Thing to Do When I am Uber Rich

February 28, 2014 - Leave a Response

Fund and direct charity organizations to:

(1) Promote Utilitarianism philosophy as a quasi-religion

(2) Solve scarcity by promoting energy and nanotechnology research: (a) commercialize near-limitness energy sources such as fusion, solar-satellite, anti-matter, zero-point, (b) turn limitness energy into matter, (c) rearrange matter into consumable form via nanotech, (d) reduce sickness and extend human life via nanotech

(3) Solve poverty by designing and promoting a post-scarcity economic structure that (a) has just enough government intervention to solve externalities and tragedy of commons, (b) is decentralized otherwise, (c) work is not required to achieve a basic standard of living, (d) innovation is rewarded

(4) Solve (the main cause of) suffering by promoting a revamped/modernized form of democratic government to all sovereigns: (a) power begins with the individual, (b) delegated upwards where necessary to provide goods, services, and structures IF AND ONLY IF they cannot be provided or cannot be efficiently provided by a free market, (c) strong and clear checks and balances to ensure government reports to the people

(5) Promote interstellar travel, exploration and colonization.

 

Exchange Trade Fund – The Perfect Vehicle for Shorting

January 9, 2011 - Leave a Response

The ETF is absolutely the greatest instrument ever invented for the purpose of selling short.

First of all, ETFs, like most investment pools, charge an annual management fee – typically disclosed as the “Management Expense Ratio”. As we all know, the fee is expensed out of the fund, which means that if all else stays the same, the value of the fund will slowly decay by the MER every year automatically. The flip side is that this is an inherent bias favoring the short side. If you are short an ETF, you are essentially getting paid an annual fee for doing nothing.

Let’s look at a simple example. Let’s say you are bearish on the Eurozone and would like to bet against the Euro spot rate. Why go through the trouble of opening an FX account and sell Euro there, when you can instead short the Euro currency ETF (FXE), where you will get paid the fund’s MER of 0.40% on top of speculating on Euro’s demise? Perhaps by habit. But as long as FXE is not trading at a significant discount to NAV, there is no reason why one would choose to short the underlying rather than the fund.

These single asset ETFs are godsend. Yes, regular mutual funds charge management fees as well, but none have the ease of shorting like ETF. The same situation applies for any single currency ETFs, as well as precious metal ETFs and commodity ETFs. Oh – did I mention those crazy commodity ETFs?

That brings us to the second reason why exchange traded funds provide such great shorting opportunities. By now it is clear that contango – a phenomenon where contracts for delivery of commodities far in the future are priced higher than contracts for delivery in the near future – is the bane of futures-based commodity ETFs.

A prime example is The US Oil Fund (USO), where the objective is to track the WTI oil price by holding future contracts of the nearest delivery. Of course, the fund doesn’t actually have the means and storage space to take delivery on several million barrels of real oil. So as the contracts approach delivery date, the fund is forced to roll them to the next delivery date by selling the existing contracts and buying the following month’s contracts, thus paying the difference caused by contago (AKA “roll yield”).

Other futures traders know this, and they are able to profit from front-running USO by buying next month’s contracts ahead of the fund, thus exacerbating the fund’s cost of rolling the contracts. At inception, USO started out with near 1:1 ratio to the price of oil, but after years of underperformance, it is now trading at around $38, a staggering 57% discount to the actual oil price.

Now I am by no means advocating shorting oil at this point in time or ever in the future. But if your own macroeconomic view and investment strategy dictate that you should short it, why on earth would you not select USO as the vehicle for implementing your strategy?

This article is not an exhausive list of the short-comings of ETFs. There are other good examples, like those leveraged short Treasury funds such as ProShares UltraShort 20+ Year Treasury (TBT). It may sound counter-intuitive, but after all that MER, margin costs and other risks of leverage, I would not be surprised if shorting the short Treasury fund performs better than simply going long on real Treasuries! A poorly structured fund works to the advantage of the short-seller – being traded on an exchange just makes the short position simpler to implement.

Don’t get me wrong – I am not against all ETFs, because some do add value for investors and have a place in the investment universe. For example, emerging and frontier market funds provide access to markets that would otherwise be difficult for the public. An actively managed ETF provide a cheap way to access the skills of a particular fund manager. Even funds that simply replicate an index save investors time and effort from assembling the components themselves. All these types of funds add value that justifies the MER.

But single asset ETFs, like the one on the Canadian dollar (FXC)? Not so much.

Boy I can’t wait until these jokers start offering single stock ETFs. Or better yet, an ETF on a single-stock-future!

Monetary Policies for a Modern World

December 16, 2010 - 4 Responses

There is a lot of misinformation out there that simply does not reflect the current state of the world we are in, and this misinformation is correspondingly causing a gigantic misallocation of private capital to non-productive uses (especially towards speculations in precious metals and other commodities) and an overblown distrust in the government’s monetary policies.

