Thursday, December 30, 2004

Faltering meritocracy in America

Excellent article in the Economist. The data, though complex, seem to indicate that while income and wealth inequality are growing, social mobility has either not changed or decreased slightly. Also, the US does not seem to allow any more social mobility than european countries like Germany or Sweden.

Paradoxically, "...Members of the American elite live in an intensely competitive universe. As children, they are ferried from piano lessons to ballet lessons to early-reading classes. As adolescents, they cram in as much after-school coaching as possible. As students, they compete to get into the best graduate schools. As young professionals, they burn the midnight oil for their employers. And, as parents, they agonise about getting their children into the best universities. It is hard for such people to imagine that America is anything but a meritocracy: their lives are a perpetual competition. Yet it is a competition among people very much like themselves—the offspring of a tiny slither of society—rather than among the full range of talents that the country has to offer.

...America's great universities are increasingly reinforcing rather than reducing these educational inequalities. Poorer students are at a huge disadvantage, both when they try to get in and, if they are successful, in their ability to make the most of what is on offer. This disadvantage is most marked in the elite colleges that hold the keys to the best jobs. Three-quarters of the students at the country's top 146 colleges come from the richest socio-economic fourth, compared with just 3% who come from the poorest fourth (the median family income at Harvard, for example, is $150,000). This means that, at an elite university, you are 25 times as likely to run into a rich student as a poor one."

Future investment returns

Some nice discussion related to equity risk premia in the Economist. "...Despite the slump in prices in the three years to 2002, price-earnings (p/e) ratios still look a bit high, notably on American shares, and share valuations are unlikely to benefit from falling interest rates in future. Meanwhile, lower inflation means that the pace of profits growth will slow. Assume that America's nominal GDP grows by 5% a year (3% in real terms, plus 2% for inflation). If the share of profits in GDP is constant, profits will grow at the same rate. However, profits could do much less well, because in America, Japan and the euro area their share of GDP is close to a record high. They might well be expected to fall.

Suppose, though, that profits do rise in line with GDP and that p/e ratios stay the same. Then, Mr Barnes estimates, the total nominal return on American shares over the next decade will average 6.8% (5% profits growth, plus dividends), half the figure for the past 20 years. If profit margins fall modestly and the p/e ratio reverts to its long-term average, returns will average 4.9%—well below investors' expectations. Surveys suggest that individuals expect returns of more than 10%.

Could property instead lay the golden egg of the next decade? According to The Economist's global house-price indices, housing has yielded double-digit returns (including rental income) in most countries over the past 20 years. But the peak may be close. In several countries house prices are at record levels relative to incomes and rents. At best, they are likely to flatten off over the coming years. Add in the sharp fall in rental yields, and the prospective total return on property over the next five years or so is poor."

But, there is reason to believe that p/e ratios will remain higher than their historical average, due to investor confidence in the equity risk premium.

Google Suggest and phishing attack

Google has a nice beta toy called Google Suggest, which guesses predictively as you enter search terms. What is interesting is the compact JavaScript on the page which communicates in real time with a Google server to generate the suggestions. The secret is the XMLHttpRequest object, used to communicate with a server and get new information or instructions without refreshing the page

I can see how such code could be used in a phishing attack: a phishing Web page, to which the user is directed via a fake email, can use similar JavaScript to transmit keystrokes to a remote server, even if the html post on the page submits the information (e.g., username and password) to the real authentication server. Anti-phishing technology which focuses on where the post data is sent (i.e., which is implemented on the firewall or TCP/IP level) will not detect a problem.

Anti-phishing technology like Whole Security's Web CallerID works by looking at the URL from which the potentially fake page is loaded. However, using the trick I've outlined above and some cross-site scripting the page can be served up from any number of locations - the only static component is the remote server where the keystrokes are sent. For an anti-phishing agent to detect this hack it would have to parse and understand the JavaScript on the fake page. Actually Web CallerID is weak for another reason - a phisher can use JavaScript to modify the "chrome" on the browser, replacing the Web CallerID toolbar with a fake one that gives the OK signal. (This is true for any toolbar.)

For those who don't follow Internet security, we are in the midst of a sea change right now. In the past, viruses and the like were built and released just for fun, for hackers to gain a reputation. We are now entering a period where much of the hacking is done by criminals for the purpose of financial gain. This means that the next virus on your machine may be more than just an annoyance - it may be watching while you log into your online banking account.

Wednesday, December 29, 2004

Fannie Mae exits scandalous

The generous packages offered to CEO Raines and CFO Howard are ridiculous. I think the biggest problem today in US corporate governance is the cozy relationship between directors and management. It is obvious that directors are not incentivized properly to look out for the best interests of the company, but rather to maintain good relationships with the chief executive. Not only has CEO compensation become decoupled from actual performance, but "caretaker" CEOs who inherit existing public companies with strong brands and product lines are being compensated like entrepreneurs who actually create value out of nothing (see Michael Eisner and Disney for a great example). I don't see why a CEO should make $100M for anything short of a heroic turnaround - let alone lackluster performance.

For previous posts on Fannie, see here and here. Look for congress and OFHEO to claw back some of the largesse heaped on Raines.

From today's WSJ editorial by J. Stewart: "After pledging before Congress to hold himself personally accountable for any accounting errors, news reports suggest he embarked on a strenuous campaign to save his own job, huge salary and perks. Even after the Securities and Exchange Commission faulted the accounting and said Fannie Mae had misstated $9 billion in profits, Mr. Raines's benefit included an astonishing $1.4 million-a-year pension for life, not to mention a multimillion-dollar array of other goodies. Mr. Raines already is immensely wealthy; he earned more than $17 million from Fannie Mae in 2002 alone. I'm sorry, but harvesting a massive payoff for $9 billion in accounting irregularities doesn't constitute accepting responsibility for the errors.

This is all beginning to smell like the Richard Grasso pay and severance scandal at the New York Stock Exchange, with the massive payouts and cozy relationships between management and directors. There, too, a quasipublic institution lavished unseemly benefits on its top officer and is still embroiled in litigation and reform efforts meant to regain public trust.

Like the NYSE, the Fannie Mae affair goes to the heart of a serious problem, which is that a quasipublic institution that enjoys protection from the usual risks of the market, in the name of public service, has insisted on treating its top officers like their most highly paid peers in the far-riskier private sector."

Monday, December 27, 2004

Equity risk premium

In theory, stocks should provide a greater return than safer investments like Treasury bonds. The difference is called the equity risk premium: it is the additional return that you can expect from the overall market above a risk-free return. The historical value of this risk premium is about 4%. Currently, TIPs yields are about 2%, so one would expect real equity returns of about 6% going forward.

A paradoxical aspect of this risk premium is the following: once people realize that equity returns dominate bond returns, why should they continue to demand a premium for owning equities (assuming they have long time horizons)? Over the last 20 years, it has become conventional wisdom that one should own stocks, rather than bonds, for the long run ("stocks for the long run","buy and hold", even "buy on the dips"). Nothing wrong with this conclusion, as the data certainly support it. But as more investors accept this wisdom, the more the price of equities gets bid up, leading to large P/E ratios and, eventually, a smaller risk premium. To me, this is the most plausible explanation for recent secular increases in P/E ratios. However, it also implies that equity returns in the near future should lag the historical average.

