Burgess Laughlin

How well understood is the modern economy?

36 posts in this topic

I suspect the following story, if true, might qualify as advance warning, at least by implication. (Bold added for emphasis.)

Thank you for the article on the Bank of China, but would you post a link to it? I'd like to read the rest of it.

I think this phenomena is not an economic one as much as a philosophic one (or even psycho-epistemological). When enough people invest in a secondhand manner -- just following the crowd -- I expect to see a bubble which will burst when reality "asserts itself." Mind you, I've thought this has been the case with China for a long time, at least since they took over Hong Kong in 1997. The extent of real growth in China is an open question as far as I can tell, with evidence on both sides of the argument. Will there be a crash soon? I don't know. Someday? Yes, unless: there's a bailout of some sort; the better investors and companies end up outweighing the worse ones; and the worse ones mend their ways or get out.

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Thank you for the article on the Bank of China, but would you post a link to it? I'd like to read the rest of it.

New York Times articles quickly become pay-for-view. That's why I didn't bother posting a link, but here it is, apparently in an updated, edited and expanded version.

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I don't understand how the Bank of China story is relevant to explain broad economic factors. It might or not be a bad investment, but for now it's just an independant occurence, completely immaterial with regard to the US economy.

If it were one example of an investment community run amok, then I would agree to its relevancy. However, the IPO story of the week is the complete flop (justified) of the Vonage's IPO, which suggests that the investor community is still at least partly rational.

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I don't understand how the Bank of China story is relevant to explain broad economic factors. It might or not be a bad investment, but for now it's just an independant occurence, completely immaterial with regard to the US economy.

If it were one example of an investment community run amok, then I would agree to its relevancy. However, the IPO story of the week is the complete flop (justified) of the Vonage's IPO, which suggests that the investor community is still at least partly rational.

Why do you think that the Bank of China is completely immaterial with regard to the US economy?

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I don't understand how the Bank of China story is relevant to explain broad economic factors. It might or not be a bad investment, but for now it's just an independant occurence, completely immaterial with regard to the US economy.

I don't understand your not understanding.The title of this topic indicates the subject: "How well understood is the modern economy?, Are major, disastrous surprises possible?" Further, I didn't specify the U. S. economy. To the contrary, the discussion here has included other countries, such as Venezuela.

When you say "completely immaterial with regard to the US economy," are you suggesting that the collapse of a major bank in China could never, under any circumstances, damage any element of the U. S. economy, not even in a line of dominoes?

If it were one example of an investment community ...

What do you mean by "investment community"?

P. S. -- What is the answer to Nicholaus Nemeth's original question? ("Would you please explain why you think that this is the proper way to invest?") I too wondered what principles, relevant to this topic-thread, led you to your conclusions.

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Burgess,

I don't understand your not understanding my not understanding. :) A very profitable and over subscribed IPO is meaningless in isolation. The amounts involved are completely immaterial to the US or Chinese economies. If the IPO was priced irrationally high, then the company's stock might well go down over time, but that's not a catastrophic event. Even a bank collapse (which a stock price decrease is not in any way) wouldn't be material much beyond its direct user base.

There are strong arguments to be made that the Chinese market is generally overvalued, but even if it proved to be indeed the case and if there was a correction, that would be nothing more than that - a correction. In any case, this bank's IPO doesn't seem to me to be a material enough event to support a positive or a negative answer to your questions.

Investing community is meant as the sum of individual and institutional investors.

As to my investment strategy, it stems from the following:

1) Empirical findings show that people are incapable of predicting the future of any specific investment. Even over the short term, roughly 50% get it right and 50% get it wrong - and those are not always the same people.

2) To the extent that people can accurately predict asset price fluctuations, the market is very efficient in reflecting this information nearly immediately in prices. For example, suppose that information surfaces that stock X worth $100 has a 50% chance to drop $10 next month, then the market would immediately reprice the stock to $100 - 50% * $10 = $95 (not factoring in discount factors, etc). Therefore, even if you could predict an event and build a portfolio to accomodate your prediction, the cost of doing so would be exactly equal to the amount at risk times the probability of the event (not factoring in transaction costs, etc). The exception here is if you find a completely unique way to analize the market (which presumably would allow you to become a multibillionaire - maybe Buffet is in this situation), or if you have information that nobody else has (insider information).

3) A diversified portfolio allows you to minimize your exposure to any single event. E.g., if you own bonds, stock, real estate, gold, across geographies (from US and non US companies), any single drop is likely to be limited in scope and somewhat offset by an increase in another asset. Of course, this is not a perfect solution, as it wouldn't protect you against a generalized drop - but then, nothing would.

Portfolio / investment strategy is fascinating in its own right, but it goes beyond the scope of your question. My comment was really in reponse to this specific statement:

Acting accordingly, an investor might devise a portfolio and a personal perspective that will allow him to ride such dips and continue moving forward.