This is actually somewhat expected, because even most of our policy makers do not have the proper educational background to understand what they are dealing with and how the fiat currency system really works. Ben Bernanke and his contemporaries are, in fact, learning on the job. It is no secret that they (as well as a lot of the doomsday prognosticators aka finance columnists out there) were educated by textbooks and schools of thought formulated during an era of gold standard with fixed exchange rates. An updated conceptual framework is required for good decision-making in a modern economy.

The best framework for describing our system of fiat currencies is the Modern Monetary Theory. MMT basically shatters everything we learned from our Macro Econ textbooks, because the old conventional thinking evolved out of an obsolete economic model. In a world where free-floating fiat currencies are the norm, the conventional model does not apply. PragCap has a good write-up on it.

The theory itself is actually not very modern – the first iteration of it was formed in the 1920s and it was called Chartalism. It is currently experiencing a quiet revival because it most accurately explains and predicts what we are now observing in our modern economies. Unfortunately it has not yet become a mainstream school of thought.

But it’s super important that it does, because in one fell swoop Modern Monetary Theory explains

  1. Why the periphery EU countries are having fiscal troubles;
  2. Why the same troubles did not occur to the Japanese government after 2 decades of extreme deficit spending and monetary easing;
  3. Why they also will not happen to the US – the US government is in no risk of default, and in fact it is debatable whether they have dished out enough stimulus;
  4. The hyperinflation/doomsday scenario is not destined to happen, therefore gold and other precious metals are in a speculative bubble.

Without being too technical, I will try to summarize the MMT basics in this article. Essentially, the following assumptions hold true for all major developed economies outside the eurozone (i.e. US, Canada, Japan, UK, Australia etc.):

  • a) Money is not physically backed by any commodity or pegged to any foreign currencies.
  • b) The government is the sole issuer of money.
  • c) The government has the power to maintain the legal tender status of money (through a functioning taxation and court system).
  • d) The fiscal and monetary arms of the government effectively work as a single unit.

Assumption (d) is VERY important and this is where it breaks down for the EU, because while they have a monetary union via ECB’s euro, they do not have a fiscal union on the “federal” level. In other words, the arm of government that spends most of the money (e.g. national governments like Ireland and Greece) does not have the power to print money (euro).

These countries cannot monetize their euro-denominated debt, which arbitrarily forces them into the same constraints that regular households and private enterprises experience everyday – the need to balance budget, the need to fund expenditures with income. In fact, MMT predicts that the current arrangement of the European Union is not sustainable, and they will have to either break-up or pursue a greater federal union in order to synchronize their monetary and fiscal policies.

However, in a true Modern Monetary System (e.g. US, Canada, Japan, UK, Switzerland), the government does not behave like a private household/enterprise. The government has no obligation to balance revenue and expense – in fact it can spend on deficit forever, with the only ceiling being the economy’s ability to produce (aka Inflation). But more on that later – first we have to see that all domestically denominated government debt is an illusion under MMT.

In economies such as US where (d) is true, the government never actually “owe” money in the traditional sense, because they are also the ones who can print money. A recent example is the Federal Reserve’s QE2, where on the surface they created money to buy US Treasuries from the private sector in the open market. When all is said and done, $600 billion of treasury bills will appear as “Assets” on the Fed’s balance sheet, and the same $600 billion is already on the US Government’s balance sheet as “Liabilities”.

In all practicality, this is a wash. It is just an accounting illusion, and the government, when view as a single unit, no longer has any real obligations. All that happened was a transfer from the government’s printing press (indirectly via the private sector) to the Treasury Department which funded the government’s spending. A government who issues debt in the same currency as the money it prints will never have a debt problem.

Naturally then, the next question is why would a society accept fiat money as a storage of value/unit of exchange, when the money can be haphazardly printed by the government and not be backed by any tangible commodity?

A fiat currency is not just backed by “faith” as some would have you believe. In assumption (c), having a stable government implies that we have an army and/or a police force strong enough to maintain a functioning tax and court system. Meaning, the government can force you to surrender a portion of your livelihood every April as taxes, and you must pay them in the form of their currency, or they jail you. This creates instant demand for the currency – even if you choose to transact all of your private businesses in gold, you must convert a pre-set percentage of your income to the currency at least once every year.

Likewise, the courts can rule that plaintiffs and defendants settle damages in the form of the government’s currency. The accused pays in money and the victim must accept money as compensation for the damages. The government has the power to make sure the courts’ rulings are enforced.

And just like that – because the government declares by fiat that their currency is legal tender , the currency has intrinsic value as long as the government is functioning and has a loyal arm force that maintains the integrity of money. This is not a matter of faith. And because of this de facto intrinsic value, the private sector also chooses to transact in money themselves, even for transactions where the government is not directly involved.

So to recap what we know so far: the government does not need to “balance their budget”, they can print money and then spend it, and the private sector accepts it because they will need it because the government has the power to tax for it. Fine, you say, but what is the upper limit of money that can be printed and spent?

