Rethinking Risk

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A fair amount of risk management thinking is focused on loss aversion.Recently, I have had a slight euphony that such an approach in my case has been detrimental. Risk as a measure should not be considered as a pure mathematical or statistical component of trading. An individuals innate psychology has a vital role in identifying his/her optimum risk management. For ex: What’s the maximum dollar figure you can stomach per trade & how is this related to portfolio size.

As for myself, an application of the law of averages has been a vital driving force in navigating unpredictable price levels in market- which drive the entry to exit of a trade. I now tend to look at risk as a measure of taking profit off the table rather than pure technical or statistical stop loss level. This of course assumes that the strategy in place has been optimized and tested with a viable positive probability. In other words, what I am trying to convey here is “average is good”…and Thanks to a certain gentleman for unknowingly bringing this to my attention!

Where from here

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The humdrum of an increase in US interest rates in September 2015 has now unfolded. Respecting Uncertainty did reflect a similar outcome. I am now questioning the logic of the masses pertaining to the good old quote; “Fool me once shame on you, fool me twice shame on me”.

There is still a main stream expectation for an increase in interest rates as we close into 2015. But I am yet not convinced of this happening; mainly due to the upcoming US Presidential election in 2016. If anything, I am looking forward to QE4 (2016?) with a statement from the Fed reserve stating that the economic numbers have yet not got up to mark as expected but the US economy is getting there(where?).

Taking a look at the seasonality of an increase in interest rates in pre-election years for the months of October and December (FOMC Interest Rate Decision-October 28th & December 16, 2015).

Pre-election year 1971, October & December– No change in interest rates

Pre-election year 1975, October & December– No change in interest rates

Pre-election year 1979, October & December– Decrease through the months

Pre-election year 1983, October & December-Lowered in October, unchanged in December

Pre-election year 1983, October & December– Lowered in October, unchanged in December

Pre-election year 1987, October & December– Lowered in the weeks after October 19, unchanged in December

Pre-election year 1991, October & December– No change in interest rates

Pre-election year 1995, October & December– Unchanged in October, lowered in December

Pre-election year 1999, October & December– No change in interest rates

Pre-election year 2003, October & December– No change in interest rates

Pre-election year 2007, October & December– Interest rates lowered

2009 onwards rates remained the same as today.

From the above, the probability of an increase in interest rates historically in a pre-election year (October & December months) is bleak.

Simultaneously, also keeping an eye on any trigger event that could come in the form of change in economic policy pertaining to the financial system as a whole; the first indication to an increase in US interest rates. Discussions of which I wouldn’t be surprised have been initiated in the recent UN’s General Assembly gathering in New York, USA- a geopolitical event.

 

The Problem With Honest People

***Non Financial Market Related***

In my opinion there is nothing as good or bad. It’s just how humans perceive things to make something considered so. While there may exist some innate moral beliefs in society such as honesty is good and dishonesty bad; I have noticed a major flaw with the manner in which honest people function with respect to dishonest people. This flaw in the honest party (if I may say so,myself included); in many ways indirectly promotes dishonesty among people- who want to remain honest in their dealings.

The dishonest on the other hand; very well manage this “process trait” naturally to promote their type.

I call this process trait- You scratch my back and I scratch yours. Dishonest people do this wonderfully, while honest people on the other hand when realizing a honest character similar to themselves is in need, are reluctant to help! (Apparently, in the name of honesty)

If this world has ever to experience the trait of honesty as something natural in the human species-I reckon it is time for honest people to lobby for honest people. Just like the dishonest that lobby for each other. These is applicable in all aspects of life, be it personal or professional.

Bull Markets – Gold vs DJIA

Bull Markets - Gold vs DJIA

Bull Markets – Gold vs DJIA

This chart compares the early stage secular bull market in gold that began in April of 2001 with the Dow Jones Industrial Average secular bull market that began back in May of 1982. Since the dow and gold tend to move in a counter-cyclical fashion, it would seem to indicate that the Dow bull market is on its last legs while the gold bull run could have quite a long way to go yet.

Data Sources: LBMA, Yahoo Finance

The Great Aussie Credit Crunch

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I have been holding myself from making this post, but what the heck!

Some of my friends are continuing to buy into the housing market craze. While a few tout the double digit returns they have already scored in just a year- ignoring their loan has yet to been paid off & liquidity concerns, just in case they choose to cash out in the foreseeable future. Others are being whipped (as I see it) into the housing craze by their partners with the view- If things go bad, at least they’ll have a roof over their head.

