Stock Market Speculation

A few weeks ago a colleague of mine was telling me how he had been watching this great company and was thinking of investing in it. All the pundits had said that the stock is on the up and it was a great deal – a “strong buy” they said, but he paused mid way though his sentence and said “why would anyone sell me their stock if they knew the price was going to rise?”

He had inadvertently stumbled upon the Efficient Market Hypothesis (EMH).   

The Competition

In the US 57 million households own shares out of 115 million, if we apply this logic the rest of the west there is a total of 139million people holding shares. Not all of these will be actively trading them; many will be sitting on the asset in the hope of selling it when it reaches a certain height, but a lot of them will be. The big money is controlled by hedge fund mangers, who can push and pull money around the world in an instant. They have the tools which provide them the latest information before anyone else (other non-traders), the minute a news story hits, millions of pounds are traded in an instant. They use every statistical and mathematical modelling there is to help them make the best purchasing decisions.

Often you will hear a friend say “invest in this company it’s under priced, you’ll make a fortune!” Before you do, ask them, “Do you think you have seen something that none of the 139 million traders haven’t?”

EMH

If an asset market, that has good level of liquidity (lots of buyers and sellers), the price is a perfect indicator of value. That is, the price reflects all information that is available. If the price was not truly reflective of the value of the stock, the millions of traders around the world would identify it and trade until the price did. 

Imagine a new piece of news hits the market that would cause a change in the value of the share. The price would respond almost immediately. By the time you read about it the paper the next day, the price is already fully reflective of that news story. If you were to buy the asset then, you are no longer going to gain from that particular news story. However you do have a 50:50 chance of gaining on the next story, before it comes out. This is the only way, according to the Efficient Market Hypothesis; you can beat the market and earn a short term return.

The price of an asset as an aggregate reflection of the combined wisdom of all the traders and analysts, with millions of traders speculating around the world, often disagreeing on strategy, no one trader can be expected to consistently gain over the others. When prices are not fair, they are randomly so, this means a trader will gain as much as they loose.

In short, when you think you can beat the market because you’ve heard a news story or just have a belief in a stock just remember “Trust markets, not people”. This also applies to the analyst in the papers that tell you to buy or sell a share; in this respect they are no different to an astrologist.

Animal Spirits

Like many economic theories, there is a slight problem with the EMH, humans are animals and are not entirely rational.

Humans suffer from all sorts of irrational behaviour, for example underestimating the odds of wining the lottery is common one. This irrationality also applies to the markets. Some traders hold a false belief that a stock is going to continue to rise due to cognitive biases (when holding a belief, the trader will search evidence that support that belief and ignore the evidence that does not).   

Prices can offer suffer mass distortions of value by traders not looking at the value of stock, but at what other people think the stock is worth. John Maynard Keynes (the equivalent of Jesus to economists) said “We have reached the third degree where we devote our intelligences to anticipating what the average opinion expects the average opinion to be.”

In a case of some bad news hitting the markets, traders are not looking at what the true value of a stock is, but what the average person is going to do with that stock. This creates herd type behaviour, where every shareholder runs for the exit in a mass panic with a ‘beggar thy neighbour’ mentality – Get out before anyone else does.    

Equally bubbles can form, where an assets price is massively overvalued. Because the average person believes the average person believes the stock is going to rise, it will do - in a self fulfilling prophecy.  A great example, I believe (although I suffer from cognitive biases as much as the next…) is gold. Gold historically was used for the basis of several currencies; in that respect it was an excellent store of value. Today however it is not the basis of any currency in the world. It’s only practical use is for jewellery and electrical products. However speculators believe that the average person believes that it is still a good store of value. As such, during the recent tough times, the price of gold has increased 160%. Buyers of gold believe they can sell it to a greater fool, and that greater fool believes he can sell to an even greater fool, and the bubble continues.

John Maynard Keynes lost a fortune, to what he called the ‘animal spirits’ in the markets. When a wheat was under valued he brought tonnes of it, assuning it would rise, however the rest of traders continued to sell, causing Keynes to left with tonnes of wheat that he was unable to sell .  

The list of irrational behaviours is a long one, and judging when markets will behave rational (EMH), and when it will not (animal spirits), is a difficult task.

 

If you’re thinking of investing in a stock, ask your self this – does the average opinion expect the average opinion to be rational? 

US Debt Default: What if?

Currently Barack Obama is doing his utmost to avert a financial disaster. The US has a debt limit of $14.3 trillion dollars. This has already been surpassed (see US debt clock below) and is being financed by short term emergency arrangement with the Fed which involved holding back aids to states and borrowing from Federal pensions. By 2^nd August if the US has not raised their debt ceiling, they will default. 