The ultimate limiter is inflation. Inflation does not happen automatically when we expand the monetary base, especially when the velocity of money is declining (for example, when the private sector is deleveraging). Even if both the base and the velocity of money expand, inflation only happens when the money pushes the economy to operate near maximum capacity, such that it cannot produce more goods at stable prices. A bigger amount of money chasing a limited amount of goods causes prices of those goods to go up.

This is not happening in the developed world right now. Unemployment is high, and factories are operating at below capacity. In addition, much of the production work is being offshored to developing countries, which expands the available pool of labour and productive capacity even further. With so much slack capacity, an economy simply adapts by producing more goods to match demand when there is more money going around. Inflation will not kick in until we are at near full employment and full capacity utilization. The corollary is: the government should expand the money supply until we are closer to full employment.

It may be awkward for many people to admit, but MMS (or fiat currencies) is indeed superior to all prior monetary systems because it creates flexibilities that did not exist before, and we as a society need to accept this as general knowledge. A modern government taxes and/or issues debt primarily as instruments for injecting and removing stimulus, not as means to “finance” public expenditures or “balance the budget”. In a recession, the government can spend without regard to deficit, in order to compensate for the drop in private consumptions; in a boom, the government can curb spending and raise the cost of borrowing (reduce the money supply) to avoid excess inflation.

Ultimately, money is a man-made illusion. Our policies should be designed to control this illusion in such a way that facilitates full employment and low inflation, thus enhancing real long-term prosperity of nations.

Men Who Can Cook

September 10, 2010 - 2 Responses

So we were having dinner at Black Hoof the other day where there was an open kitchen, and Janice brought up an interesting question. At the restaurant, all the cooks were men. But in a society that seems to have more women than men who are able to cook, why are most professional cooks male? In typical fashion, I had to quickly formulate an inhumanly logical yet politically incorrect response to explain this. Using evolutionary psychology, no less.

Obviously, this conversation took place over dinner so I researched absolutely no hard data to back all of this up. But that doesn’t make it not true. Not that I would do it even if I had the time, because why do any fact-checks when it already makes such perfect sense based on what we intuitively know? That, and I’m lazy. Moving on…

First, let’s define what I was trying to explain, because I don’t think this phenomenon is isolated to culinary. In fact, in almost all competitive arenas, male dominates. Not only do men dominate in physical sports due to their stronger physique (another phenomena explained by evolutionary biology), but also in all other non-physical and very diverse fields. The world’s top chess players, poker players, hedge fund managers, mathematicians, music composers, painters, and yes, cooks, are predominately men.

There will always be exceptions – there may be several women here and there who emerge on top in a particular competitive field. But they are exceptions to the rule and the general trend is clear. Where there is a trend, there usually is an explanation…

Back in the prehistoric days, polygamy, or in particular, polygyny (where one man mates with many women) was common. Similar to the societal structure of gorillas, each of our alpha males has more than their fair share of women in their harem. Due to the roughly equal number of men and women, and alpha males take more than their fair share, there are not enough women for the rest of the males, which means there are the “beta males” who stay bachelor for most of their lives (unless they are able to overthrow one of the alphas).

This winner-takes-all arrangement, mediocrity is severely punished by a lack of mating opportunities. Because it was not enough for a man to be average, or “sort of” good – he had to be outlandishly successful to stand out. And when he does, he wins big (by having multiple women) at the expense of other men (who go home with none).

In the polygynic mating game where the male faces this all-or-nothing pay-off, he is rewarded by having a single-minded focus at being exceptionally competent and competitive, at the neglect of perhaps other more mundane tasks. His extreme dedication is rewarded by creating a huge spike in one area. This explains why we have more men who are dedicated to a single task (e.g. playing competitive Starcraft) so much that they would starve themselves or forget about personal hygiene. We also have *six times* more male savants than female savants in the world.

On the other hand, females can afford to be more all-rounded (no pun) due to this arrangement, because on average each woman will share an alpha male with other women, and the mating success of the female depended less on standing out above others. This allows them to (traditionally) perform less competitive, more nurturing, but nonetheless necessary functions of the society, such as child bearing, nursing, teaching, home-keeping etc.

So, this was our biological legacy. Importantly though, our shift to monogamy (1 man, 1 woman) in the modern society has softened some of the edge. We can now afford some mediocrity in men because women come to expect a one-to-one relationship, which means not every woman can stay hooked up to an alpha male, and this, in time, will cause the competitive gap between male and female to narrow. Our old instincts, for the time being, remain in our genes, which is probably the best and only explanation why most profession cooks, who are so dedicated to their craft, and become so well regarded that they can serve at a top-tier restaurant, are men.

Why I’m Long Silver, Short Gold

July 23, 2010 - One Response

I have a short position on gold through GLD and a long position on silver through SLV.

Each share of GLD is backed by about 1/10th of an ounce of gold, and each share of SLV represents roughly 1 ounce of silver. Base on current market prices, one ounce of gold has the equivalent value as a bag of 65 to 70 one-ounce silver coins.

Now, consider that a geological analysis of the Earth’s crust shows that silver is only 17.5 times more abundant than gold. In fact, over the last 4500 years of history the average price ratio between silver and gold is pretty close to that number. Back in the days when metals are still money, you could exchange 1 gold coin for 16 silver coins.

