==============

It is often a wise thing to look around and see where people are doing that is nuts.  Often it is obvious in advance.  In the past, the two most obvious were the dot-com bubble and the housing bubble.  Today, we have two unrelated pockets of nuttiness, neither of which is as big: cryptocurrencies and shorting volatility.

I have often said that that lure of free money brings out the worst economic behavior in people.  That goes double when people see others who they deem less competent than themselves seemingly making lots of money when they are not.

I’ve written about Bitcoin before.  It has three main weaknesses:

  • No intrinsic value — can’t be used of themselves to produce something else.
  • Cannot be used to settle all debts, public and private
  • Less secure than insured bank deposits

In an economic world where everything is relative in a sense — things only have value because people want them, some might argue that cryptocurrencies have value because some people want them.  That’s fine, sort of.  But how many people, and are there alternative uses that transcend exchange?  Even in exchange, how legally broad is the economic net for required exchangability?  Only legal tender satisfies that.

That there may be some scarcity value for some cryptocurrencies puts them in the same class as some Beanie Babies.  At least the Beanie Babies have the alternative use for kids to play with, even though it ruins the collectibility.  (We actually had a moderately rare one, but didn’t know it and our kids happily played with it.  Isn’t that wonderful?  How much is the happiness of a kid worth?)

I commented in my Bitcoin article that it was like Penny Stocks, and that’s even more true with all of the promoters touting their own little cryptocurrencies.  The promoters get the benefit, and those who speculate early in the boom, and the losers are those fools who get there late.

There’s a decent public policy argument for delisting penny stocks with no real business behind them; things that are worth nothing are the easiest things to spin tales about.  Remember that absurd is like infinity.  If any positive value is absurd, so is the value at two, five, ten, and one hundred times that level.

The same idea applies to cryptocurrencies; a good argument could be made that they all should be made illegal.  (Give China a little credit for starting to limit them.)  It’s almost like we let any promoter set up his own Madoff-like scheme, and sell them to speculators.  Remember, Madoff never raked off that much… but it was a negative-sum game.  Those that exited early did well at the expense of those that bought in later.

Ultimately, most of the cryptocurrencies will go out at zero.  Don’t say I didn’t warn you.

Shorting Volatility

This one is not as bad, at least if you don’t apply leverage.  Many people don’t get volatility, both applied and actual.  It spikes during panics, and reverts to a low level when things are calm.  It seems to mean-revert, but the mean is unknown, and varies considerably across different time periods.

It is like the credit cycle in many ways.  There are two ways to get killed playing credit.  One is to speculate that defaults are going to happen and overdo going short credit during the bull phase.  The other is to be a foolish yield-seeker going into the bear phase.

So it is for people waiting for volatility to spike — they die the death of one thousand cuts.  Then there are those that are short volatility because it pays off when volatility is low.  When the spike happens, many will skinned; most won’t recover what they put in.

It is tough to time the market, whether it is equity, equity volatility, or credit.  Doesn’t matter much if you are a professional or amateur.  That said, it is far better to play with simpler and cleaner investments, and adjust your risk posture between 0-100% equities, rather than cross-hedge with equity volatility products.

Again, this is one where people are very used to selling every spike in volatility.  It has been a winning strategy so far.  Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer.  The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you.  Also, for those playing long on volatility and buying protection on credit default — this has been a long credit cycle, and may go longer.  Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing.  Just remember that new asset classes that have never been through a “failure cycle” tend to produce the greatest amounts of panic when they finally fail.  And, all asset classes eventually go through failure.

 

Picture Credit: Peanuts Reloaded || Perhaps today Brexit; Monday an exit from Italy or Spain; [then] Europe dismantles

Picture Credit: Peanuts Reloaded || Roughly: “Perhaps today Brexit; Monday an exit from Italy or Spain; [then] Europe dismantles”

=-==-=-=-=-=-=-=-=-=-=-=-=-=-==-=-

At a time like this, when the Brexit Boogeyman goes “Boo!” it’s time to take stock of the situation amid panic.

Though the UK will face some political unrest as the Prime Minister resigns, and article 50 is likely but not certainly invoked, the nature of political discourse hasn’t shifted in full.  Though an important question, it is only one question, and more things will remain stable than change.