The equity risk premium plays an important role in discussions of social security privatization - the particular value assumed makes all the difference in future projections. But we should remember that equities are like any other scarce resource subject to supply and demand. If demand for shares increases, their prices will also increase, even if there is no change in the "intrinsic value" = sum of future dividend payments. Eventually the supply of shares can increase, as perhaps the rate of business formation speeds up. But, it seems obvious that the growth in capitalization of the broadest index of equities cannot exceed GDP growth for any length of time, so it would be surprising if this rate of value creation could accelerate drastically.

From this perspective, it seems that social security privatization is likely to bid up equity prices and depress their future returns. Imagine the following analogy: one day, foreign investors wake up and decide to increase their portfolio allocation to US equities. The result may be a buoyant stock market, but to what extent does this increase real value creation in our economy? Does it create enough value (i.e. future earnings and dividend growth) to justify the amount by which prices are bid up? (An even simpler analogy: I have a chicken, which produces eggs at a fixed rate. Demand for egg-laying chickens increases, driving up the price of my chicken. Will it lay eggs any faster as a result of its increased price?)

Sunday, December 26, 2004

Man in the middle phishing attacks

I posted before about phishing being the next big security problem, after viruses, worms and spyware. Protecting against viruses and worms has become a billion dollar a year industry, and now anti-spyware companies are being snapped up by Microsoft and other acquirers. I mentioned before that there is no easy solution to the phishing problem. This NYTimes article describes some anti-phishing measures being tested by banks, such as RSA's SecurID key fob. SecurID uses a cryptographic one-time password (OTP), which is synchronized between the chip on the fob and the algorithm running on the authentication server.

But, this method has an obvious vulnerability. The fake bank site that the phisher redirects the user to could easily proxy the real site:

User ------ phish proxy ------ real bank site

in which case, the OTP is simply passed through when the user types it in. Once the authentication is complete the phisher drops the connection to the user and continues with the banking session. The only drawback is that the phisher has to execute this attack in real time - he sits by his machine, which beeps when a new account is compromised. He has only one login session to do his dirty work, since he can only get the OTP by proxying.

Buffet bearish on dollar

This is old news, but I found the March 2004 letter from Warren Buffet to Berkshire Hathaway shareholders, from which the following is excerpted. Buffet anticipated in 2002 the sentiment only now becoming conventional wisdom among US investors. However, he does note the tendency for people who bet against the US economy to get burned :-)

During 2002 we entered the foreign currency market for the first time in my life, and in 2003 we enlarged our position, as I became increasingly bearish on the dollar. We have – and will continue to have – the bulk of Berkshire's net worth in US assets. But in recent years our country's trade deficit has been force-feeding huge amounts of claims on America to the rest of the world. For a time, foreign appetite for these assets readily absorbed the supply. Late in 2002, however, the world started choking on this diet, and the dollar's value began to slide against major currencies. Even so, prevailing exchange rates will not lead to a material letup in our trade deficit. So whether foreign investors like it or not, they will continue to be flooded with dollars. The consequences of this are anybody's guess. They could, however, be troublesome – and reach, in fact, well beyond currency markets. As an American, I hope there is a benign ending to this problem.

Then again, perhaps the alarms I have raised will prove needless: Our country's dynamism and resiliency have repeatedly made fools of naysayers. But Berkshire holds many billions of cash-equivalents denominated in dollars. So I feel more comfortable owning foreign-exchange contracts that are at least a partial offset to that position.

Thursday, December 23, 2004

Hedge funds or central banks?

Who is keeping long bond yields low? If it is self-interested Asian central banks, one can imagine the status quo continuing for some time. If it is hedge funds plying the carry trade, the status quo is very, very vulnerable. We noted in this previous post that hedge funds are the fourth largest holder of Treasury debt after Japan, China and the UK. In the article below it is claimed that hedge funds are more likely to be on the long end of the yield curve than foreign central banks.

From Bloomberg today: When one considers that the inflation risks are skewed to the upside, a 10-year note yield near 4 percent is puzzling. Even discounting the surge in oil prices that has boosted the year- over-year increase in the consumer price index to 3.5 percent in November, the core CPI, which excludes food and energy, is accelerating, any which way you look at it. The core CPI rose 2.2 percent in the year ended November, double the increase of a year ago.

...What happened to the higher expected yields that weren't? One frequent answer is massive Asian central bank buying of Treasuries from countries that intervene in the foreign-exchange market to prevent their currencies from rising (Japan) or that acquire dollars from exporters who can't convert them in the open market (China).

While China grabs all the headlines, as of October Japan held $715 billion of U.S. Treasuries, a 40 percent increase from a year earlier. (The Treasury statistics on foreign holdings include both official and privatei nvestors.) China, whose trade surplus with the U.S. ballooned to $131 billion in the first 10 months of the year, increased itsh oldings by 16 percent to $174.6 billion.

...The hole in that argument is that foreign central banks traditionally park their dollars in the short end of the yield curve, according to Jim Bianco, president of Bianco Research in Chicago.

``Don't make the mistake of confusing bonds with GDP futures,'' Bianco says. ``Financing rates are more important to bonds than the inflation rate.''

Easy money since the Sept. 11,2 001, terrorist attacks has encouraged ``a new breed of leveraged investor, with most of the hedge-fund growth coming in fixed-income arbitrage or relative value funds,'' Bianco says, based on data from Hedge Fund Research in Chicago.

The growth in hedge funds is also evident from the explosion of trading in U.S. stocks and bonds from the tax-haven countries of the Caribbean, where total turnover is up 100 percent in the past year, according to Bianco.

If cheap money has been the inducement for hedge funds to load up on 10-year notes, then higher real rates should be the trade's undoing. With core CPI up almost as much as the funds rate this year, there's been no change in the real cost of financing bond purchases so far.

Cheap money has been an incentive for more than leveraged trading. ``It was a big employment incentive, too,'' Bianco says. ``For hedge funds.''

Derivatives too complex for accounting?

Fannie buys mortgages. Some it repackages and sells, others it holds in its portfolio. Since borrowers can refinance and repay their mortgages early if interest rates drop, the income stream from a mortgage portfolio is hard to predict. You can think of numerous variables that might affect the refinancing rate: interest rates, level of consumer debt, employment rates, etc. Fannie wanted smooth, predictable earnings - investors would demand a risk premium for shares in a company whose earnings are volatile. CEO Franklin Raines and company smoothed earnings using derivatives to hedge the fluctuations in value of their portfolio. Or did they? Well, we don't know. And the SEC claims it won't know for a year or more as auditors go carefully over the books at Fannie. "Books" here really means software models with some intricate mathematics and questionable assumptions about stochastic interest rate fluctuations, prepayment rates, etc., etc.

At the moment we are in the dark as to whether the $8B charge Fannie will take over its incorrect use of hedge acounting reflects real losses by the company, or just lack of compliance with FAS 133. From the discussion below, taken from today's WSJ, even Raines himself (Harvard College, Rhodes Scholar, Harvard Law, former head of OMB, $40M or so in total compensation in recent years) didn't know what was going on. Who can you trust these days except a quant with a PhD?