What this means is that gold is severely overvalued versus silver, and the gap will revert over time, regardless of whether precious metals as a group rise or fall.

This is all before we consider the industrial usage of silver. Our silver supply gets used up in various industrial applications, whereas almost every ounce of gold we ever dug out of the ground throughout human history is still in existence today.

Gold is currently trading with a fat speculative premium – a premium driven mainly by fear of the fiat money system come crashing down. This fear is overblown, but even in the off-chance that Armageddon does happen and we all go back to buying things with metals, silver coins will be more liquid than gold coins. With silver currently at $17.5/ounce and gold at $1200/ounce, you’re more likely to carry around silver for your weekly grocery shopping.

Either gold will fall or silver will rise until the ratio is closer to the historic mean. For an aggressive investor, long silver short gold will prove to be a very profitable trade. For less aggressive investors or funds that have restrictions on short-selling, either get out of precious metals or replace gold with silver for your precious metal diet.

Odds Favor Shorting Paper Gold

December 7, 2009 - One Response

The advent of paper gold in the forms of funds/ETFs/ETNs is a godsend for those who want to play gold on the short side. I don’t claim I can predict the movement of gold accurately, but all else being equal, the odds are stacked against paper gold. If you must own gold, try to own physical gold bullions and bars. If you want to short gold, paper gold is the perfect instrument – it is like being the house at a casino. Here’s why (I will use SPDR Gold Trust (GLD) for some of the examples but this is directed at paper gold in general):

(1) GLD has an expense ratio of about 0.40% per annum. Which means GLD will lose value at 0.40% per annum even if the value of gold stays the same; And if you are on the short side, it is functionally the same as receiving 0.40% per year. Unlike stocks and mutual funds, gold is a non-cashflow producing asset – it will never pay a positive dividend, which means there will never be anything that offsets the 0.40% in fees you’ll have to pay if you’re long or you’ll “earn” if you’re short. Granted, 0.40% is nothing to write home about even in the current near-zero interest rate environment, and it will easily get swamped by any capital gain on gold, but it does move the needle slightly in the short’s favor.

(2) In a doomsday scenario, you have a much better chance of keeping your physical gold than your paper gold. One of the reasons for investing in gold is that it is viewed as the money of last resort when the existing governments/financial institutions/fiat currencies fail. Although most paper gold instruments are backed by actual gold stored in a warehouse somewhere, you will experience counterparty risk on doomsday if you own them. A look at the prospectus of SPDR GLD, we see that it has World Gold Trust Services as its sponsor, BNY Mellen Asset Servicing as its trustee, and HSBC as its custodian. When disaster strikes and one of these institutions fail, it’s unclear how much gold you will be able to claim for your GLD shares.

In another scenario where US Government bans the ownership of gold to save its currency (as they did indeed in the Great Depression), you will have a much better chance of running to another country with your private, physical, stash than to try to claim your gold from a trust. But riddle me this – if you are short the GLD ETF, what happens when the government confiscates all their gold?

(3) Paper gold is exposed to fraud and accounting risks. There could be inaccurate accounting or out-right fraud at the trust/trustee level. Or some dishonest employees at the custodian could have stole some gold for themselves. Or, the custodian may have tight controls, but one of the sub-custodians that the custodian subcontracted to may not. It will be a stretch to say that all of the many precious metal ETFs and funds out there have perfect accounting and controls. If there is anything Bernie Madoff taught us, it’s that there is risk of fraud in the most established of institutions – and this is magnified with paper gold because there can be so many intermediaries between you and your physical gold.

I cannot predict the precise movement of gold the same way I cannot predict the next pai-gow hand at a casino. But what we do know beyond a doubt, is that the odds are stacked, and the house always wins in the long run.

Disclosure: short GLD

Beat the Market with 5 Basic Tenets of Long-term Investing

June 17, 2009 - Leave a Response

So you want to beat the market. Despite the fact that you can effortlessly earn market return by investing in index funds, despite the constant discouragement from the financial academia telling you that it’s impossible to beat the market, and despite research showing that most professionals really do fail to beat the market, you think you can do it.

The good news is it is possible. Warren Buffett once said, “Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.” And I tend to agree that, if one is willing to bring intensity to the game, it is possible to earn excess return, or alpha.

But in the end the quest for alpha is a zero-sum game. By definition, the average investor cannot earn more than the average. Each dollar you make in excess to the market is taken from other investors who are earning below average return, and how much you make is depended on the edge you have over the other investors.

I believe that regardless of what your investment strategy is, incorporating these 5 basic tenets below will give you an edge over an investor who is not, all else being equal. They should form the foundation of any winning active strategy with a long-term horizon. Without further ado…

Read Wide

Have a wide variety of interests, and get into habit of reading anything that’s remotely relevant. I am not referring to simply browsing financial websites. Of course, “reading deep” in terms of doing rigorous research on the companies/sectors/asset classes you are investing in should go without saying. But if you are only reading the same things as the rest of the investing community is reading, you are more likely to think the same things as well. “Reading wide”, or seeking information beyond the normal realm of investing, increases the opportunity for synergizing outside information into an investment thesis, and you can never tell beforehand where you will come across relevant information. Also, having interests outside of investing gives you a better chance at noticing major trends ahead of the curve. For example, if you were a computer geek back in the 80s or early 90s, you might have bought the Microsoft stock ahead of the rest of the community.