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2) To the extent that people can accurately predict asset price fluctuations, the market is very efficient in reflecting this information nearly immediately in prices. For example, suppose that information surfaces that stock X worth $100 has a 50% chance to drop $10 next month, then the market would immediately reprice the stock to $100 - 50% * $10 = $95 (not factoring in discount factors, etc). Therefore, even if you could predict an event and build a portfolio to accomodate your prediction, the cost of doing so would be exactly equal to the amount at risk times the probability of the event (not factoring in transaction costs, etc). The exception here is if you find a completely unique way to analize the market (which presumably would allow you to become a multibillionaire - maybe Buffet is in this situation), or if you have information that nobody else has (insider information).

Fooey on the efficient market hypothesis! I've thought for some time that I ought to create an "Inefficient Market Hypthesis" -- and just like the academics, prove the market is always wrong!

The price of any good is set by "The Market" -- meaning the collective judgement of everyone involved in buying or selling that good or alternative goods (since $1 spent on the competition is a $1 vote against that good). Just like any human judgement, it is in accordance with the nature of human epistemology. That is:

- Every judgement is contextual. Every individual knows something about the market, and has his particular value hierarchy and financial resources to work with. Inside information is a factor here, but not the only one.

- Rationality is a volitional choice. For every Warren Buffet, there are fund managers that CONSISTENTLY fail to surpass their indices. There are libraries filled with all sorts of economic theories and financial approaches that contradict each other... and surely they aren't all right, but each has its proponents.

- People are fallible. A typo here or there, or mistaken addition, or a misunderstanding gets written into a contract, and people can (and do) lose money. How many earnings reports have to be reissued to correct mistakes? How many times do "The Experts" miss on their earnings estimates?

- Morality is volitional. How many Ken Lays, Enrons, and Global Crossings are there to deceive investors?

- Most people are secondhanders. How many people on Wall St are racing after the latest investment fad? How many people buy houses or dot com stocks under the "greater fool" theory of investing (i.e., buy high, sell even higher to an even bigger fool)? How many people buy stocks based on what they see recommended on CNBC? How many people go into massive debt in order to impress their neighbors with new homes and big SUVs they can't afford? How many people make risky investments without considering the consequences? (Or conversely, think any investment is too risky, and lose their wealth to inflation?)

- People often let their emotions override their judgement, selling out of fear and buying out of greed when a rational assessment would not support such actions.

- There's only so much time in the day to do the background work to look into a company. With all the companies out there, the better fund managers have their hands full just trying to keep track of a few big companies. Small companies get a fraction of that attention. With that disparity, I'd say the larger companies are generally more fairly values than the smaller ones.

I agree with Warren Buffett on this. In the short run, the market is a voting machine: the popular stocks take off. But in the long run, the market is a weighing machine: the better companies outlast and outshine the worse ones, and people eventually catch on to which is which.

Making matters worse are the work of professionals. Consider: Why are there so many more recommendations from analysts to buy then to sell? Why are their estimates often far off? Why do many funds churn their assets, instead of keeping turnover, costs and taxes low?

And of course, as any good capitalist knows, you throw government intervention and all heck breaks lose.

To my mind, I think we're lucky the market is as good as it is. In the long run, the market is efficient, which is why I think index investing makes sense for macro trends. Yet it is the inefficiencies in the market that keeps gems hidden in the short run, serving as potential home runs for the better investors who can recognize that value when others can't.

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The BOC IPO provides some interesting information about the market. First, BOC should really be seen more as a government agency - sort of like a welfare office for state-owned enterprises, along with a number of pseudo-tax-collection branches, and lots of other forex services. Presumably the idea is that someday it will be reformed with the help of foreign partners, and so now is the cheapest time to place one's chips on a "company" that the PRC intends to someday become its version of Citigroup. The PRC govt has already shown repeatedly that it will cover any and all debts and bad loans of BOC.

The hot IPO suggests that there are lots of investors now who buy into this story, and the peripheral story about China reforming and improving, combined with some investors who may be more interested in it as a "strategic" show of support for the PRC. It is indeed unusual for investors to be willing to overlook the fact that a "bank" is still not really a regular company, and assign it a nice valuation. Kind of like the way investors were willing to overlook the fact that a lot of internet IPOs weren't structurally designed to make much money anytime soon.

The interesting question to pursue is whether China's disfunctional financial system could someday be associated with a financial crisis that might disrupt global investment and production linkages.

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Ed & al., I'm going to start a new thread. This is an interesting and important discussion, but it's drifting way off Burgess' original questions.

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The interesting question to pursue is whether China's disfunctional financial system could someday be associated with a financial crisis that might disrupt global investment and production linkages.

Given the amount of material goods manufactured in China, I've wondered what the consequences to the U.S. would be if that flow suddenly stopped. Wal-mart would be annihilated (no problem with me personally since I practically never shop there, but it would have huge economic consequences to America generally), and no doubt a vast number of other companies would be affected. I don't think it would be a stretch to say that thousands of American manufacturers shut down American plants, either moving to China or going bankrupt because of competitors who did, with the far lower labor costs.

Do you know if any formal studies have been done to try to estimate the effects on the American economy if China suddenly stopped producing or if products made there were no longer available to Americans?

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Do you know if any formal studies have been done to try to estimate the effects on the American economy if China suddenly stopped producing or if products made there were no longer available to Americans?

The Defense Department almost certainly has done some and their public web sites and journals would be a good place to see if there's been anything published.

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