According to people who attended the meeting, SEC officials described their findings about Fannie's accounting, which reinforced the views expressed previously by Ofheo. The biggest issue was Fannie's use of so-called hedge accounting for its derivatives, which allowed the company to spread out losses or gains over long periods. The SEC and Ofheo found that Fannie hadn't taken the steps needed to qualify for hedge accounting.

During the meeting, Mr. Raines took issue with the accounting rule for derivatives, known as FAS 133, at the center of the controversy.

"Many companies can and do comply with the rules," Donald Nicolaisen, the SEC's chief accountant, shot back, according to two participants. "Sir, hedge accounting is a privilege, not a right," he continued. "[It] is applied only under strict circumstances, and you did not comply."

Mr. Raines seemed shocked, participants say. He then asked how far off Fannie's books had been in relation to FAS 133. In response, according to one participant, Mr. Nicolaisen held up a sheet of paper and told Mr. Raines that if it represented the four corners of the rule, "you were not even on the page."

Wednesday, December 22, 2004

Asia and America's debt trap

Martin Wolf has a nice column on the current account situation in today's Financial Times. It seems all analysts more or less agree on the figures and what has to happen for a solution to emerge. I think Wolf is crazy to think that non-Japan Asia is going to soon run large current account deficits (become net importers of capital), although I agree it is desirable both for the world and for their future development. My comments are in bold below.

Asia could solve America's debt trap
Financial Times, December 22, 2004

Structural issues on all sides:

It takes two to tango. This has been one of the twin themes of my recent columns on global current account imbalances (November 24 and December 1 and 8). The huge deficits being run by the US are the mirror image of the surplus savings of the rest of the world. But the dance is becoming ever wilder. That has been my second theme. It is necessary to call a halt before serious injury occurs. The "blame game" among policymakers is idiotic: they have created the problem together and must solve it together.

There is no disagreement on the numbers:

...How difficult would the needed adjustments be? The first step towards an answer is deciding what a sustainable US current account deficit might be. In a recent column (FT, December 15), Raghuram Rajan, the chief economist of the International Monetary Fund, argues that the US could sustain a current account deficit of 3 per cent of gross domestic product (half the current level) indefinitely. Given US potential growth, net external liabilities would stabilise at 50 per cent of GDP, against roughly 30 per cent today. Given the chronic savings surplus of Japan and several other high-income countries, such deficits and liabilities seem reasonable for the world's biggest and most dynamic advanced economy.

...Now turn to the required changes in real exchange rates. To achieve a fall in the current account deficit, at full employment, of 3 per cent of GDP, the increased domestic supply - and reduced domestic demand - for tradeable goods and services in the US would amount to about an eighth of current output in this sector. Some analysts suggest that the needed overall real exchange rate adjustment could be close to 30 per cent from the peak three years ago. This would imply a further depreciation nearly as large as the one so far.

Bretton Woods II - eventually the EU caves in?

...As economists at Deutsche Bank have argued, a new informal dollar area has emerged that contains countries that either run fixed exchange rates against the dollar (notably China) or at least intervene heavily in foreign currency markets. This new dollar area contains over half the world economy. But it will also run an overall deficit of about $260bn (£133bn) in 2004. It is not surprising the dollar area's currencies have been declining against the rest.

As the pain grows, argues Deutsche Bank, the eurozone may also embark on foreign exchange interventions and so join the informal dollar area, even in the teeth of opposition from the European Central Bank. Most of the world would then be underwriting the US external (and domestic) financial deficits. That would be a nirvana for US policymakers in the short term. But it would also postpone - and exacerbate - needed adjustments.

Asia to the rescue? Not likely soon...

...The world will only dispense with its dependence on the accumulation of mountainous US liabilities if non-Japan Asia - above all, China - play the role to be expected of the world's fastest growing and most populous countries. Continent-sized countries should not go on playing the mercantilist game of piling up reserves indefinitely.

Non-Japan Asia needs to become a large net importer of capital. Aggregate current account deficits of at least $150bn a year, in today's prices, would be very helpful. Facilitating the emergence of the efficient capital markets and dynamic consumer demand needed for this is much the highest priority in global macroeconomic policy. Such reforms not only offer the only durable escape from the US debt trap. They are also exactly the changes Asia needs for its own long-term development.

Election eases Taiwan straits tension

Recent legislative elections in Taiwan went surprisingly well for the KMT. The pro-independence DPP and its allies only picked up a single seat. This leaves them far short of the 75% majority needed to call a referendum to modify the constitution and declare independence. It also suggests that the electorate is becoming less supportive of President Chen Shui-bian's aggressively pro-independence posture.

War between China and Taiwan, most likely resulting from a declaration of independence by Taiwan, is in my mind the single largest threat to development and growing prosperity in east Asia. The PRC government has made reunification with Taiwan a patriotic issue, and would have no choice but to react militarily to a unilateral declaration by Taiwan. The US would very likely be drawn into the conflict - which is why Washington has been bluntly warning Chen's government against any hasty action.

In a best case scenario, the status quo can continue for another decade or two, by which time China may be democratic enough that peaceful reunification can occur, embraced by both sides. In the worst case, Chinese civilization could be set back a hundred years in a conflict involving nuclear adversaries.

The last time tensions were high between Taiwan and China (during the 1996 Taiwan Presidential election), the US sailed a carrier group through the Taiwan strait with impunity. That would be a risky move now, given China's purchase of kilo-class quiet submarines from Russia, and advances in PLA missile technology.

Tuesday, December 21, 2004

Morgan Stanley Global Economic Forum

They've outdone themselves with a lengthy year end report covering, well, the whole world. Thanks to Brad Setser's and Brad DeLong's blogs for the pointer.

Given the cautionary perspective of Stephen Roach (Morgan Stanley) and other well-known economists, I am amazed that (a) implied vol is at a multi-year low and (b) long bond yields are so low. The latter can perhaps be explained by foreign central bank buying (and hedge funds plying the carry trade), but why are equity markets so sanguine about the coming year? Perhaps there are structural forces at work there as well? Will realized vol in the coming year be much higher than the market is currently predicting?

Roach: Finally, the US also needs a further weakening of the dollar, in my view. On a broad trade-weighted basis, the dollar’s real effective exchange rate is down about 15% from its early 2002 peak. This is a relatively small decline for a US with a current account deficit that is expected to rise to at least 6.5% of GDP over the next year. Back in the latter half of the 1980s, when the current account deficit peaked at 3.5%, the broad dollar index fell about 30% in real terms. In other words, America today has a current-account problem that is almost twice as bad as it was in the 1980s but a dollar that has fallen only about half as much. For that simple reason, alone, I would argue that the dollar has at least another 15% to go on the downside. While a weaker dollar will not alleviate America’s imbalances, it could well trigger the interest rate adjustments that might — especially since the current-account conundrum means that marginal changes in US rates are increasingly in the hands of America’s overseas creditors.