Laziness is a Virtue

I could have said “Patience is a Virtue”, but this one is a little less cliché. I want to emphasize that it is good to be lazy when it comes to actual trading (but not when it comes to doing the prep work, which you definitely should not be lazy on). One of the longest running conundrum is that the average investor does significantly worse than the market average. On the surface, this statement sounds ridiculous – it is like saying the average NBA player shoots worse than the NBA average. But the former statement is, in fact, true, and the single biggest reason is that the average investor loses out by paying too much commissions and short-term taxes from over-trading. Avoid over-trading, and not only will you beat the average investor, you will probably beat the majority of the professionally run active mutual funds.

Once again quoting Warren Buffett: “Lethargy, bordering on sloth, should remain the cornerstone of an investment style.” So go ahead, procrastinate, and refrain from trading until the real opportunities arise, which leads to…

Expect Ridiculousness

The securities marketplace is part of Extremistan, the home of Black Swans.

“Black Swans” are very extreme events that have huge consequences, and Extremistan is a place where these types of events happen a lot more often than predicted by statistical normality (the Bell Curve).

What this means is don’t buy something merely because it is attractive. History has proven over and over that Black Swans live in the financial markets, thus it pays to keep your ammo dry to prepare for them. If you ever hear yourself saying, “holy s#!+, I can’t believe this market/commodity/condo/stock just dropped so much,” first, review the fundamentals. If they are still sound, you are probably witnessing a great buying opportunity. But if an investment merely seems interesting, add it to your watchlist, and then wait for that “holy s#!+” moment. You might miss a few opportunities this way, but the excess return you earn more than compensates, and more importantly, if you wait for Black Swans, you are less likely to get hit by the wrong side of one.

The flip side is also true: if it feels about right to sell a stock at $7, wait for it to go to $10! Markets often overshoot. This also works very well with the “lazy” tenet. Time and time again events have occurred in the markets that are beyond our normal range of expectations, so err on the side of inaction until the ridiculous happens – it probably will eventually.

Keep Your Options Open

It is usually not wise to have 0% exposure or fully leveraged exposure. You should always have a handful of positions ready to be sold if the market surges, and a handful of positions in your watchlist ready to be bought (and unused capital to buy them with) if the market moves against you. But, wait for the extreme moves.

Don’t be married to a particular idea. By necessity, you should have more investments that you want to buy than investments you actually end up buying. This is because, if you are following the previous tenet properly, you are not just going to invest in something merely because it is attractive; you are sitting there waiting for an extreme event to happen so you can get in at fire sale price. It is wise to monitor a large variety of choices because you never know where a Black Swan will land. “Luck favours the prepared” – position yourself such that you can take advantage of opportunities that come up.

If a particular investment runs away from you, don’t chase it; instead, make all the potential investments on your watchlist “compete” for your limited capital. This is similar to how one can do well in the dating scene – always keep a lot of options open so that your prospects are the ones doing the chasing and proving themselves to you.

Put Your Eggs in a Basket and Watch It

Diversification is a double-edge sword. The more diversified you are, the closer you are to earning the average market return, which is a terrific way for an amateur to invest and forget, and I recommend to anybody who do not wish to spend a lot of time managing money to not put all your eggs in one basket. But diversification won’t help you win the alpha-generation game you signed up for. Again by mathematical definition, you cannot beat the market by buying the market. To add value for your portfolio or your clients’, you will need to concentrate your eggs in some kind of basket (or a small set of baskets), and watch that basket. This is the mirror image of the previous tenets: read wide and keep a lot of options open, but invest rarely, make big concentrated bets, and get to know your holdings very, very well.

A Capitalist’s Letter to Obama

May 7, 2009 - One Response

Dear President Obama,

I had always been a supporter of you, precisely because you are not married to any particular ideology, and you have an ability to listen to varying opinions, weigh their merits, and ground them on reality.

I am writing to you because your heavy-handed economic policies are too interventionistic for their own good. I previously wrote about Capitalism in Jeopardy (http://seekingalpha.com/article/102629-capitalism-in-jeopardy), where I feared that governments all over the world will use the recent credit crisis as an excuse to enact various protectionistic and socialistic economic policies, undoing human progress over many decades past. My worst fears are beginning to take hold.

I will not go as far as naming you a socialist, as I remain convinced that your decision-making process is not overly hindered by any ideology. Which is why I even attempt to make a free-market capitalist’s case to you at all.