Current US Debt as of 12.01 17/07/2011

At the moment the Republicans, who control the House of Representatives will not agree to a debt ceiling increase without planning significant spending cuts. Presumably at some point a compromise will have to be met and the US debt clock can continue ticking. But what if they didn’t agree, what if the unthinkable happened, the US defaulted -time for some ‘back of the envelope’ calculations and a hypothetical scenario.

Firstly the impact of default all depends on the type of default. For this calculation there needs to be some broad sweeping assumptions.

THE DEFAULT: If the US defaults on the interest payments only and not on the principal this will change the $14.3 trillion to a mere $502bn loss, assuming a 3.5% interest on the debt.

THE IMPACT: Many countries have large holdings of US debt, China would take a hit of $38bn and Japan $31bn. In the UK most of the holders of US debt are pension funds and private banks; they would be hit with an initial collective $11.5bn hit (£7bn). Note that this initial impact only hits the P&L. This would hit the profits of these companies but would not necessarily kill them.  The problem is when the value of the bonds falls.

Assuming that the risk reward appetite has not changed (which it certainly would), the value of the bonds would continue to fall until the expected return of the asset equalled 3.5%. For example bond with a face value of $100 will fall to $96.62 This would mean an additional £7bn write down of assets.

THE CONCEQUENCES: The problem with an asset write down, is that if it leaves a company with more liabilities than assets, no one would lend to it. The reason being is that if the bank was liquidated, the lender would not be able to get all their money back. If a bank were to have this problem, no bank would lend to it and all its creditors would try to regain their money. In other words, there would be a Run on the bank.

The Banking sector has a further Macro issue. When a bank looses money, it is not able to lend it out. Normally a bank will lend out many times what it has in cash reserves, this known as Fractional Reserve Banking. In this instance the£7bn hit to assets turns into around a £70bn loss of available credit, which would otherwise have gone to businesses, mortgages etc.

There is also something far greater to worry about…systemic risk. All banks have lent money to many other banks.   In the case above where a bank fails, all the other banks that have lent to it are also hit. They in turn will have to make asset write downs, perhaps not as big as the US default write down but if it is the tipping point for one bank then the rest of the industry will have to make another write down, and this process could potentially continue through several banks. This was the precise fear that stuck the banking industry when Lehman Brothers went down in Sep 2008.

Since 2008, banks have been increasing their reserves and improving their balance sheets so that risk of such an event would not happen again. But would it be enough? Recent stress tests showed that European banks would require another 80bn Euro to protect themselves form a Greek default, a US default would require significantly more.

A US default like the one described above would be unlikely to herald the end of capitalism as we know it, but it could prove to be the tipping point for several companies, banks and, possibly nations.

Thoughts, comments and questions welcome.

Quantitative Easing: Inflating Hardship

Quantitative Easing is a policy used by the Bank of England, but what are the consquences?

Quantitative Easing (QE), as it’s oddly called, is a means of increasing the flow of money in the economy. It works by a central bank (Bank of England) purchasing financial assets off banks and other financial institutions and leaving them with a pile of cash to spend.

QE helps the Private Sector in three key ways. Firstly the purchase of the financial assets will increase their price and cause the interest rate that the asset yields to fall. If a company is considering a major investment project, it will have a greater incentive to invest it in a project rather than buying a financial asset. More generally the Opportunity Cost of consumption and will fall.  Secondly, where before the bank had an asset giving a fixed return each year, the bank now has cash which does not give any positive return (unless deflation is taking place). The bank will then lend this out to aspiring entrepreneurs, company’s looking to invest and consumers looking to take advantage of the reduced interest rates. Lastly, there are the multiplier effects that follow this.

Whilst QE sounds sensible, it has many unintended consequences.

Firstly the supply of sterling has increased significantly. This means that the Pound is worth less. This is good news for exporters as their products will be cheaper on international markets however imports like oil and other commodities become more expensive. This problem is further exacerbated by other retaliating countries following similar policy. Since QE policies have been adopted by several central banks, there has been a great deal of volatility between currencies, in what some commentators have called a currency war.   All this volatility has lead many investors to search for solid stores of value i.e commodities (see below).

FX indexed GOLD (BBC)

$/oz Silver

The increase in commodities has pushed inflation even further. Considering the role of the Bank of England is to control inflation is QE logical? -beacuse the results speak for themselves (see below)

Thoughts and comments welcome.