Now seeing a very interesting scenario develop in the Aussie housing market.About a week or two ago some of the major banks decided to increase their fixed loan interest rates. This is sure to be followed by other banks in the future. Speaking for myself, I reckon the main stream media did a horrible job of showcasing this event…or perhaps I wasn’t observant enough with my minimalist approach to watching television.

When banks take such a stance, the relationship (inverse to near equilibrium) between credit availability and cash rates is disrupted. To elaborate further, I am using the USA as a benchmark (mainly due to availability of data).

The graph below is a plot of US Fed rates and 30 year mortgage rates.

United States MBA 30-Yr Mortgage Rate and Fed Funds Rate

United States MBA 30-Yr Mortgage Rate and Fed Funds Rate

Notice the year beginning 2008 where the relationship between mortgage rates and Fed fund rates is disrupted with mortgage interest rates increasing as Fed fund rates dropped. This was followed by a steep drop in the Housing Price Index as depicted below.

US Housing Price Index

US Housing Price Index

A similar tone at home was in action during 2008; mid July onwards the RBA begun a spree of cuts in interest rates while the banks increased their mortgage rates throughout the year. The follow through…a dead drop in the housing price index.

However, the concern this time is the velocity with which credit levels have increased since the start of 2010 (sounds similar to the US). And with interest rates already at historic lows, leaves the RBA in no man’s land if it has escalating housing price concerns and maintaining a lower Australian Dollar to improve our competitiveness on an international scale.

CropperCapture[6]

Australian Consumer Credit

Coming back to the recent increase in mortgage rates by Banks in a low cash rate environment- Theoretically, an increase in interest rates from Banks or the RBA for that matter is meant to curtail or discourage credit availability in the market. So the expectation is that an increase in the cost of credit achieved through the banking sector will slow down rocketing housing costs & a drop in cash rate by the RBA will keep the Aussie Dollar lower; thus keeping things in check. Not that I am implying the RBA and Banking sector are in talks to maintain an equilibrium by “division of labor” (but in reality that’s how things often work). Alternatively, we might subscribe to the main stream view of APRA (Australian Prudential Regulation Authority) requiring the Banks to hold more capital reserves to protect against mortgage defaults as the underlying reason for the rate rise by banks. Either ways it’s a two edged sword. Perhaps, a restriction on Loan to Value Ratio’s (LVR) would have been a more apt solution.

The fault here is, an increase in mortgage rates with a view of discouraging consumers to obtain credit is in conflict with increasing Building Permits; at all time highs.

Building Approvals

Building Approvals

So the question I am asking myself is what happens when mortgage rates increase in an inflated consumer credit environment; adding in a touch of falling household savings (see graph below) and oversupply of housing.

Saving Ratio

Saving Ratio

And the thoughts to my question is inclined towards the unintentional creation of more debt & this debt is unlike the debt we are seeing today (couldn’t source housing foreclosure data for Australia…should give ABS a call to check availability) where the average person is managing their mortgage payments. The sorrowful debt looming is “debt due to consumer mortgage defaults”.

Markets Intertwined

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Suspecting that markets are a combination of factors involving psychology,sociology,statistics,economic theories,quantum physics- & yes the pure fundamentals and technical followers; the underling nature in many ways reflects the true tangibility of reality. I have often tried to frugally translate some of these concepts into logic pertaining to markets such as in the Uncertainty post

With that said, in the last 5 months I have been blessed in many ways to dive deeper into these general concepts & while I have come across people who inadvertently believe that their unique strategy is the way to understanding markets- I fail to comprehend. But with that mentioned, I also believe there is an element of truth in what they have to say; it’s just not the complete story.

Ultimately, the goal is not ” merely to ponder” but translating this information into actionable decision making processes to participate in markets. This is where modern economic theories taught at university level has got me gob-struck…right from the efficient market hypotheses to those based on pure historical extrapolation. Many if not all of these economic schools of thought are completely contrary to those practiced by major market players.

The more I listen, read about and observe some of these major market participants- the more disconnect I am exposed to with respect to the retail investor. With the exception of one or maybe two individuals known to me, I yet haven’t come across a money manager/individual whose mental frequency is aligned towards that of a major player. What I do come across is many “Fake it till you make it types” (not that there is anything wrong with this; within limits) with a completely out of balance ego quotient.

