say about how great they are doing.  It is of course no different in finance and the markets.

Short news cycles keep the investor herd running from side to side in a state of flurry, boosting commissions to Wall Street, and destroying investor long term trades, allowing Investment Professionals to keep all the bigger gains.

Buying where you think it’s low, and selling where you think it’s high, or at fear of going lower – essentially buying wrong and selling wrong.  Simple.

How can investors avoid this trap of Masterful Psychological Manipulation?

First, is refuse to participate.  If you are not a deliberate day trader, watching CNBC or Bloomberg is really not going to help, unless you have the discipline to not make ANY trade decision on what you see or hear.  Better to leave it off.

Second, is to not make a trade based on a stock pick.  If it’s on telly – it’s too late more often than not.

Thirdly, and I think most importantly – There seems to be long-term macroeconomic shifts at play.  These are the trades to make.  A strenghtening US dollar, the coming of increased interest rates, a stronger US economy, weaker emerging markets, and even longer term is a recovery In Europe.  None of these are affected in the long term by whatever they decide to sell you in the media today.

Remember the media’s only job is to get you to watch and read regularly, to view or click on the ads that appear – not provide ANY sound advice.  Even worse than that is that it can become addictive!  So well are we conditioned and targeted towards emotional responses, cultivating a fear of missing out (FOMO) need to continue watching even if it is to our disadvantage.

“Its just noise and B-S.”

“What’s just noise?”

“It ALL is.  Except for the part that is B-S!”

2015, Risk and the Moon

Being prepared for when things do not work out as planned is important.  But planning for failure, is not planning to fail.

"Fate has ordained that the men who went to the moon to explore in peace will stay on the moon to rest in peace."

This is the opening of the speech President Nixon would have given the world, had the Apollo moon landings failed in 1969.  At the time it was one of the most complex endeavours humans had ever attempted, with high risk, but an immense preparation for these risks, and the many measures to control them.

I hope 2015, brings you the best of outcomes, from the risks you choose to take, in full knowledge that they may not work out as perfectly as planned.  But being prepared to minimise these bad events, will make the chance of many more good outcomes likely.

Its always good to shoot for the stars.  But be ready and able to have the resources for a second and third Shot!

Leverage – The Bringer of Destruction. Risk vs Return.

I recently saw this chart of “Max Drawdown % Risk” verses “Return %”, of a large number of traders on the SaxoBank website.

Interesting!

Firstly and obviously, zero risk is zero return.  Returns rise from this point until the number of 50% return-makers flatlines from 8% - 30% max drawdown risk, (lower horizontal green line).  It then seems to start to fall along the top of the cluster above the red trend.

As risk increases, the red trend is far more significant to the downside in an almost linear relationship.  Over 80% max drawdown risk seems to imply a return approaching 100% loss.

If you look at the overall cluster running along the top of the red line, it seems safe to say, that increasing risk does not constitute increasing returns for most traders.

The top performers (who must take some risk to generate a return) sit in the 40-55% max drawdown risk range.

No-one with 75% max drawdown risk or more has doubled their money.

The greatest cluster of 100% return-makers, sits somewhere around the 20-30% max drawdown risk range, (upper horizontal green line). This seems to be a reasonable place to be when you include the possible returns below it as well.

Importantly, these are just subjective eyeball observations, and the traders here are most likely using a variety of strategies, and are of varying skill/experience.  A bigger sample size would also be great to have, (820 on the website).

Humans have a great awareness of risk through survival instincts, but this does not seem to translate into the markets!

https://www.tradingfloor.com/posts/how-much-trading-leverage-is-too-much-2940875

China – Causes for Concerns.

A few weeks ago I wrote a blog about the parallels between The Japanese Bubble Economy of the 90’s and how I see China now.

http://investingpsychologyblog.blogspot.com/2014/11/kamikaze-capitalism-its-correlation-to.html

Today another concern to add to the list popped up, after the recent run-up of the Shanghai Exchange.

China is adding money to its financial system to fuel growth, as forecast growth rates continue to fall.  While doing this, China’s leaders and state media are using the statement of a “new normal” of slower growth as expectation management on investors’ appetites.

I love the term “new normal” as a contrarian signal, telling me that it will not end anywhere like what is being expressed in relation to it.  (As example: a “new normal” of low volatility from now on – I would see as high volatility to come!)  The more “new normal” talk there is, and belief in the concept – the more it is impossible to be true.

A new normal of “slower, high quality growth,” is coming to China.  Uhuh-sure! 