A spike in interest rates would definitely cause an equities crash. Roach should put his money where his mouth is and buy SP puts - or at least advise his clients to!

More brain drain slowdown

We've been shooting ourselves in the foot with misguided security restrictions since 9/11. This article mentions some nutty screening process called "Visa Mantis" (probably Homeland Security), which delays entry to many Chinese students studying science and engineering.

NY Times: ...Foreign students contribute $13 billion to the American economy annually. But this year brought clear signs that the United States' overwhelming dominance of international higher education may be ending. In July, Mr. Payne briefed the National Academy of Sciences on a sharp plunge in the number of students from India and China who had taken the most recent administration of the Graduate Record Exam, a requirement for applying to most graduate schools; it had dropped by half.

Foreign applications to American graduate schools declined 28 percent this year. Actual foreign graduate student enrollments dropped 6 percent. Enrollments of all foreign students, in undergraduate, graduate and postdoctoral programs, fell for the first time in three decades in an annual census released this fall. Meanwhile, university enrollments have been surging in England, Germany and other countries.

Monday, December 20, 2004

Digital mania

It's boom times in the $10B per year videogame industry, which is now comparable in size to the film industry. (US box office receipts are about $9B, but worldwide box office plus DVD/VCR revenues total about $20B.) Development costs for sophisticated games now reach $10-20M, which, while only a fraction of the $100M cost of a Hollywood blockbuster, is easily enough capital for most tech startups to develop a software product and bring it to market.

$125 million: Value of total sales for the first 24 hours of Halo 2
$114 million: Opening-weekend gross for "Spider-Man," a Hollywood record

On a related note, Pixar is the most successful movie studio of the last decade, with a perfect 100% record of hits, earning $3B in revenues. Not bad for a company Steve Jobs paid only $10M for in 1986! The technical infrastructure created at Pixar is very impressive - for example, the ability to produce the water effects in Nemo required solving a number of challenging numerical simulation problems. Their campus in Emeryville, CA is nice, too!

Sunday, December 19, 2004

Brain drain slowdown

It used to be the case that almost all world class researchers in Asia were trained in the US, Europe or Japan. Lately I've begun to meet scientists whose PhDs were earned in China, Korea and Taiwan who are nonetheless at the cutting edge of research. It is becoming more common for the some of the most talented students to stay at home at leading institutions such as Tsinghua (Beijing) or Seoul National University or Taiwan National University (Taipei). Looking at undergraduate degrees, China already produces vastly more engineers than the US - some estimates say three times as many per year.

China tech segmentation

WSJ: Already in China it's possible to detect regional technology centers and competition for workers, similar to the rivalry between Silicon Valley, Boston and Seattle in the U.S.

Southern China's Guangdong province, dominated by the cities of Guangzhou and Shenzhen, is the center of most TV, stereo and computer assembly. Meanwhile, the city of Suzhou, not far from Shanghai, is home to a lot of notebook PC production, notably many of the operations of Taiwan's giant contract manufacturers.

A group of telecom-equipment makers is based in Hangzhou, which is also along the central coast near Shanghai. The country's biggest homegrown chip maker, Semiconductor Manufacturing International, is farther north in Tianjin, near Beijing, in facilities originally built by Motorola. Meanwhile, both Motorola and Intel are way out in the western city of Chengdu. They're taking advantage of access to engineering universities that for years offered support to the country's military contractors, located there by the government in the belief they would be insulated from attack.

Employee stock options and efficient markets

The FASB (Federal Accounting Standard Board) has decided that companies must count employee stock options (ESOs) as an expense on their balance sheets. This policy is of course eminently sensible (so agrees Warren Buffet), since ESOs dilute the value of pre-existing shares in the company. However, thanks to lobbying on the part of Silicon Valley and tech companies in general, ESOs have been off balance sheet until now.

Of course, a believer in (anything but the weakest version of) the efficient markets hypothesis would claim that whether or not ESOs are included in reported earnings is of no consequence, since they do already appear in the text of every public company's quarterly report. (Surely any rational, intelligent investor reads the text of quarterly statements? ;-) But pretty much every tech CEO and VC has been predicting imminent destruction of our marvelous innovation engine due to expensing of ESOs, so I guess they don't believe in efficient markets.

There are some technical issues to be addressed here. How should accountants value ESOs? One could plug the historical vol of the issuing company into the Black-Scholes model, but the timescale of the ESOs (usually one to several years) is much longer than the period over which one usually trusts historical vol. Also, many employees leave the company before their options vest, letting companies recover part of the value, which means employee attrition rates have to be part of any model. I see a consulting opportunity here for quants who want to help CFOs and accountants with this problem :-) I also see a further reduction in the quality (reliability) of the earnings numbers that we investors have to rely on.

Saturday, December 18, 2004

Contrarian macro numbers

Here are some numbers suggesting the US current account deficit is sustainable. They come from a 10/31 FT article by Richard Cooper, Harvard economics prof and former undersecretary of state for economic affairs.

Cooper assumes a continuing US account deficit of $500B, which is 5% of current GDP. (This year it is a bit bigger - at 6%, but going forward $500B is not implausible.) If US nominal GDP growth is 5% (3% real + 2% inflation), the fraction of US assets owned by foreigners as a consequence of the account deficit will rise over the years (due to payments), but not unsustainably.

From the rest of the world's point of view, the numbers are also not necessarily alarming. The ex-USA world produces $6 trillion per year in savings, so the account deficit means the US absorbs 10% of savings from other countries. Let's think about this a bit - if US GDP is $10 trillion, then ex-USA GDP is $30 trillion, so $6 trillion represents a world ex-USA savings rate of 20%. This seems a bit high to me (although the savings rate in China is reported as 40%!), but is confirmed by this Morgan Stanley report (How Depleted is the Global Savings Base?): ... the deterioration in the US C/A has been matched by an even larger accumulation of overseas savings.   As a result, the US now absorbs a smaller share of the rest of the world’s savings compared to the historical trend.  A related figure, which is often reported, is that the US account deficit absorbs almost 80% of foreign trade surpluses (usually the reports confuse foreign savings and foreign trade surpluses). Now, the US is 25% of the world economy, has 50% of marketable financial assets, and higher economic growth rates than either Europe or Japan, making it a desirable destination for investment. So perhaps absorbing 10% of foreign savings is sustainable. A portfolio manager might advise foreign investors to place at least that amount in US assets each year.

From this macro perspective, a meltdown is not inevitable. However, investor sentiment is a tricky thing. If foreigners become convinced that the dollar must decline in the coming years, they are unlikely to allocate 10% of their savings to US investments, even if we are a large and relatively dynamic component of the world economy.

Friday, December 17, 2004

Fed model reconsidered

The Fed model for equity valuation compares the E/P of stocks to the 10yr yield on Treasurys. The usual justification is that stocks and bonds are competing asset classes, and one should compare their future cash flows to obtain a relative valuation. When yields on bonds are low, investors will tolerate a lower E/P (or higher P/E) in equities. One subtlety here is future inflation, which seems to "pass through" to corporate earnings, but erodes the real returns on bonds. While E/P might be a plausible forecast of future real corporate cashflows, the 10yr yield is only in nominal dollars. Perhaps it would be better to substitute the 10yr yield on TIPS for the bond component.