At least that is most likely.  If you think of “real options” theory, you could say, “Okay, a door opened today that was previously locked.  What new doors beyond that one could be opened?”  Other countries could leave the EU and/or Eurozone [EZ].  The EU/EZ could dissolve.  The odds of other countries leaving isn’t that high.  For the EU or EZ to dissolve would take a lot of doing, and the odds of that happening is very low, though higher than the odds yesterday.

As I said a week ago:

Governments are smaller than markets; markets are smaller than cultures.

What I am saying is that almost everything affecting the needs of people will get done when there is sufficient freedom.  If Brexit occurs, the UK will negotiate some agreement that is mutually beneficial to the UK and the EU, and most things will go on as they do today.  Even with a subpar agreement, perfidious Albion is very effective at getting what they need completed.  This is especially true of their very effective and creative financial sector in the City of London without which most effective international secrecy, taxation avoidance and regulatory avoidance business could not be done.

Whatever happens, it will happen slowly.  Leaving a complex multinational group like the EU takes two years at least.  How it all works out in detail is not predictable.

I can say that human systems tend toward stability.  People act to preserve the things that they like.  Only under severe conditions does that cease to be true, and even then typically only for short periods of time.

I can also say something a little more controversial.  Wealth, assets, and money [WAM] act like they are alive and have more votes than people do under most conditions.  Why am I saying this?

Governments come in, and go out, but for the most part, the same things get done.  Those thinking that radical change will come are usually deeply disappointed.  WAM tend to maintain the status quo, not because their owners bribe politicians and suborn regulators pay political action contributions,  but because people want the streams of goods and services that help make WAM valuable.  Only a genuine crisis at least as large as the Great Depression or the Civil War can create truly radical change that reshapes the basic desires of most of the people in a nation.

Capitalist democracies that respect the rule of law (e.g., the government is also governed by a higher law) are usually pretty stable; systems that don’t have significant capitalism or democracy may last a couple generations, but tend to fall apart.

All that said, there is significant economic pressure to do two things after the Brexit:

  • Rethink the single currency and common laws
  • Maintain a free-ish trade zone in goods and services

The Eurozone does not allow for the necessary economic adjustments across nations in a fiat monetary system.  Nations need their own currencies, central banks, etc.  They also need to govern themselves via their local culture, not someplace far away with misguided idealists who think they know what’s best for all.

Free-ish trade maintains most of what is needed for human needs.  The European Union is a political construct meant to prevent war from ever recurring in Europe.  The best way to do that is through trade.  Severe wars rare start between nations that rely on each other and interact through commerce.

My view is that ten years from now, the goods and services that people want will get delivered, regardless of the governmental structures in Europe.  I will invest accordingly.

Practical Implications

Things will be rocky in the short run, and there will be more bumps along the road as the Brexit negotiations go on.  I will be resisting panic and euphoria in modest ways.  This isn’t the sum total of my strategies, but I expect that profitable business will continue, and that people and nations will pursue generally intelligent long-term self-interest as events unfold.

When I say modest, I tweak my portfolios at the edges.  Brexit does not comprise more than 5% of what I would do with assets.  As with any investment idea, spread your bets, diversify, don’t bet the farm.

And, I would say the same even to governments — if you don’t have contingency plans for the possibility of the EU shrinking or even disappearing, you are not truly prepared for all contingencies.  As Warren Buffett once said (something like) “We’re paid to think about the things that ‘can’t happen.'”

In closing, many thought that Brexit could not happen.  Now, what else “can’t happen?” 😉

Photo Credit: Friends of the Earth International || Note: the above is just a photo to illustrate a point. I do not endorse debt cancellation under most coircumstances

Photo Credit: Friends of the Earth International || Note: the above is just a photo to illustrate a point. I do not endorse debt cancellation under most circumstances.  I do support debt-for-equity swaps to delever the system.

Debt, debt, debt… debt is kind of like a snowflakes.  A single snowflake is a pretty star, but one quintillion of them is a horrendous mess.  In the same way, most individual debts are reasonable and justifiable, but when debt becomes a pervasive part of the economic system, the second order effects kick in:

  • As fixed claims grow relative to equity claims, the economy becomes less flexible, because many are counting on the debts for which they are creditors to be paid back at par.
  • Economies that are heavily indebted grow slower.
  • Central banks following untested and dubious theories like QE and negative interests rates try help matters, but end up making things worse.  (Gold would be an improvement.  Just regulate the solvency of banks tightly, which was not done in cases where the gold standard failed.)
  • Political unrest leads to dubious populism, and demands for debt cancellation, and a variety of other quack economic cures.
  • The most solvent governments find high demand for their long debt.  Long-dated claims raise in value as inflation falls along with monetary velocity.