When you pump money into banks to ensure liquidity, as recent history shows, its usually too late to save a bad outcome.  And I don’t think anyone knows the depths to how bad the banking and property sectors are in China really – not even the government.   There seems to be way too much regional government intervention and corruption for that.

Share buybacks, and state-owned company share investments, that were “encouraged” by the authorities, have pushed up stock prices enticing local and now foreign investors into the share market at elevated prices.

Due to this recent run in Chinese stocks (17% this month, 35% this year), China banks have suffered investor withdrawals to fund their entry into the stock market.  Much of that has then been leveraged.  Margin use in total trading has almost doubled since May, and non-bank trust companies are lending up to 300% of capital!

Loose margin requirements, which have not been tightened recently despite liquidity concerns, threaten only to cause more big drops similar to the decline Tuesday, that was the biggest one-day drop since the GFC, on fears of tightening requirements for margin credit.

Japanese use of margin at ridiculous levels, especially in property prices tells us that this kind of leverage is unlikely to lead to “slower but quality growth.”

This “new normal” could just be masking the high volatility to come.  Clearly, investors do not seem to learn from history.  Nor consider the psychological implications of a run of margin calls as banks with liquidity problems tighten up.

Taleb’s “Alternative Histories” and Investing.

“Clearly my way of judging matters is probalistic in nature; it relies on the notion of what could have probably happened….

            If we have heard of {histories greatest generals and inventors}, it is simply because they took considerable risks, along with thousands of others, and happened to win.  They were intelligent, courageous, noble (at times), had the highest possible obtainable culture of their day – but so did thousands of others who live in the musty footnotes of history.”  (Taleb, Fooled by Randomness).

Julius Caesar was a fantastic general, yet was amazingly lucky (until he was not), whereas Erwin Rommel, also a fantastic general was plagued by bad luck on multiple occasions, (with a random and erratic Commander in Chief not helping).

What other outcomes for these generals could have happened?  And, would they be judged by history differently for their decisions, despite no change in their skills?

http://www.jstor.org/discover/10.2307/3290595?uid=2134&uid=2487545583&uid=2&uid=70&uid=3&uid=2487545573&uid=60&purchase-type=none&accessType=none&sid=21105412931033&showMyJstorPss=false&seq=1&showAccess=false

http://www.military.com/Content/MoreContent1/?file=dday_leaders4

“Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius,” (Marks, The Most Important Thing),  … or a fool.

But how do I picture these alternative histories that could have occurred but did not? 

(I saw this graph somewhere but couldn’t re-find it, so recreated it below).

At point X now, current conditions are known (as best as available information can be utilized).  The correct decision (always) to take is the one that is logical, intelligent, and informed “at that time” (Marks).

At point X now, all red outcomes are “possible” and unknown, but some are more “probable” than others.

At point Y later, only a single red outcome has eventuated.   At which point it often becomes hard to imagine that any of the others were “possible” to begin with.

(Note: The distribution in reality may be skewed towards one side of possible outcomes.  This is more to highlight the concept of possible and probable only, not the mathematics).

When things go as predicted (luck playing a role), people tend to look like geniuses for their correct actions.  “Coincidences look like causality.  A lucky idiot looks like a skilled investor.” (Marks).   However, the correctness or quality of a decision cannot be judged by its outcome, especially if randomness is involved.  For this reason correct decisions based on a sound process are often wrong, and the macro events that may have caused it, beyond anticipating.  Incorrect decisions and processes can also be seen as correct, with an unanticipated event causing the outcome you wanted.

Whilst the mean is the most “probable” outcome (reversion to the mean?), it is not at all certain, as for any individual situation, all outcomes are “possible”.  In fact the collective likelihood of all the other outcomes is higher than the one we think is most probable!

The most extreme outliers at +3s and - 3s can be the black swans (good and bad). (Maybe there should be black swans AND white knights?).

At least by having a good process at X, we can limit the pain of black swan events and not necessarily experience account destruction when they do occur.  We must trade based on what we think are probable outcomes, while not doing too much damage or loss in the rest that occur.   We need to cut off the bad tails effect on us, or limit it.  Fortunately options do that, yet expose us to the full range of favorable possibilities.

This does not mean to imply not trading a contrarian strategy, or positioning to get lucky etc.  Its what we think are probable and possible, based on our analysis, not probable as in the herd thinks it likely.

I think understanding that we can’t know the outcome of all that is possible, but can try to understand what is probable and position accordingly, whilst protecting the risk of severe damage to my account, is the best thing I have learnt in 2014.  (Possibly! Probably!)