Never-the-less, one of the more rarely heard about economic theory which has sparked my interest is that of Fallibility, Reflexivity and the Human Uncertainty Principle (ironically, has a link to the Heisenberg’s uncertainty principle as posted in one of my previous posts)

Fallibility refers to the tenancy of humans to generalize and in many ways structure thing around us to create a set of rules and assumptions based on which there is an expected outcome.The mere act of us trying to understand markets could be considered as a case of acute Fallibility.

Reflexivity on the other hand requires a continuously thinking loop of sequences in the present.This is further complex-ed  by thinking mechanisms that are purely objective (Efficient market hypothesis as example) and those that are designed to be manipulative (Quantitative easing as example); influencing the objective outcome. Reflexivity is subjected to Fallibility and vice-verse.

The Human Uncertainty Principle is a mush of both Fallibility and Reflexivity as we experience it in the now.

Financial markets are a epitome of the Human Uncertainty Principle which unfortunately in futuristic states does not validate the laws of statistics and probability with complete accuracy as expected theoretically (quantum physics like??) This leaves the investor/market participant in a constant state of uncertainty depending upon the outcome of this tug-of-war between Reflexivity and Fallibility.

In other words, the investor has not only to deal with quantifiable risks (the statistics and probabilities associated) but more importantly human uncertainty- which precedes data that is later quantified to draw logical (so called) conclusions.

I hope, I am doing justice in translating my understanding of this principle which forms the basic tenant of a certain gentleman who is known for his famous single day profit of US $1 Billion on September 16th 1992 (you know who I’m talking about).

Economics seeks to be a science. Science is supposed to be objective and it is difficult to be scientific when the subject matter, the participant in the economic process, lacks objectivity—G.Soros

Ponderings

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Golden Words: 1, 2, 3…what comes next?

Responder:4

Golden Words: Not so fast, could be 3.The best predictor of tomorrow is always today.

Responder:Ok…

Golden Words: Not so fast could be 2…because things have this terrible tendency to revert back to their mean.

Responder: Ok…

Golden Words: Not so fast. Could be 1 because in the end what goes around comes around.

***Words by Larry Summers***

Respecting Uncertanity

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As we slowly but surely head into the month of September and October (2015) the chorus for a US interest rate rise is getting louder.The US federal reserve has been prompting this increase since the onset of Janet Yellen’s term as Federal reserve chairperson. The Federal Reserve’s rate hike tone has mainly been through it’s “dual nature forward guidance”, which leaves room for further taper of quantitative easing or/and potential of an increase in interest rates. In my view, the Fed’s forward guidance is not telling a story; causing market participants to anticipate and develop a bias (a rate increase).

However, lets pause and have a straight forward look and question if a rate hike is supported by underlying fundamentals.

Let’s talk US inflation rates. Since the beginning of 2015 , US economy has been nearing a deflationary territory. An increase in interest rates at this stage is an unwanted tightening of monetary policy. Resultant of such an action will put further pressure on consumer spending and potential long term increasing defaults in consumer and business loans.

CropperCapture[1]

Combining the above with tapering of quantitative easing- that has provided artificial support to the markets…we have a deadly concoction of confused policy makers and actual economic data.

For now, I am not totally buying into the concept of an increase in interest rates in September or October since the re-precautions can be enormous in a deflationary environment. In short, we need some real good data in consecutive months to entertain the thought of a rate hike.

30-Day Fed Funds futures prices- Implied Probability for September 2015 rate hike.Source:CME Group

30-Day Fed Funds futures prices- Implied Probability for September 2015 rate hike.Source:CME Group

30-Day Fed Funds futures prices- Implied Probability for October 2015 rate hike.Source:CME Group

30-Day Fed Funds futures prices- Implied Probability for October 2015 rate hike.Source:CME Group

All said and done, following 2008 the Fed introduced quantitative easing…who is to say the Fed will not pull another rabbit out of it’s hat. Also, lets not forget the ripple effect of an increase in US interest rates on Greece and consequently the Euro zone.

The US Fed rate hike outcome is more that a pure resultant of globalization in economies but a globalization of politics in the making.

Irrespective of how the US interest rates play out; I am taking an approach of being adaptive rather than right or wrong as we head into the rest of the year.