Thus the mess.  Bloomberg had an article on the topic recently, where it tried to ask whether and where there might be a crisis.  I’ve argued in the last year that we shouldn’t have a major crisis in the US over domestic debts.  There are a few areas that look bad:

  • Student loans
  • Agriculture loans
  • Corporate debts to speculative grade companies that are negatively affected by falling crude oil and commodity prices.
  • Maybe some auto loans?

But those don’t add up to a debt market in trouble as when residential mortgages were on the rocks.

But what of other nations and their debts, public and private?

Tough question.

That said, the answer is akin to that for a corporation with a tweak or two.  It’s not the total amount of indebtedness versus assets or income that is the main issue, it is whether the debts can continue to be rolled over or not.  A smaller amount of debt can be a much larger problem than a bigger amount that is longer. (point 2 below)

Take a step back.  With countries there are a variety of factors that would make skeptical about their financial health:

  • Large increases in indebtedness
  • Large amounts of short-term debt
  • Large amounts of foreign currency-denominated liabilities (also true of the entire Eurozone — you don’t control the value of what you will pay back)
  • A fixed, or pseudo-fixed exchange rate (versus floating)
  • A weak economy, and
  • Debt and/or debt service to GDP ratios are high

The first point is important because whatever class of debt increases the most rapidly is usually the best candidate for credit troubles.  Debt that is issued rapidly rarely gets put to good uses, and those that buy it usually aren’t doing their homework.

Under ordinary circumstances, this would implicate China, but the Chinese government probably has enough resources to cover their next credit crisis.  That won’t be true forever, though, and China needs to take steps to make their banking system sound, such that it never generates losses that an individual bank can’t handle.  Personally, I doubt that it will get there, because members of the Party use the banking system for their own benefit.

Points 3, 4, and 6 deal with borrowers compromising on terms in order to borrow.  They are stretching, and accepting terms not adjustable in favor of the debtor, or can be adjusted against the debtor.   If you control your own currency, these problems are modified, because of the option to print currency to pay off debt, and inflate problems away. (Which creates other problems…)

By pseudo-fixed interest rates, I take into account countries that as neo-mercantilists make policy to benefit their exporters at the cost of their importers and consumers.  These countries fight changes in the exchange rate, even though the exchange rate may technically float.

Point 5 simply says that there is insufficient growth to absorb the increases in debt.  Economies growing strongly rarely default.

Conclusion?

My view is this: the next major credit crisis will be an international one, and will involve governments that can’t pay on their debts.  It won’t include the US, the UK, and certainly not Canada.  It probably won’t involve China.  Weak parts of the Eurozone and Japan are possibilities, along with a number of emerging markets.

And, as an aside, if this happens, people will lose faith in central banks as being able to control everything.  I think the central banks and national treasuries will find themselves hard pressed to find agreement at that time.  QE and negative interest rates might be controllable in a domestic setting, but in an international framework, other nations might finally say, “Why would I want to get paid back in that weak currency?”  (And what holds that back now is that virtually all of the world’s currencies except gold are involved in competitive devaluation to some extent.)

My advice is this: be careful with your international holdings.  The world may be peaceful right now, and everyone may be getting along, but that might not last.  Diversification is a good idea, but don’t forget that there is no place like home, unless the crisis is in your home.

I get letters from all over the world.  Here is a recent one:

Respected Sir,

Greetings of the day!

I read your blog religiously and have gained quite a lot of practical insights in financial field. Your book reviews are very helpful and impartial.

I request you to write blog post on dollar pegs in Middle East and under what conditions those dollar pegs would fall.

If in case you cannot write about it, kindly point me to some material which can be helpful to me.

Thanks for your valuable time.

Now occasionally, some people write me and tell me that I am outside my circle of competence.  In this case I will admit I am at the edge of that circle.  But maybe I can say a few useful things.