First off, I want to debunk a common misconception that the mortgage crisis was a failure of the markets. On the contrary, the private sector did their ordinary profit-seeking thing, but it was the government’s policies that were the prime drivers of the mortgage bubble:

(1) The Federal Reserve maintained an artificially low interest rate for over a decade, enabling cheap credit that caused a cascading effect down to the regular consumers who maxed out their credit cards and took out mortgages they couldn’t afford;

(2) Fannie Mae and Freddie Mac were created as government sponsored entities, with the mandate of increasing home ownership, again with the overall effect of encouraging low quality loans made to borrowers living beyond their means;

(3) The government sanctioned status of the rating agencies (S&P and Moody’s) were given too much influence, enough to convince investment funds to treat AAA-rated mortgage-backed securities as golden, when in fact they were junk.

It is not hard to imagaine that without the low interest rate, the credit bubble would not materialize. Without Fannie and Freddie, the supply of loans made to credit-unworthy borrowers would be significantly limited. Without the rating agencies, investment funds would rely more on their own research when purchasing these structured products.

The cure for misguided regulations is, of course, not more regulations, but smarter regulations. Now, it is very difficult to pass smart regulations on economic matters, mainly because the free market, when left alone, is a well-oiled machine that functions efficiently the vast majority of time. However, I am not implying that the government should never intervene in the economy. Contemporary economics identified some cases of true market failures, for example: instances of externality, monopolies, the free-rider problem of public goods etc. The trick is to identify if a particular fall-out was caused by a true market failure, or if it is the remnants of some previous misguided policies.

I agree with Keynes that “in the long run, we are all dead.” There are merits to his supply-side economics – the government has a role in resuscitating an injured economic by spending stimulus money. But let’s not weaken your stimulus package with any ulterior agenda. I don’t have to remind you of the global backlash you received upon inserting protectionist language like “Buy American” into the stimulus bill.

Congress’s fiasco over the banks’ executive compensation did more harm than good. If the terms of compensation were not stipulated originally when the TARP money was handed out, we should not dictate them retroactively. However, if we do dictate, it makes the banks reluctant to take the money, which reduces the effectiveness of TARP in resuscitating the credit market. There is no free lunch – tinkering with the market in one place causes unintended side effects in another.

Recently you ridiculed the bond-holders of Chrysler for not compromising their loans in order to save the company. You said “I stand with Chrysler’s employees and their families and communities, not those who held out when everybody else is making sacrifices.”

You neglected that the lenders like hedge funds and investment firms have a fudiciary duty to their own investors to maximize return, and in this particular case they actually have a duty to bring matters to a bankcrupcy court because that is where they can recoup most of their investments. The investors trusted the fund managers to look out for their interests. These fund managers bought into what they thought was the most senior of Chrysler’s debt, but your proposal would effectively make them subordinate to the UAW union.

Imagine the consequences if this took hold. The hedge funds buying into senior debt can no longer be sure of their senior status. Going forward, this will make them less willing to lend, or they will demand a higher interest rate from the companies that need the capital. The investors will no longer trust the hedge funds in watching over their money, so they would either withdraw their capital, sue them, or both. End result is there will be less capital available to lend. And did you say you need the private investors’ help in providing capital for your PPIP initiative? There is no free lunch.

The government should intervene to negate true market failures. But the bankruptcies of Chrysler and GM are not failure of the market; they are failure of Chrysler and GM themselves for producing crap that nobody wants. These companies should be allowed to fail such that they either restructure to become competitive, or, over time, have their labor and assets reallocated to other more productive enterprises.

An author of The National Review recently claimed that you declared a War on Capital. I think that is still an unfair statement at this point. Once again I trust that you will judge these arguments on their merits alone, without ideological bias. Please carefully consider each economic policy you enact and err towards the side of non-intervention; we do not need another war.

 
Sincerely,

Gene Chan

The Final Bubble

February 9, 2009 - 3 Responses

For the last two decades, we lived in a speculative economy where one bubble appeared after another in rapid succession. We had the hot money bubble in Asia that ended in 1997, then the dot-com bubble in the late 90’s, followed by the housing bubble, and then finally the commodities bubble in energy and metals. As each one ended, the financial system was not allowed to wring out its excess because central banks and governments around the world churned their printing presses, and pumped incalculable amounts of money into the economy in order to it from the short-term aftermath of each bubble. The result was that when each bubble burst, a new one began almost immediately, fueled by the flood of excess liquidity. It is not over just yet – I believe we have one final bubble to work out.

The final bubble is the US dollar itself, whose current strength is fueled by a flight to safety of investors away from all risky asset classes. The flock of investors buying US Government debt has allowed a gargantuan amount to be issued without the repercussion of sky-high interest rates, which enabled the Federal Reserve to massively expand its balance sheet, and congress to take on an astronomical amount of debt without a significant increase in borrowing cost. It was made possible by the reserve currency status of the greenback, and its perceived safety relative to all other asset classes.