I found some interesting analysis of the Fed model (and the following figures) in this paper by C. Asness. Figure 2 shows that the Fed model has been quite successful over the last 30 years, but not for earlier periods. I had always thought this discrepancy was explained by inflation - the Fed model was successful in the recent period when inflation was perceived to be under control (i.e., post Volcker). Asness has a different take. He fits E/P = a + bY + c v_s / v_b where Y is the bond yield, v_s the trailing 20y stock volatility and v_b the trailing 20y bond volatility, reasoning that the relative perceived vols will affect the attractiveness of stocks vs bonds. The result, shown in Figure 4, is quite nice. The best fit value of b is close to 1 (similar to the Fed model), and since the trailing 20y vol is by definition slowly varying, it seems the Fed model is not a bad rule of thumb for current valuation.

Historical volatility smile

Here's some historical data I dug up. It shows that the actual character of fluctuations in the SP500 changed after the crash of 1987. In particular, the appearance of skew in the implied volatility is reflected in the realized volatility.

For earlier discussion, see here and here.

Thursday, December 16, 2004

Fannie Mae derivatives accounting

I posted on this some time ago. Fannie Mae, the largest buyer of home mortgages, has been ordered to restate earnings over the last four years, which will force it to recognize a $9B loss by marking the value of its derivatives portfolio to market.

WSJ: Fannie and Freddie, whose shares are traded on the New York Stock Exchange, were chartered by Congress to pump money into the housing market. They both buy mortgages from banks and other lenders, holding some of those loans on their books and selling others in the form of securities to investors.

Both companies' rapid growth has been fueled by the investing public's longstanding belief that the federal government would bail out the two enterprises if they ever ran into solvency problems. Federal Reserve officials in recent years have tried to quash such notions, though with little success. And today, the companies continue to enjoy far lower costs of capital than other financial institutions and are held to much looser capital requirements than commercial banks or dealers in government bonds. They currently have combined debt outstanding of around $1.7 trillion, about a third of it owed to foreign central banks and other overseas investors.

...The findings concern accounting rules known as Financial Accounting Standards 133 and 91. FAS 133 sets requirements for booking gains and losses on derivative contracts, which Fannie uses heavily to hedge against swings in interest rates. In accounting for those derivative contracts, both the SEC and Ofheo found, Fannie incorrectly applied the rules in a way that allowed it to spread out losses over many years rather than booking them immediately. Fannie used its own methodology to determine that it qualified for so-called hedge accounting, which would have allowed it to spread out losses. But the SEC said Fannie didn't take the steps necessary to qualify for hedge accounting.

Fannie is increasingly holding a lot of mortgages in its portfolio (rather than just reselling them), exposing it to huge interest rate risks. I never felt confident they were hedging properly against these risks - hedge funds in this business blow up all the time. There are implications for the dollar as foreign central banks (particularly PBOC) have been buying a lot of agency debt (Fannie, Freddie). Franklin Raines is toast. Stay tuned for more...

Wednesday, December 15, 2004

Sony and Samsung to share patents

This is rather shocking news (WSJ). Sony and Samsung have agreed to cross-license about 90% of their patents (each hold just over 10K US patents alone). It is amazing that relative newcomer Samsung has a patent portfolio of value roughly equivalent to Sony's, considering the latter company has been a consumer electronics heavyweight for a generation now. It just shows how rapidly things move in technology-intensive industries.

For four of the past five years, Samsung has been among the top 10 in U.S. patent applications, and its knowhow in flat-panel manufacturing was a big reason Sony asked to collaborate with it in liquid-crystal displays last year.

I wonder if this agreement covers Sony's new multicore "Cell" chip, which is state of the art.

Hedge fund returns

Below is a graph of recent hedge fund returns (presumably net of fees) vs. the SP500. Doesn't look so great, except that their ability to sell short and use derivatives gave them a big advantage in down markets. Also, reporting of returns is voluntary, and academic studies suggest that very badly performing funds (i.e. ones that blow up) might not appear in the data.

Don't become a scientist!

Says Jonathan katz, a high energy astrophysicist at Washington University in St. Louis.

Leave graduate school to people from India and China, for whom the prospects at home are even worse. I have known more people whose lives have been ruined by getting a Ph.D. in physics than by drugs.

Katz is right on the money. If I had a son or daughter about to embark on a scientific career, I would ask them to read this essay first.

Tuesday, December 14, 2004

Stability and null energy condition

My collaborator, UO postdoc Roman Buniy, is off to sunny Miami to attend a particle theory conference. His talk is on stability of quantum field theories and the null energy condition.

Recently, cosmologists have discovered that 80% of the energy in the universe is in a very unusual form called "dark energy" (not to be confused with "dark matter," which also exists but is clumped around galaxies, rather than diffuse, and doesn't seem as weird). Dark energy causes the expansion of the universe to accelerate, due to an equation of state with negative pressure. How negative can the pressure be? There is some theoretical prejudice that it cannot be more negative than minus its energy density (in natural units where Planck's constant and the speed of light are unity), even though the data allow for and perhaps even suggest this possibility.

What do I mean by "theoretical prejudice"? Well, I mean many theorists would be shocked if things turned out otherwise. If the pressure is too negative something called the "null energy condition" (NEC) used in general relativity is violated. The NEC says that the contraction of any null, or light-like, four vectors with the stress energy tensor must be non-negative. Assuming the NEC, one can prove a number of pleasing properties of solutions to the Einstein equations. It is believed to be satisfied by any reasonable types of matter.

In our paper we show that, in a broad class of models including any constructed out of interacting scalar and gauge fields, or any model describing a perfect fluid, if the NEC is violated by some configuration of the fields, then that configuration is unstable (i.e., will fall apart). This makes it very unlikely that the dark energy violates the NEC, since it seems to have been stable over billions of years.

Electronic libraries

Google has announced it is scanning large collections of books from academic libraries such as those at Stanford and Harvard. Amazon's search engine already allows users to search inside many books. Hopefully, with both Amazon and Google negotiating with publishers we will soon have widespread electronic distribution of books. Once search engines have scanned these books, a direct sales channel is opened between publishers and buyers - find the search result in a book, buy it as a PDF file with a single click. Digital rights management will be an issue for popular books, but perhaps not for less commercial academic or technical books. For some obscure volumes, publishers might welcome the extra income from sales of electronic versions, and not be so worried about piracy. Also, the copyrights to many useful books have expired so that they are in the public domain.

Let's see: roughly speaking, 1 letter = 1 byte, 10^3 words per page, 10^6 bytes per book. So 1 GB = 1000 books and a 100GB hard drive (soon to be seen on ipods) will store 10^5 books. Since a decent university library holds about 10^6 books, I can see a day very soon when we can carry our own extensive digital libraries around with us! The main bottleneck is economic, not technical.

Monday, December 13, 2004

Income volatility: data

The LA Times continues its coverage of increasing US income volatility. As I argued in an earlier post, we should think in terms of risk-adjusted growth in incomes, just as one considers the risk-adjusted return on a portfolio. Prosperity, but at what cost?