Many countries like pegging their currency to the US dollar because it provides stability for business relationships as businesses in their country trade with the US, or, with other countries that peg their US dollar, or, run a dirty peg of a controlled devaluation.  Let me call that informal group of countries the US dollar bloc. [USDB]

The problem comes when the country trading in the USDB begins to import a lot more than they export, and in the process, they either liquidate US dollar-denominated assets or create US dollar-denominated liabilities in order to fund the difference.

Now, that’s not a problem for the US — we get a pseudo-free pass in exporting claims on the US dollar.  The only potential cost is possible future inflation. But, it is a problem for other countries that try to do so, because they can’t manufacture those claims out of thin air as the US Treasury does.

Now in the Middle East it used to be easy for many countries there because of all the crude oil they produced.  Crude oil goes out, goods and US dollar claims come in.  Now it is reversed, as the price of crude is so low.  Might this have an effect on the currencies of the Middle East.  Well, first let’s look at some currencies that float that are heavily influenced by crude oil and other commodities: Australia, Canada, and Norway:

Commodity Currencies

As oil and commodities have traded off so have these currencies.  That means for pegged currencies the same stress exists.  But with a pegged currency, if adjustments happen, they are rather large violent surprises.  Remember the old saying, “He lied like a finance minister on the eve of the devaluation,” or Monty Python, “No one expects the Spanish Inquisition!”

That’s not saying that any currency peg will break imminently.  It will happen later for those countries with large reserves of hard currency assets, especially the dollar.  It will happen later for those countries that don’t have to draw on those reserves so rapidly.

Thus my advice is threefold:

  1. Watch hard currency reserve levels and project future levels.
  2. Listen to the rating agencies as they downgrade the foreign currency sovereign credit ratings of countries.  When the ratings get lowered and there is no sign that there will be any change in government policy, watch out.
  3. Watch the behavior of wealthy and connected individuals.  Are they moving their assets out of the country and into hard currency assets?  They always do some of this, but are they doing more of it — is it accelerating?

Point 3 is an important one, and is one seemingly driving currency weakness in China at present.  US Dollar assets may come in due to an excess of exports over imports, but they are going out as wealthy people look to preserve their wealth.

On point 2, the rating agencies are competent, but read their writeups more than the ratings.  They do their truth-telling in the verbiage even when they delay downgrades longer than they ought to.

Point 1 is the most objective, but governments will put off adjustments as long as they can — which makes the eventual adjustment larger and more painful for those who are not connected.  Sadly, it is the middle class and poor that get hit the worst on these things as the price of imported staple goods rise while the assets of the wealthy are protected.

And thus my basic advice is this: gradually diversify your assets into ones that will not be harmed by a devaluation.  This is one where your government will not look out for your well-being, so you have to do it yourself.

As a final note, when I wrote this piece on a similar topic, the country in question did a huge devaluation shortly after it was written.  Be careful.

Photo Credit: Jason Wesley Upton || Of course this isn't China...

Photo Credit: Jason Wesley Upton || Of course this isn’t China…

I know this is redacted, but it is advice to a reader in a really remote area of the world.  You might find it interesting.

I am currently with the XXX team in XXX.  We are taking about trying to budget the [project] with the inflation of the past months being 50%. And September being 91%. I think XXX would appreciate your thoughts on the likely economic and inflation situation. They are trying to decide whether to move to working on dollars. And how to budget if they stay in the [local currency].

Dear [Friend],

One question that may not matter so much… is the inflation rate 50-91%/year, or 50-91%/month?  The reason I ask this is if that is the rate per month, then you should try to do as much business as you can in dollars, and/or treat the local currency like a hot potato… don’t hold onto it long – it is not a store of value.  It is normal in such a situation for another currency to become the practical currency when inflation gets that high… even if it is illegal.

If the rate is 50-91%/year, that’s not great to work with, but prices are still moving slow enough for you to have some degree of a planning horizon in the local currency.  Still, any big transactions should be done in dollars, unless you are certain that you are getting a favorable rate in the local currency.

As for budgeting, it could be useful to do the budget in both currencies.  This will help to raise the natural question of what happens if you don’t have the right currency.  Here’s what I mean: ask what currencies you would naturally use to transact to accomplish your goals – look at both revenues and expenses.  If you find your expenses are mainly in dollars or euros, but revenues are in the local currency, you will need to do one of two things.  Either a) try to charge in hard currency terms, or raise revenue rates regularly, or b) build in a significant pad in local currency terms for the things you would typically buy in a hard currency.