This too, will end. In our epic game of musical chair, we are now fighting for the last chair. This is how I think it will play out. For the time being, the bubble will continue in the short term. We will continue to see strength in the US dollar insofar as it is still perceived as the safest asset class. At the same time, even though the Fed is pumping liquidity into the system, the economy is still in the process of LOSING liquidity due to credit contraction. The funds that are pumped into the financial system are getting sucked into a black hole, because the credit market is frozen and the funds going in are not coming back out as loans. As long as banks refuse to lend, we are going to see destruction of liquidity, which is deflationary in nature. And the best asset class to hold during a deflation cycle is cash – which means as long as the financial system is in trouble, the bubble in the US dollar and its equivalent (e.g. treasury bills) will likely to continue.

Ironically, the eventual recovery of our economy will set the stage for its ultimate collapse. Firstly, the up-tick in the general economy will eventually cause institutions to start lending again, which will reverse the conditions from credit contraction to credit expansion, and turn deflation into inflation. Secondly, investors will have less need for safety, thus selling off safe-haven asset classes such as US treasuries and gold, putting pressure on the debt that US Government owes. Both of these are pillars that are currently supporting the US dollar, and as they disappear, we will suddenly realize that the US owes tens of trillions and it has no way of repaying. The US government will not default on its debt, but it will try to print its way out of trouble, which will likely burst the USD bubble, drive the dollar towards zero, and trigger hyperinflation.

Nobody is sure exactly what will happen when the US dollar collapses, except that it will be bad. There will probably be chaos in international trade, as a large portion of goods are priced in USD. There will be chaos in the derivative markets, as majority of the derivative models are driven by the US treasury yield with the assumption that it is “risk-free”. The currency reserve of most of the world’s central banks will become virtually worthless. The world’s largest importer, the United States, will suddenly lose its purchasing power. There will be riots on the street similar to those that happened after the collapse of Iceland, except it will be worse by orders of magnitude.

Where will be good places to park our funds in this scenario? To be honest, there aren’t very many. A lot of countries are in a similar predicament as the US. The UK banking system and fiscal situation is just as bad, if not worse, so the British pound will collapse along with USD. There are already secession talks from some of the fringe EU countries, who are soon to be facing the stark choice of either bankruptcy or abandon the Euro because the countries have no control over their own money supply, so the Euro may not survive this crisis. The Japanese has a public debt that is a larger percentage of their GDP than the United States, and it is to be serviced by a population that is aging quicker than the United States.

This leaves a few places in the world. The Canadian banking system is currently the most stable in the world, and its fiscal and trade balances are in relatively good shape, so I am bullish on the Canadian dollar. Same goes with some of the major emerging markets: Brazil, China, and India (Not Russia, whose government seems set on reversing all the progress they have made in economic liberation since the collapse of USSR). Their currencies will do well versus the rest of the world, although their equity markets will not due to the export-focused nature of their economies, and their biggest trading partners will be the countries whose purchasing power disappeared. It is my view that Hong Kong will unpeg its currency from the United States when it becomes clear that the USD is on the path of disintegration, and China will also float its currency when the rest of the world goes to hell.

Gold, traditionally a good inflation hedge, will retain its value as the major fiat currencies collapse. However, I believe there will be a chance for us to go into gold at an entry point cheaper than now, during the early stage of the economic recovery, and before inflation truly appears. When that happens, I recommend moving a sizable portion of our networth into gold, but not so much that we would miss out on a benign recovery if the Armageddon thesis turns out to be false.

There will likely be a short-lived, but voracious, stock market rally when signs of economy recovery first appear, and we should use that opportunity to off-load certain names in our stock portfolio. Companies that sell to the United States or the other failing countries will not do well, which means BRIC and Canadian exporters, and companies that serve the US, UK, European domestic markets. The banking system will implode so financials is also a sector to avoid. To the extent that we must keep some equities in our portfolio, we should focus on the ones that may outperform, relatively speaking. Domestic-focused emerging market companies should do OK (like emerging market real estates and utilities), as well as US exporters (like General Electric (GE)), and companies in industries supported by major tailwind (health care, mining, alternative energy, and technology).

Instead of trying to get the timing exactly right, let there be humility as the aforementioned strategy is implemented, in that it should be implemented in a piece-meal fashion. I would sell a little bit of the positions that don’t fit the overall strategy at each major rally of equities, and I would add a little bit to gold at each correction of the metal.

Getting back to gold, the instrument a lot of retail investors will be using for their gold investment will be the SPDR Gold ETF (GLD), because that is the simplest way we can invest in gold through regular brokerage accounts. However, I recommend that we purchase some physical gold coins or bars as well when the prices go down a bit. Ultimately, the rationale for buying gold is the same as that of the people who are stocking up on guns, ammo, and water: “just-in-case”. In the “just-in-case” scenario, which is the complete annihilation of the existing financial system, the fund company that offered the Gold ETF may not survive, and the banks where we opened our brokerage accounts may cease to exist. To fully hedge against this possibility, we will all need a little bit of physical gold, stored in several different undisclosed locations that are known to be safe.

Good luck.

The Marriage Contract

December 18, 2008 - Leave a Response

Observe that:

 

(1) Fundamentally, marriage is a private contract entered into by two consenting adults for a life-long commitment, and a divorce is a voiding of that contract, with associated costs and penalties.