Clearly some “alternative histories” would have been far worse than the one we know.  But in 1940, our now known outcome was nowhere near certain, and one could argue improbable.  The things that HAVE happened in the world are just a “small subset of the things that COULD have happened.”  And finally, “ensure survival” (Marks).

(If you want to think more about alternative histories, watch the Back to the Future movies!)

The Importance of Reversion To the Mean in Investing. (Part 2)

The Three Illusions of Reversion to the Mean. (Part 2)

Reversion to the mean creates three illusions - cause and effect, feedback and declining variance, (Mauboussin, The Success Equation).

1.  Illusion of Cause and Effect – The human mind has an innate programming to want to explain occurrences by finding the cause of them, even if there isn’t one.  Yet, reversion to the mean is a “statistical artifact,” that our minds try to interpret with a cause that often is not there, (Mauboussin).

Reversion to the Mean “happens without the need of a cause.”  This is problematic to our minds with that need to assign one, even if it causes an error.

“The DOW fell 2% on the back of weak employment data.”  No – it probably just regressed back towards its 50 day Moving Average, more likely.

2.  Illusion of Feedback – The idea here is that after an event, you take an action and believe that this causes the next event to occur as a result of that, even though reversion to the mean might be all that is occurring.

Mauboussin’s example of doctors is: You have higher blood pressure than your last consultation, which the doctor treats with a drug.  Blood pressure subsequently lowers towards the average at the next consultation, which the doctor believes is due to his treatment (which it may, or may not be).  But in the whole population, everyone’s blood pressure would revert towards the mean with or without treatment.

The illusion of feedback will persuasively suggest that the treatment was the cause and lower blood pressure the effect,” (Mauboussin).  Clearly the illusion of feedback plays right into the hands of the illusion of cause and effect, and the narrative produced can be a strong and highly erroneous belief.

3.  The illusion of Declining Variance – (the hardest to conceptualize) is the illusion that as something moves to its average, the variation in the numbers shrinks.  This is not necessarily the case, and sets a trap in our analysis.  In other words as stock price reverts to its mean, it does not imply that the individual prices observed will cluster closer together around the mean, as would be evident by a closer standard deviation.

http://www.psychology.nottingham.ac.uk/staff/pal/stats/C82MST/C82MST%20Lecture%202a%20Notes_files/image011.gif

The chart below shows how price reverts to its mean at P from Po, variance increases initially as price begins to move, but then stabilizes, yet does not contract, as the illusion would dictate.

Also, reversion to the mean occurs even when the statistical properties of the distribution remain unchanged (Mauboussin).  According to Bob Jensen at Trinity University it looks like this:

http://www.cs.trinity.edu/rjensen/readings/realoptions/faqs/FAQ%20Number%206%20Risk%20premium%20for%20mean%20reversion%20and%20jumps.htm

http://www.cs.trinity.edu/rjensen/readings/realoptions/faqs/FAQ%20Number%206%20Risk%20premium%20for%20mean%20reversion%20and%20jumps_files/rev-dis1.gif

The red line can be flipped to show a declining price reversion to the mean with similar variance results.

http://www.cs.trinity.edu/rjensen/readings/realoptions/faqs/FAQ%20Number%206%20Risk%20premium%20for%20mean%20reversion%20and%20jumps_files/rev-dis2.gif

Mauboussin’s final point on the Illusion of Declining Variance offers the warning that; “None of this is to say that results cannot exhibit a decline in variance over time… But just because you observe reversion to the mean, that’s doesn’t suggest that individual outcomes are converging toward the average.”

Summary:

Reversion to the Mean does not need a cause.

We fail to predict to an adequate amount its effect when making predictions about the future.

Reversion to the Mean is most pronounced at extremes.  Things that are great won’t stay that great, things that are terrible rarely stay that terrible.

When a lot of luck is involved Reversion to the Mean is stronger, and inevitable.

The paradox of skill, (increases in the skills of investors and access to information, has narrowed the skill variation in the population, making luck more important in success), has lead to an increase in the power of Reversion to the Mean, (Mauboussin).

The Importance of Reversion To the Mean in Investing. (Part 1)

The definition at least, is simple: When something happens that is not average, the following event is likely to be closer to the average.   But, the outcome is difficult to predict, understand and prone to illusions. 

Why is Reversion to the Mean important to consider?  In cases where Luck plays a large role in outcomes, such as prices of a stock, “Reversion to the mean is very powerful,” and “failure to regress outcomes sufficiently” causes people to “buy what has done well and sell what has done poorly” leading to the dumb money effect, (Mauboussin, The Success Equation).  Further: “Any activity that combines skill and luck will eventually revert to the mean.”  Howard Marks, when referring to this uses the term cyclical, but I believe it’s essentially the same.  But it’s important to realize that nothing can go up in price forever and down is only limited by zero, but otherwise cant go down forever.