Feel free to send me a spreadsheet on this.  As an aside, you can tell XXX that I have little trust that the situation will improve rapidly.  The government is too corrupt, its budget way out of balance, and any revenue from oil is down.  It would take a hero willing to end the corruption, and then survive ending it, in order for the inflation to stop.

In closing, the following paragraph is illustrative, and not strictly relevant:

I realize that you all aren’t investing in the country, but if you were, I would give the following advice: invest in land.  In a nation where there are no securities market, and the government is the cause of the inflation, land is the only thing that retains value.  AIG used to do this all the time in countries, particularly when they couldn’t remit their earnings there back to the US.  As they say in Argentina, “The wealthy preserve their wealth by owning land.”  So long as land is not expropriated, it protects wealth against governments who steal via inflation.  Gold is similar, but where you are, something that light and valuable could easily be stolen.

Anyway, I missed you at XXX, and hope and pray that you are doing well.  If you or anyone else on the team has questions on this, just let me know.  I’ll make time for you.

In Christ,

David

Recently I ran across an academic journal article where they posited one dozen or so risk premiums that were durable, could be taken advantage of in the markets.  In the past, if you had done so, you could have earned incredible returns.

What were some of the risk premiums?  I don’t have the article in front of me but I’ll toss out a few.

  • Many were Credit-oriented.  Lend and make money.
  • Some were volatility-oriented.  Sell options on high volatility assets and make money.
  • Some were currency-oriented.  Buy government bonds where they yield more, and short those that yield less.
  • Some had you act like a bank.  Borrow short, lend long.
  • Some were like value investors.  Buy cheap assets and hold.
  • Some were akin to arbitrage.  Take illiquidity risk or deal/credit risk.
  • Others were akin to momentum investing.  Ride the fastest pony you can find.

After I glanced through the paper, I said a few things to myself:

  • Someone will start a hedge fund off this.
  • Many of these are correlated; with enough leverage behind it, the hedge fund could leave a very large hole when it blows up.
  • Yes, who wouldn’t want to be a bank without regulations?
  • What an exercise in data-mining and overfitting.  The data only existed for a short time, and most of these are well-recognized now, but few do all of them, and no one does them all well.
  • Hubris, and not sufficiently skeptical of the limits of quantitative finance.

Risk premiums aren’t free money — eggs from a chicken, a cow to be milked, etc.  (Even those are not truly free; animals have to be fed and cared for.)  They exist because there comes a point in each risk cycle when bad investments are revealed to not be “money good,” and even good investments are revealed to be overpriced.

Risk premiums exist to compensate good investors for bearing risk on “money good” investments through the risk cycle, and occasionally taking a loss on an investment that proves to not be “money good.”

(Note: “money good” is a bond market term for a bond that pays all of its interest and principal.  Usage: “Is it ‘money good?'”  “Yes, it is ‘money good.'”)

In general, it is best to take advantage of wide risk premiums during times of panic, if you have the free cash or a strong balance sheet behind you.  There are a few problems though:

  • Typically, few have free cash at that time, because people make bad investment commitments near the end of booms.
  • Many come late to the party, when risk premiums dwindle, because the past performance looks so good, and they would like some “free money.”

These are the same problems experienced by almost all institutional investors in one form or another.  What bank wouldn’t want to sell off their highest risk loan book prior to the end of the credit cycle?  What insurance company wouldn’t want to sell off its junk bonds at that time as well?  And what lemmings will buy then, and run over the cliff?

This is just a more sophisticated form of market timing.  Also, like many quantitative studies, I’m not sure it takes into account the market impact of trying to move into and out of the risk premiums, which could be significant, and change the nature of the markets.

One more note: I have seen a number of investment books take these approaches — the track records look phenomenal, but implementation will be more difficult than the books make it out to be.  Just be wary, as an intelligent businessman should, ask what could go wrong, and how risk could be mitigated, if at all.

 

Here’s the second half of my most recent interview with Erin Ade at RT Boom/Bust. [First half located here.] We discussed:

  • Stock buybacks, particularly the buyback that GM is doing
  • Valuations of the stock market and bonds
  • Effect of the strong dollar on corporate earnings in the US
  • Effect of lower crude oil prices on capital spending
  • Investing in Europe, good or bad?