(2) A couple who love each other, and who are most happy together compared to any of their other alternatives, will prefer to stay together anyway, with or without official marriage. (In other words, marriage is irrelevant if two people stay in love with each other, because they would have been kept together regardless.)

(3) Because of (2), the only instance where marriage actually makes a functional difference is when a couple, who were initially in love when they entered into marriage, stopped loving each other at some point, but are forced to stay together due to the difficulties associated with a divorce.

 

Just from what I wrote above, you may come to the conclusion that I have quite a dismal opinion of marriage, and that I think marriage has no value at all. That is, however, not exactly true. I believe marriage adds value to the society in a very specific case, and the value added is positive enough to justify the existence of marriage, but not significant enough to warrant too much of our attention over other much greater issues. Marriage in general, and gay marriage in particular, do not deserve as much of our collective attention as it does now.

I am specifically talking about the legal institution of marriage, not the wedding celebration and other fluffiness surrounding it – anybody can throw a huge party without actually being legally married.

The specific case where marriage adds value is when a couple stopped loving each other AND they have had children together.  Note again that if a couple never stopped loving each other, they would have taken care of their children together regardless of marriage. Without children, the only thing that marriage accomplishes is to keep unhappy couples together, so there is no value added in that case. Let’s consider the specific case where the love stopped but they have had children together.

Without the stability of marriage, couples would break up more easily and children would be left more often with a single parent. Granted, even with marriage, couples can still divorce, but it is relatively more painful and costly, so it would at least give them some incentives to try to work things out. The difference from the children’s point of view is significant – having the time, attention, and resources of two parents is vastly better than one parent in terms of their development. In other words, in this specific case, there is a trade-off between the parents’ suffering (from having to stay together) and the children’s happiness (from having two parents), and as such, the ONLY time where value is added to the society is when children’s gain in happiness is greater than the parents’ loss.

I believe this specific case happens often enough to justify marriage, or something like it, but its exact definition is not important. We can call it whatever we want, but what people do is create institutions of two (or more!) people, formed consensually and held together by a private contract, to provide a stable backdrop for raising children. Gay or straight, two or many, they are agreements reached by consensual parties, therefore I do not have strong opinions on them, and I do not think they are something that the government should meddle in.

As a corollary, I do not have a strong opinion on gay marriage, other than the view that the entire marriage legal framework is unnecessary noise because existing laws surrounding private contracts would have sufficed.

But the reality is we have laws governing the marriage contract that we have to obey. However, within this framework, what I do have a problem with is how this gay marriage issue is framed. Gay marriage advocates often claim that gay people deserve the same rights as straight people, therefore they should be allowed to marry each other. The fact of the matter is, they already have the same rights as straight people, so this had nothing to do with inequality. What they are asking for is not equal rights, but additional privileges. Fairness under the law is objective fairness, not subjective. Let me explain.

The law does not adjust for personal preferences. The law prohibits drinking and driving, regardless of whether you like to drink or not. The law (here) says you must drive on the right side of the road, regardless of your preference. The law says an adult cannot have sex with underage children, regardless of whatever sick fetish one has. I am not suggesting any moral equivalence among these acts; I am merely illustrating that equality under the law means it is applied equally to everybody without regard to subjective preferences.

So, as it stands currently in most places, anybody, straight or gay or lesbian, is allowed to marry someone of the opposite sex – man with woman, woman with man. The law is applied equally to all regardless of each individual’s sexual preference of man over woman or vice versa. The law does not, and should not, apply differently to different kinds of people. Just like how all people, vegetarians or meat-eaters, are not allowed to eat endangered animals, we have equality because justice is blind to differences in individuals. The law is fair objectively in that same sex marriage is prohibited for people of all sexual preferences.

This fact in itself does not determine the merits of gay marriage either way. But as we debate, we should know that what we are asking for is not equality, but a special provision – a brand new privilege for a man to marry a man, and a woman to marry a woman. The issue of equality has no place in this discussion – don’t cry wolf or we are diluting the argument when REAL problems of equality arise.

***Update***
I have received some feedback since publishing the article above, illustrating certain misunderstanding that I would like to clarify.

What I wrote above is a cold rational dissection of the marriage contract. I wrote that on an intellectual level, the only benefit to society of marriage is for raising children. I may have inadequately explored the emotional side of the issue because I felt that the topic of marriage is already saturated with such literature on the emotional side, but not enough from a rational perspective.

However, I would personally be marrying on an emotional level, because I am a product of evolution and I experience the same emotions as everyone else. So despite what I wrote, I will be marrying for love.

(But what is love? That is whole another topic… Just like this one, love also has both an emotional side and a rational explanation based on evolutionary psychology.)

Please accept my apologies if the content of this essay was confused with what I feel on a personal level and reflected unfairly on my character.

I believe rational discourse and human’s innate desire to pursue happiness are both worthwhile activities; the differing perspectives that result are not in conflict – they are just two ways of looking at the same thing.

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