Spierdijk & Bikker (2012), “Mean Reversion in Stock Prices: Implications for long-term investors,” summarized much of the literature. http://www.dnb.nl/en/binaries/Working%20Paper%20343_tcm47-271856.pdf

Fama & French’s 1988 study explained 25%-40% of the variation in stock returns on mean reversion in long term investments over one year to ten years in duration.  Campbell & Shiller (2001) found that adjustments of the P/E ratio towards an equilibrium level was more by the price of the stock than the company fundamentals (price vs. quality).  Coakley & Fuertes (2006) found mean reversion behavior to be attributable to investor sentiment.  Further, mean reversion in stock indices of whole countries was almost absent in periods of low economic uncertainty, but of course very fast during high uncertainty or crisis.

In investing, mean reversion can occur in essentially every asset class, size of company, investing process, valuation model, and geographical boundary due to the roles of luck or randomness.

Mauboussin argues that people usually fail to revert their predictions sufficiently to the mean, and that its one of the biggest hazards decision makers face.   So it makes sense that when price regresses it should move more to the mean than you think it will, and that price often overshoots the mean.  The bigger the movement from the old price to the mean, and the momentum of that move seems to imply the possibility for a larger overshoot.

If everyone in the market is generally failing to calculate the amount of reversion to the mean that may occur, it seems a great contrarian view to take, that it will be greater than expected.  Howard Marks (The Most Important Thing) discusses a paradox where investors think quality rather than price is the main determinant of whether something is risky, yet price is more correlated with risk than quality.  A high quality stock is likely to be high priced and therefore far more at risk of reversion to the mean, despite its positive sentiment.

Contrarian strategies based on mean reversion in stock prices have been shown to yield excess returns, Balvers et al. (2000).  Further, generating risk adjusted excess returns by selling past winners, and buying past losers was profitable, De Bondt & Thaler (1985).  In other words there is less risk in mean reverting stocks especially over long investment periods. 

However, evidence of the actual existence of mean reverting behavior is harder to prove in stock prices, perhaps due to the difficulties in empirical assessments of mean reversion, and a risk averse investor should base investment decisions on conservative assumptions regarding mean reverting behavior occurring in a given timeframe, especially shorter durations, (Spierdijk & Bikker, 2012).    But once it occurs, expect it to exceed expectations of the magnitude of reversion.

Mean Reversion of a Slinky. (It always overshoots its mean!)

Summary:

Reversion to the Mean does not need a cause.

We fail to predict to an adequate amount its effect when making predictions about the future.

Reversion to the Mean is most pronounced at extremes.  Things that are great won’t stay that great, things that are terrible rarely stay that terrible.

When a lot of luck is involved Reversion to the Mean is stronger, and inevitable.

The paradox of skill, (increases in the skills of investors and access to information, has narrowed the skill variation in the population, making luck more important in success), has lead to an increase in the power of Reversion to the Mean, (Mauboussin).

Untangling Skill & Luck – Mauboussin Article. Legg Mason Capital Management. http://vserver1.cscs.lsa.umich.edu/~spage/ONLINECOURSE/R15SkillandLuck.pdf

The Best Paragraph I Have Read All Week.

The Best Paragraph I Have Read All Week.

"Since other investors may be smart, well-informed and highly computerised, you must find an edge they don't have.  You must think of something they haven't thought of, see things they miss or bring insight they don't possess.  You have to react differently and behave differently.  In short, being right may be a necessary condition for investment success, but it won't be sufficient.  You must be more right than others ... which by definition means your thinking has to be different."

Howard Marks "The Most Important Thing: Illuminated."

http://www.samdiener.com/wp-content/uploads/2009/12/different-3.jpg

Kamikaze Capitalism, Its Correlation to China, and US Self-Confidence.

1980’s Kamikaze Capitalism.

Speculative episodes and euphoria seem to occur during periods in the shift of the balance of economic power between nations. Two examples: the Tulip Mania appeared in Holland not long after the Dutch “economic miracle” and Amsterdam's rise to prominence as the centre of world trade.  And secondly, the New York stock market boom in the early twentieth century occurred as the USA overtook Britain as the worlds leading industrial powerhouse.

In the mid 1980's America was struggling with growing trade deficits, while Japan had trade surpluses.  The Reagan government also produced large budget deficits, "that were only sustained by the willingness of Japanese investors to sink their country's trade surplus into US Treasury Bonds" (Chancellor, Devil Take The Hindmost: A History Of Financial Speculation).