Seven minutes roar by when you are on video, and though taped, there is only one shot, so you have to get it right.  On the whole, I felt the questions were good, and I was able to give reasonable answers.  One nice thing about Erin, she doesn’t interrupt you, and she allows for a few rabbit trails.

Photo Credit: Zach Copley

Photo Credit: Zach Copley

I’ve generally been quiet about Bitcoin.  Most of that is because it is a “cult” item.  It tends to have defenders and detractors, and not a lot of people with a strong opinion who are in-between.  There’s no reward for taking on something that has significance bordering on religious for some… even if it proves to be a bit of a “false god.”

I view Bitcoin as a method of payment, a collectible item, a commodity that is not fully fungible, and not a store of value.  It is not a currency, and never will be, unless a government takes it over and adopts it.

In order for a tradable item to be a store of value, the amount of variation in value in the short- to intermediate-term versus other items that has to be limited.  If there are other tradable items with greater stability toward the other items, those tradable items would be better stores of value.  Thus Bitcoin is inferior as a store of value versus the US Dollar, the Euro, the Yen, etc.  It is far more volatile versus goods and assets that one might want to buy, and goods and liabilities that one might want to fund.

Now as an aside, the same thing happens in hyperinflationary economies.  Merchants have to change their prices frequently, because the currency is weak.  Often another currency will begin to replace the weak local currency, like the US Dollar or the Euro, even if that is not legal.

Fungibility implies that any Bitcoin is as good as any other Bitcoin.  But with failures like Mt. Gox, a Bitcoin exchange that had Bitcoins under its care stolen from it, a Bitcoin under the care of Mt. Gox was not as valuable as one elsewhere.  (Another aside: that happened in a minor way with the Euro when Euros in Cypriot banks were forced to have a “haircut,” while Euros elsewhere were unaffected.)

Bitcoin is a means of payment, a way of transferring value from one place/person to another.  It seems Bitcoins move well, but they are less good at being safely stored.

The theft of Bitcoins points out the need for there to be a legal system to protect property rights.  Licit participants in Bitcoins as a group have not been adequate to assure that the rightful owners might not lose them as the result of computer hacking.  Contrast that with the protections that credit card holders have when false transactions are applied against credit card accounts.  The credit card companies eat the losses, funded by profits from interest charged an interchange fees.

The libertarian vision of a currency that does not require a court, a government to protect it is misguided.  Where there are thieves, there is a need for courts to try cases of theft, and deal with questions of equity if theft leads to an insolvency.

Now, governments can be less than fair with their own judicial systems.  I think of Dennis Kozlowski, formerly CEO of Tyco, who was barred from using his own money in self-defense when the US Government brought him to trial.  Much as you might like to have value protected from the clutches of the government, that is easier said than done, and there are thieves that will pick away at those who get value away from governments, because ultimately in an interconnected world, you have to trust other people at some points, and trust can be violated as much as the rights of a citizen can be violated.  Repeat after me: THERE IS NO PERFECTLY SAFE PLACE ON EARTH TO STORE VALUE!  That said, though, there are safer places than others, and so you have to live with the risks that you understand, and are prepared to take.

If you think that Bitcoin fits that bill, well, knock your socks off.  Have at it.  I will stick with US Dollars in banks, money market funds, bonds, and public and private stocks.  Maybe I will even buy some gold that does nothing, just for the sake of diversification.  But ultimately my store of value is in the bank of Heaven, as it says in Matthew 6:19-21:

“Do not lay up for yourselves treasures on earth, where moth and rust destroy and where thieves break in and steal; but lay up for yourselves treasures in heaven, where neither moth nor rust destroys and where thieves do not break in and steal. For where your treasure is, there your heart will be also.”

There is no perfect security on Earth, try as hard as you like.  Bitcoins may keep value away from the government under some conditions, but who will protect your property rights in Bitcoins in the event of theft?  You can’t have it both ways, so Bitcoins as property would either be taxed and regulated by governments, or be totally underground, which would diminish utility considerably.