Sunday, December 12, 2004

The impending singularity

I wrote before about what might happen if machine intelligence ever exceeds our own. Here is an amusing graph from an essay by the roboticist H. Moravec of CMU (known for work on mobile robots).

I also found the original paper by sci fi writer and computer scientist Verner Vinge, who coined the term singularity to describe the unlimited acceleration of technical progress that might result from machine intelligence. Finally, here is another amusing graph from Moravec.

Saturday, December 11, 2004

Housing bubble, and possible hedge

Robert Shiller, the Yale economist who coined the phrase "irrational exuberance" to describe the tech bubble, has been advocating new financial instruments that let ordinary people manage the increasing levels of risk in their financial lives. This NYT article describes new derivative instruments designed by Shiller's company that are essentially index funds linked to home prices in certain major markets. They will trade on the Chicago Mercantile Exchange and allow investors to, e.g., hedge against a decline in real estate values in their city.

Interestingly, there will be a pair of derivatives linked to each underlying index, whose prices behave oppositely. This allows bets against the index without requiring a short position that might lead to margin calls or unbounded losses. One mismatch between the Shiller indices and the actual housing markets is the favorable tax treatment of leverage for someone who buys a house (as opposed to the index).

"Volatile markets are increasingly becoming a part of our lives," Mr. Shiller added. "The home market itself is becoming more volatile. We're in the biggest real estate bubble in history, I believe.

Nationwide, home prices rose 7 percent a year, on average, from 1999 to 2003, roughly double the rate for rental prices. Over the previous 15 years, the two rose more or less in tandem, with one outpacing the other for a while before the pattern reversed. I discussed bubble dynamics in a previous post.

Friday, December 10, 2004

Prisoner's dilemma, altruism and Silicon Valley

Prisoner's dilemma is a two player game, in which each player separately and simultaneously decides whether to cooperate with the other, or to defect. It is analogous to the situation a criminal might find himself in: either testify against his accomplice in return for a lighter sentence, or keep quiet and hope that the other guy does as well. The highest point payoff results if both parties cooperate, but if one has no idea what the other party will do it is best to defect. Ironically, if each player follows his best strategy (assuming no knowledge of what the other will do) both will defect rather than cooperate, ending up worse off.

Clearly the prisoners would be better off if they could trust each other. But how does trust arise? An academic at Michigan has been running prisoner's dilemma tournaments between software agents (programs) for some time. Each competitor programs his agent and they play against each other in a round-robin tournament, whose key feature is that the agents will meet repeatedly and can remember what happened in previous rounds. The dominant strategy - that of the winning agents - seems to be a kind of benevolent "tit for tat," in which an agent assumes the other will cooperate when they first meet, but punishes a defection by behaving similarly at the next meeting. This allows altruistic cooperation to develop, and deters bad behavior. I am oversimplifying here because, obviously, the success of a strategy depends quite a bit on the overall distribution of algorithms in the pool of agents. However, it seems to be a fairly robust fact that tit for tat styles of play tend to do well. This observation has been taken as evidence that there might be evolutionary selection for altruism. Humans who don't have at least some instinct for cooperation will have lower survival and reproductive probabilities, and the nice (but stern) genes will eventually predominate.

It's a nice story, and perhaps even has a kernel of truth. Of course, as anyone who has worked in a large organization can attest, there are other, nastier, niche strategies that work well too. (Like, pretend to be a nice tit for tat person but defect as much as you can get away with it.) Interestingly, I find that in the silicon valley world of entrepreneurs, VCs, engineers and salespeople, there is a very strong tendency towards benevolent tit for tat behavior. To first approximation, I can email anyone without ever having met them, introduce myself, and, by making a sufficiently logical case for it, elicit some amount of cooperation. This routinely happens along the lines of "I am researching an idea in this space, and wonder if you know anyone who would talk to me about the (market, competitors, technology, etc.)" It is understood that other agents in this virtual world would do the same under similar circumstances. Sometimes you end up wasting your time, or having your time wasted, but other times you develop very useful additions to your trusted network. A business ecosystem lacking this culture of cooperation would have a hard time competing with silicon valley in terms of innovation or development of new companies.

Thursday, December 09, 2004

Life as a Quant

I've been reading Emanuel Derman's memoir, My Life as a Quant: Reflections on Physics and Finance. Derman was trained in theoretical physics, but left for finance after multiple postdocs and a stop at Bell Labs. He had a long and distinguished career at Goldman-Sachs, where he worked closely with Fischer Black of Black-Scholes fame. One of his most famous papers is on the volatility "smile" or skew, which I discussed in previous posts.

An entire chapter of the book is devoted to volatility, and ends with Derman admitting that no one really knows the fundamental cause behind the smile. His work had to do with extracting "local" volatility from an implied vol surface that is itself extracted from option prices over a range of strikes and expirations. One tantalizing fact I learned from the book is that prior to the 1987 crash there was no vol smile in SP options. This strongly suggests to me that the smile is at least partially caused by crash-averse portfolio managers buying puts as insurance and selling calls to defray the cost of that insurance (or simply to enhance profits). Puts would then be overbought while calls are oversold. (I took advantage of this in 2004 by buying a lot of long-dated SP calls, which are now in the money.)

I recommend this book to anyone interested in theoretical physics, mathematical finance or derivatives. Derman has a very down to earth writing style, but is also very insightful. This book is particularly valuable to students and postdocs in physics who want an insider's view of what a career in finance might be like.

Wednesday, December 08, 2004

Lenovo (Legend) buys IBM PC unit

Lenovo, the largest PC maker in China, paid $1.25B (about equal amounts of cash and stock) for IBM's PC unit. Lenovo's market cap is about $3B so this amounts to a 19% stake for IBM in Lenovo. For those non-geeks out there, the IBM Thinkpad was long regarded as the best Windows laptop line.

Lenovo, originally known as Legend, had its origins in the Chinese Academy of Science. This acquisition vaults it to no.3 in the world in PCs (after Dell and HP) with a 9% world market share. Integration of the IBM unit should prove quite challenging. However, it does provide Lenovo with key ingredients that even leading Chinese companies have thus far lacked: a recognized brand, sophisticated product design and worldwide distribution.

Earlier I noted that both Schwinn (bicycles) and RCA (electronics) brands were now in the hands of Chinese companies.

Tuesday, December 07, 2004

Sustainability of China economic growth

A reader commented that my earlier estimates for the emergence of a middle class might be optimistic. My main assumption was that the differential in growth rates between China and developed countries would average about 5 percent per year. (e.g. 7% vs 2%)

Below are some figures from the IMF, which suggest that China's rapid economic growth could continue for some time. Determinants of growth, such as savings, investment and opportunity for reallocation of human capital, compare favorably with Japan or other NIEs (Korea, Singapore, Taiwan) at a similar stage of development.

Monday, December 06, 2004

Labor vs technology arbitrage

The Times business section today has special coverage on China. The piece about venture capital in China is right on the money - despite all the dynamism there I think there are better VC investments to be made in the US right now. Most opportunities in China are based on labor arbitrage, not technology innovation.

