My Life, Economics, and Finance

I should make it clear from the beginning; I’m convinced that there is NO such a thing as a “hedge fund conspiracy”, I just wanted to come up with a catchy title, but if there were one (even though there is no) the online newspaper I want to write about would be on their payroll.

Arbitrage funds are making financial markets efficient. They are driving the price of stocks to its fundamental value, by selling (shorting) when noise traders (uninformed traders, or idiots as Krugman puts it) drive the price too high, and buying when noise traders panic and drive the price too low.

This is a very simple (=great) idea that was slightly complicated with the advert of behavioral economics, which proves that arbitrage is risky. If the noise traders goo too crazy it might be rational for an arbitrager to stay out of the market, because he doesn’t know whether the noise traders won’t go completely nuts driving the prices extremely low and making poor arbitrager loose money in the short run.

If we forget about behavioral economics for a while, we can clearly see that the more mistakes noise traders (usually individual investors) make, the more arbitrage opportunities arise and the more money will the arbitrage funds earn. In such a setting it would be optimal for arbitrage funds to spread false information. Issuing a warning that stock XY is overvalued (when it’s not), would cause the price of XY to plunge, the fund could buy it, wait till the price recovers, sell and pocket the difference. So it’s all about false information.

After reading this assesment of the economic situation of Europe, I feel that the MSN Investing page spreads exactly this kind of an information. THESE PEOPLE HAVE NO CLUE WHAT THEY ARE TALKING ABOUT and still individual investors in the US read it and presumably believe it. You can be a genius but how can you make reasonable investment decisions when the “finance gurus” feed you this BS? Noise trader needs not to be an idiot as Krugman says, he might only be misinformed or disinformed, which is sad given that we live in an informational age…

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To add a short note. If we realize that arbitrage is risky, it is actually in the best interest of the arbitrage funds to let everyone know that there is a mispricing, after they identify the mispricing at elast. After they identify it and buy (or short) the stock, they need other actors (even former noise traders) to help them “fight” the crazed noise traders who believe the stock is too expensive (or too cheap).

At Citigroup and Lehman Brothers, or it seemed that way to Forbes in 2005! For me, this chart only confirms that the bankers, analysts, and others with MBAs had no clue what kind of financial mess is coming (not like anyone else did). I just think that the crisis was no conspiracy of the Wall Street, as some would like us to believe, but simply a bad luck… (That’s my a bit unconventional interpretation of the table)

I went to a United Nations Book Launch Event, where the former governor of the Reserve Bank of India Y.V.Reddy was introducing his new book on the financial crisis: INDIA AND THE GLOBAL FINANCIAL CRISIS, MANAGING MONEY AND FINANCE.

What stroke me was the general enthusiasm for regulations. I had the feeling that people at the UN would regulate just about everything.

One of the panelists enthusiastically quoted Reddy saying that finance is here “..for the service of the economy.” How ridiculous is that? The sole mission of a private enterprise is to create value for the shareholders,period. By doing so, it serves the society ( or so I freely interpret Smith’s Wealth of Nations, the Invisible Hand part)

It seems to me that most of the debates, including this one, about the state of economy and what to do about it are about emotions rather than about facts. That’s sad…

One of the Graduate Institute,Geneva professors recently published a column on the US-China relationship with the focus on Chinese dollar reserves.

He says three things.

1. Chinese central bankers are wrong in whatever they are doing because they have a western, mainstream, economic education.  (He doesn’t say what’s wrong with the western economic education, just “states the obvious”)
2. Chinese central bankers are wrong to assert that  holdings of Chinese dollar reserves are “pure market operations” and “should not be politicized”.
3. China has to politicize the foreign currency reserves issue, because the Americans are politicizing it…

I have two problems

1. When the hell will people learn, not to talk about things they don’t understand? – As a matter of facts, I would really like to see some reasonable critique of the mainstream economics.
2. US is politicizing the issue, because they think China is politicizing the issue. China is politicizing the issue because they think the US is politicizing the issue. Don’t you see that it’s a problem of trust, not of evil Americans?

The (stupid, arrogant,etc.) central banker was trying to overcome this problem of trust. He was saying that China won’t use it’s foreign currency reserves as a political weapon. Seems like a good idea to me…

I do very much like Thaler and Sunstein’s book Nudge. They promote the idea of liberal paternalistic state, which nudges, but doesn’t force, people to do the right decisions. An example would be a choice architecture, which encourages people to consume more vegetables, buy an insurance policy, save for retirement, etc.

Recently they have posted a Simpson comics at their blog featuring a supposedly good choice architecture.

Of course, I don’t like the comics. First of all, why should an entrepreneur care for someone’s health? An entrepreneur should care for his profit, not Homer’s diet! The only reason why the entrepreneur rearranged his store, and so impeded his profits, was to meet some bureaucratic regulation! Good choice architecture improves the welfare of some while not diminishing welfare of others. A choice architecture that arbitrarily helps some (Homer), while damaging others (Indian shopkeeper Apu) is a bad choice architecture.

The risk of liberal paternalism is that the liberal part of the choice architecture will be omitted, and we will end up living in a paternalistic state, where everyone will be told what to do in order to achieve the highest level of welfare, like in North Korea…

I came across a behavioral finance paper Information Uncertainty and Expected Stock Returns, which (among other things) ranks stocks based on the level of their “ambiguity”. Ambiguity, or information uncertainty as they call in in the paper, measures how hard it is to value a stock.

The most difficult to value are services, such as business, health, etc.. The least difficult to value is for example railroad transportation. Why these two?
Valuing a railroad transportation company is relatively easy, there is nothing hard about valuing the assets, such as trains, wagons, few buildings. The business relations and so the revenue stream is likely to be very stable. Finally the costs won’t fluctuate very much either (unless the unions go nuts of course).
On the other hand valuing a consultancy company (business services) is much tougher. Their main asset are the employees, about which you as an investors have very limited knowledge (what if a key employee left last year? What if the newly promoted partner turns out to be incompetent? etc.). Their revenue stream will also be significantly more volatile than in the previous case. Coal has to be transported from a mine to a power plant every day, but consultancy jobs come and go.

I guess you got where I am going by now. The least ambiguous category of stocks is the “Tobacco products” category. The reason why should be relatively clear by now. Tobacco companies have an extremely stable flow of revenues, they can truly rely on their customers and their demand for tobacco products.

Thank you for smoking…

Feldstein blogs on the future of the US dollar. He is way more optimistic than most of the “would like to be” market analysts. I think he is right in what he says. We should expect slow/mild depreciation rather than any dramatic fall in the value of the dollar.