One final note: Bitcoins can’t be used of themselves to produce something else.  They are a fiat currency, and only has value to the degree that users place on it.  I liken it to penny stocks, where traders can bounce the price around, because there is nothing to tether the price to.  At least with gold, you have jewelers demanding it to turn it into jewelry, and a broader pool of people who are somewhat less jumpy about what the proper exchange rate between gold and dollars should be.

But, gold can be stolen… again, no Earthly store of value is perfect.  All for now.

Photo Credit: Storm Crypt || Ah, to be in Zurich, and enjoy the additional purchasing power of the Franc

Photo Credit: Storm Crypt || Trusting the Swiss National Bank, Really?

Significant currency brokers relied on the Swiss National Bank to keep its currency peg in place. Now some of them are insolvent, and many of their clients also. Should they be surprised? Currency pegs put into place for political reasons rarely hold up, and this has happened in Switzerland in the past.

On thing I learned early in my career is that you never bet the firm. You never allow there to be a single point where a change brings failure.

You don’t rely on the kindness of strangers. In markets, always ask “What are the motives of the other players?” As an example, think of all of the people who lost money on auction rate preferred securities. There was no guarantee that auctions would always succeed, or that if one failed, the sponsor would take up the slack. No, when they failed, those that relied on the implicit idea that “auction rate preferreds are a safe reliable way to earn extra money in the short run” got hosed.

That’s why I say be wary, particularly where politically motivated entities like Central Banks are involved.  Are you certain that the Fed will tighten this year, and that interest rates will rise?  Do be so certain; people have been betting on that for some time, and the Fed is more than happy to let things slide until something forces their hand, or they think the risks of a move are minuscule.  Though we are at record lows for the 30-year Treasury, rates could go lower still.

Credit: Bloomberg

Credit: Bloomberg

Who knows?  Maybe rates go low enough that someone relying on them to remain above a certain level gets forced to buy into a high market already, and put in the top for prices, and bottom for yields.

On the other hand, there are some that argue that the Fed can’t raise rates because then the US Government would have problems financing its deficit if interest rates rose.  Maybe, but I wouldn’t rely on that, either.  I’ve been long long Treasuries for quite some time, but we are getting near the points where Hoisington and Schilling have suggested the trade might be over. Add onto that that banks may finally be starting to lend, and maybe indeed, we are near the bottom for interest rates. I just would not rely on it and make a one way bet.

In my next segment on “Learning from the Past,” I’ll go over my first really major loss where I traveled on the coattails of a famous value investor and lost royally. The point is: don’t rely on the kindness of strangers. Analyze where things can go wrong, and where other parties may have a different view than you do. Why are you smarter than they are? If they are in a position of power, what makes you think they will use it in your favor, rather than act in their own interests? As an example, just because the banks were bailed out last time does not mean that it will happen next time. The players and politics could be vastly different, with policymakers finally realizing that they only have to protect depositors, and nothing more.

So be wary.  More next time, and I should be returning to a more regular blogging schedule once again.  My extracurricular project nears completion.  More on that later also.

Photo Credit: Hans and Carolyn || Do you have the right building blocks for your model?

Photo Credit: Hans and Carolyn || Do you have the right building blocks for your model?

Simulating hypothetical future investment returns can be important for investors trying to make decisions regarding the riskiness of various investing strategies.  The trouble is that it is difficult to do right, and I rarely see it done right.  Here are some of the trouble spots:

1) You need to get the correlations right across assets.  Equity returns need to move largely but not totally together, and the same for credit spreads and equity volatility.

2) You need to model bonds from a yield standpoint and turn the yield changes into price changes.  That keeps the markets realistic, avoiding series of price changes which would imply that yields would go too high or below zero. Yield curves also need ways of getting too steep or too inverted.

3) You need to add in some momentum and weak mean reversion for asset prices.  Streaks happen more frequently than pure randomness.  Also, over the long haul returns are somewhat predictable, which brings up:

4) Valuations.  The mean reversion component of the models needs to reflect valuations, such that risky assets rarely get “stupid cheap” or stratospheric.

5) Crises need to be modeled, with differing correlations during crisis and non-crisis times.

6) Risky asset markets need to rise much more frequently than they fall, and the rises should be slower than the falls.

7) Foreign currencies, if modeled, have to be consistent with each other, and consistent with the interest rate modeling.

Anyway, those are some of the ideas that realistic simulation models need to follow, and sadly, few if any follow them all.