Labor arbitrage is illustrated very clearly by the two profiles, of a textile worker in Georgia, and another in a factory town north of Shanghai. With 150 million excess rural workers in China, and modern supply chains connecting factories there to US markets, how long can a 30x disparity in pay ($15 per hour vs $4 per day) persist?

Sunday, December 05, 2004

Executive summary

This Economist article is the best summary I have seen yet of the US current account situation and its likely effect on the dollar.

An interesting point about a looming reversal in net payments:
So far America's hefty debt has not been a burden on its economy, mainly because it has pulled off an extraordinary trick. Although it is a large net debtor, it does not have to make net payments of interest and dividends to the rest of the world. Instead, America still enjoys a net inflow of investment income because it earns a higher average return on its foreign assets than it pays on its liabilities. Returns on foreign direct investment and equities are higher abroad than at home, and America has benefited from unusually low interest rates on its borrowing in recent years. Unlike in previous periods of dollar decline, bond yields have remained low—largely thanks to those huge purchases by foreign central banks. But as interest rates rise in future and net foreign debt mounts, America's net investment income is likely to turn negative, probably next year. Not only will that swell its current-account deficit, but it will also exert an increasing drag on the economy.

I expect the dollar-yuan exchange rate to follow the pattern below in the next decades. This is why, assuming further progress in China, the PPP exchange rate is a better indicator than the current pegged exchange rate.

Net foreign liabilities are about $3 trillion, or 30% of GDP. Half of this is held by Japan and China.

Benchmarks in China development: emergence of a middle class

The emergence of Chinese consumer markets - in particular, a Chinese "middle class" - is often discussed, but without quantifying exactly what is meant by middle class. Below I describe some rough calculations that suggest a population of 300M could emerge by 2020 with per capita buying power similar to that in developed countries. One could characterize this as equivalent to adding an extra EU or United States to the world economy.

2003 China GDP per capita (PPP) is $4K. Assume 5% differential between PRC and developed-world GDP growth rates (e.g. 7% vs 2%), or a doubling time of about 14 years. This is consistent with sustained performance of Japan, Taiwan or Korea during similar periods in their development. (Current growth rate differentials are larger - as much as 7% - so our estimate is not aggressive.)

To catch up with developed nations in GDP per capita (e.g., Korea, Greece or Portugal, currently at $16-18K per year) would require 30 years. (A more aggressive 6% growth differential would imply 24 years.)

Now assume income inequality similar to that of the US: 80th percentile family income is twice average income (this is conservative as actual income inequality in China is likely to be more uneven). Then, in 14 years there will be a "middle class" in China of 300M people whose household income is at developed country levels. In 20 years this middle class will easily be larger in population than either the US or EU. Note that while we refer to this as a middle class it actually comprises the richest 20-25% of the Chinese population.

Keep in mind that these figures use PPP (purchasing power parity) and not nominal exchange rates. But I expect an FX equilibration to occur over these same timescales (i.e. appreciation of the renminbi just as with the yen in previous decades), resulting in a gradual closing of the gap between PPP and nominal exchange rates. (For those not familiar with PPP, it is an exhange rate computed by comparing the local currency costs of a common basket of goods in two countries. At the PPP rate the two baskets cost the same.)

If one uses a more generous definition of "middle class" - say, GDP per capita of $10K at PPP - then there are already 200M such people in China.

Wal-Mart facts

From The New York Review of Books:

With 1.4 million employees worldwide, Wal-Mart's workforce is now larger than that of GM, Ford, GE, and IBM combined. At $258 billion in 2003, Wal-Mart's annual revenues are 2 percent of US GDP, and eight times the size of Microsoft's. In fact, when ranked by its revenues, Wal-Mart is the world's largest corporation.

...As of last spring, the average pay of a sales clerk at Wal-Mart was $8.50 an hour, or about $14,000 a year, $1,000 below the government's definition of the poverty level for a family of three.[4] Despite the implied claims of Wal-Mart's current TV advertising campaign, fewer than half— between 41 and 46 percent—of Wal-Mart employees can afford even the least-expensive health care benefits offered by the company.

Half of US productivity growth from 1995-2000 was in retail and wholesale distribution. Part of that comes from containing payroll costs, but IT and logistical efficiency are also key to Wal-Mart's success. Hopefully most of these clerks are only part-time workers and not sole breadwinners of their families. We noted before that Wal-Mart accounts for 10% of US imports from China.

Saturday, December 04, 2004

NYT on JPN,CHN central banks and traders

This article profiles central bankers in Japan and China. A couple of important points: the majority of Japanese dollar holdings are in US Treasury debt: $720B out of $812B, whereas the PBOC only holds $180B of its $600B in dollar reserves in Treasurys, with the rest in agency debt (Fannie, Freddie), mortgage backed securities, etc. China views its dollar reserves as a component of national wealth, so has been managing it for return, not just as a strategic instrument of trade, which explains the greater diversification.

...In Beijing these days, one of the fastest-growing fortunes the world has ever seen is managed by fewer than two dozen traders, chosen for showing mathematical brilliance at China's top universities.

...In contrast to Japan, China's money managers, while selling little of their existing Treasury holding, have not been buying much more. China's foreign currency reserves rose by $111.3 billion in the first three quarters of the year, according to official Chinese data. But its Treasury holdings, American filings show, climbed by only $16.4 billion.

Instead, officials at the State Administration of Foreign Exchange in Beijing have been seeking higher yields by plowing billions of dollars a month into bonds backed by mortgages on houses across the United States, according to bankers who help Beijing manage the money. By helping keep mortgage rates from rising, China has come to play an enormous and little-noticed role in sustaining the American housing boom.

Friday, December 03, 2004

Comments on volatility

The comments below are from a practitioner in quant finance. I find his explanation of why implied vol is so low to be persuasive. The "technical" cause he mentions (people writing a lot of covered calls) leads to skew - asymmetry of the implied prob. dist., with upward moves of the spot less probable than downward. I'm a bit confused about whether this affects the relation between implied and realized vol - it depends on why the calls are being sold. BTW, I also recently learned that one can directly trade realized vol through CBOE variance futures.

I speak to volatility brokers on a daily basis, and whilst their opinions can vary considerably in detail, they seem to have generally the same explanation as to why market volatility has been going down over the last 18-24 months.

On the fundamental side, corporate deleveraging has caused a drop in vol. if you view a company as a leveraged series of cashflows, where cashflows are representative of net earnings, then balance sheet deleveraging means that the magnification of perceived earnings volatility should decrease. in this sense credit and vol have moved together, more or less.