Not only was that trade surplus spent on US Treasuries, but also investors spent up on other assets luxury goods, fine art and property, often at above it's real value. “The rising value of (Japanese) land became the engine for creation of credit in the whole economy,” (Chancellor).

Non-bank, loosely regulated lending in Japan was occasionally offered at double the value of the property.  The price of a small apartment in Tokyo exceeded the lifetime earnings of an average graduate salaryman.  Multi-generational hundred year mortgages were undertaken to purchase property.  All this on the speculation of continued domestic property rises which at 1990 prices, equaled four times the real estate value of the entire US!

The Rockefeller Center was purchased by Japanese interests, as was the Exxon Building, Columbia Pictures and even Pebble Beach Golf Club.  A new anxiety that "Japan is buying up the United States" was written about in countless magazines and papers, and this deluge of Japanese capital revived some sense of WW2-type xenophobia in America.   These fears occurred simultaneously with a rise in Japanese self-confidence and nationalistic pride.

This Japanese capital expansion and financial speculation, in almost everything it seems, had not really had a precedent in Japan.  That economy and culture was strongly anti-individualist, community based, hierarchical, state controlled and supposedly more stable, according to Chancellor.

However, when speculation came to Japan in the 1980's, "it burrowed so deep in the Japanese system that when it departed, after a mere five years, the system was in ruins."  Many of the Japanese owned US properties were eventually repatriated to Americans at discounted prices, compared to their inflated sales prices. (Pebble Beach at a $300 Million Loss).

Ultimately, the social consequences of speculation became evident in Japan that were not intended by the government.  It was only then, that for reasons of social control rather than economic side effects, that a decision to prick the bubble was made, (Chancellor).

"History doesn't repeat itself, but it does rhyme." (Nucky Thompson, Boardwalk Empire, Season 5).

2000’s China and US Self-Confidence.

1. Surely we are, and have been witnessing an economic balance of power shift back the USA since the GFC troughs.

2. America has been struggling with a large deficit, while China has had trade surpluses.

3. Chinese surpluses have been sunk into US Treasury Bonds.

4. Chinese surpluses have been spent on US and world property, often at inflated prices.

5. The Waldorf Astoria building in New York has recently been purchased by Chinese Angban Insurance Group for the possibly inflated price of almost $2 Billion.  (http://www.forbes.com/sites/erincarlyle/2014/10/15/stories-from-the-waldorf-astoria-chinese-acquirer-buying-link-to-glamorous-past/)

6. The “China is buying up all the property” fear, has been published repeatedly.

7. Chinese nationalistic pride and self-confidence has risen, and been shown on the world stage increasingly over this period, nowhere more so than South East Asia.

8. The Chinese economy and traditional culture is somewhat anti-individualistic, heirarchical, and state controlled.  Cronyism was rampant in both Japan and China.

9. The height of Japanese speculation occurred during the later half of its economic rise and then its market top, as has China’s - so far at least.

10.  Much of the speculation that has occurred, is on the back of rising property prices domestically, as evident in Hong Kong and China (plus the empty cities issue adding to this risk).

11. Much of the speculation has created ever-increasing disparities of wealth in China, as it did in Japan.  Social side effects have been occurring in China and Hong Kong in the form of protests and a greater awareness of the public of the ultra-rich disparity.

I would argue that Occupy Central in Hong Kong is not just about the universal suffrage and right to vote, but that it also encapsulates issues such as Mainland control and perceived unfairness in the city, and issues about housing prices and wealth.

History would argue that we should see speculation right to the pivot point, and then a decline in China’s economy, and that of the export countries it supports.

The probable current economic balance of power shift, should lead to a beginning of speculation in the USD on top of its recent new gains.  Ultimately a repatriation of many of the American-located sold properties back to their own citizens at discounted prices seems reasonable to expect.  Conversely, Australia and NZ as more reliant on China’s economic health, may not see that happen, as many Australians or Kiwi’s wouldn’t be in a position, or have the confidence to buy at that time.

And finally, a return of US self-confidence would only serve to bring more people back into the market.  All we need to see is that Templeton Optimism to start it off.  The many effects of a strengthening USD and consequently lower commodity/energy prices could be that catalyst.  People would be more optimistic as their purchasing power rises.

This view is essentially nothing new to anyone studying economic history, but I found reading about the historical parallels REALLY interesting today, sitting in the sun at HK Islands Delaney’s Bar, watching massive container ships full of cheap junk, sailing east into the Pacific Ocean.