On the "technical" (meaning non-fundamental) side, one thing that has increased in the last few years has been corporate call overwriting. that is, companies with large cross share holdings writing OTM calls on part of their holdings. the seller wants to sell the stock, but isn't particularly bothered about exact timing or the exact level, so may sell that option to the market and get paid. unicredito italiano went from an implied vol of 40% to under 15% mainly because of this effect!

for a very long time there has been call overwriting by money managers with moderate sized positions, but this has increased as well recently. contrary to popular belief by some derivatives traders and hedge fund traders, many intelligent people work in normal equity funds, and these people have learned that call overwriting can produce extremely good returns. as intelligent people they are likely to increase this activity in the future. my opinion there are too many vol traders out there who look only at statistics and think "vol was historically higher and vol reverts to the mean, therefore i should buy it". whilst many senior traders don't fall into the mean-reversion trap, more vol traders need to think about the game theory aspect of what they are doing. if everyone who delta hedges is long gamma, there will have to be an extra large volatility shock for implied vol to increase, as everyone will want to try and take profits by selling their options! and if nobody sells their options, everyone will delta hedge against market moves, as discussed, and decrease implied vol.

it is like people who play poker and only look at their own hand, just playing the statistics. they should look around them and think about what other people are likely to do, given the information available.

El-Erian on emerging mkts

Mohamed El-Erian is PIMCO's resident guru on emerging market bonds. These comments are excerpted from a Financial Times editorial of today.

We should keep in mind that for most of history, with the exception only of the last few hundred years, world economic activity was concentrated in the near and far east, so any predominance of "emergent" economies would only be a reversion to the historical norm.

The strengthening of emerging economies is undeniable and has triggered talk of a "new paradigm". Instead of constituting a source of volatility for the global system, these economies are now seen as providing an element of stability. They are also reducing their historical vulnerability to disruptions from abroad. It comes at an opportune time for a world that has become overly dependent on debt-financed growth in the US. The current improvement in emerging economies differs from earlier advances that proved unsustainable, because it involves a set of self-reinforcing enhancements in economic, financial, policy and institutional factors.

...The history of emerging markets has rarely seen the present combination of current account surpluses, surging international reserves, declining public sector debt and improved domestic growth conditions... These economies now account for almost half of global economic activity in terms of purchasing power parity; they represent the most dynamic portion of international trade; their low cost structures have enabled the world to contain inflationary pressures emanating from the surge in oil prices; and, through their large purchases of dollar-denominated financial instruments, they have helped keep interest rates low for now. This comes at an appropriate time for the global economy. The US, which has carried the burden of being the global growth locomotive, has done so at the cost of high household indebtedness, a sharp deterioration in government finances and an unprecedented current account deficit.

Wealth Inequality

Here are some disturbing statistics. Many studies focus on income, but the distribution of wealth is probably more revealing. The average net worth of the wealthiest 1% of Americans is $10M. The threshold net worth to be in the top 1% is probably a few million dollars. (This means easily more than a million households of millionaires.) Most studies show the level of inequality today to be at an all time high, rivalling only the period just before the great depression.

The US wealth distribution is the most unequal among all developed countries (the UK is second). Americans tend to tolerate this inequality, confident that our society allows for more economic mobility and is more meritocratic than others. I have heard rumors of recent studies showing that this is no longer the case. If so, it is only a matter of time before the have-nots in this country begin to resent the status quo.

I discussed income volatility in a previous post.

Thursday, December 02, 2004

Current account history

Looks like we need a Plaza Accord II to sustain Bretton Woods II.

China climbing value chain: chip design

We know all about the billion dollar fabs under construction near Shanghai, but the growing number of chip design firms tend to get less coverage.

WSJ: Morris Chang, chairman of Taiwan Semiconductor Manufacturing Co., the world's biggest contract manufacturer of chips, compares China's design industry to an object with "zero speed but infinite acceleration." His company this year opened a nearly $1 billion plant in Shanghai, its first in China, in part to cater to local design companies.

"If you look at the large number of small design companies created here, you are seeing the foundation of an industry created," said Craig Barrett, Intel's chief executive, during a trip to China in November.

As I mentioned before, China's future economic growth will be based on more than just low-cost manufacturing. See also this Guardian article on radical progress in China using fetal cell tissue to treat paralysis.

Wednesday, December 01, 2004

Bubbles and timescales

It seems to me that the persistence of a financial bubble is related to temporal limits on the arbitrage process. In the strong efficient market view (which I don't subscribe to), there are no bubbles because the price incorporates all available information (questionable, due to information asymmetries and bounded cognition) and arbitrage acts to eliminate any mispricing. However, even if all parties are smart and have equal information, it is not always possible to sustain a bet against a bubble long enough to collect.

During the tech bubble of a few years ago, many investors strongly believed that the market was mispriced (I was convinced by '99). But, it takes mucho cojones to sustain a bet against the market for several years - the best I was able to do is just stay away from techs during this period. An institutional investor is in an even worse position, as he or she may have performance-based compensation that effectively precludes trades taking more than a quarter or perhaps a year to reach fruition.

This conclusion is supported by a recent paper in the Journal of Finance, which shows that hedge funds were riding the tech bubble, not betting against it. Hedge funds are subject to redemptions by investors over quarterly (or at most yearly) timescales, and managers are compensated based on annual performance, so again really long-term bets are off the table. It seems to me that in the financial markets there are almost no actors capable of taking long term bets against a persistent bubble. (To be more precise, the fraction of total capital controlled by such actors is very small.)

The current housing bubble is an even more egregious example. Because real estate is not a very liquid investment - the typical family has to move and perhaps change jobs to adjust to mispricing - the timescale for popping a bubble is probably 5-10 years or more. Further, I am not aware of any instruments that let you short a real estate bubble in an efficient way.

Finally, one can consider the FX case. Everyone thinks the dollar will have to fall on a trade-weighted basis over the coming years. But one doesn't know when or how, due to possible intervention by central banks. Any individual hedge fund that leverages up and bets against the dollar is taking a big risk. We won't see large moves until a critical mass of capital is willing to take that risk.

The market can remain irrational longer than you can remain solvent!

First real lie detector?

I've been waiting for this for a long time! Apparently, functional MRI can be used to tell when someone is lying. Of course, it is possible that a determined and practiced deceiver might fool the machine - further testing will be required. But just imagine the societal implications of a reliable, portable lie detector! (I can't decide whether it would more useful in business meetings or on first dates :-)

Overall, it seemed to take more brain effort to tell the lie than to tell the truth... Lying caused activity in the frontal part of the brain - the medial inferior and pre-central areas, as well as the hippocampus and middle temporal regions and the limbic areas.

Tuesday, November 30, 2004

Bretton Woods II and ASEAN summit

WSJ: Meeting on the sidelines of a regional gathering in Laos, the leaders of South Korea, Japan and China agreed on the need for exchange-rate stability, according to a statement issued by the South Korean presidential office. A separate meeting of finance-ministry officials from the three countries to discuss the dollar's decline led to an "understanding," though no agreement on any concerted action, South Korean Deputy Finance and Economy Minister Chin Dong Soo told reporters in Seoul.

...South Korean President Roh Moo Hyun met with his counterparts, Prime Minister Junichiro Koizumi of Japan and China's Mr. Wen, on the sidelines of the Asean summit yesterday. A statement from Mr. Roh's office quoted the Korean president as telling Messrs. Koizumi and Wen that "a dramatic change in exchange rates is not appropriate" and that "currency stabilization is important for the economies in this region." According to the statement, Messrs. Koizumi and Wen agreed. The statement paraphrased Mr. Koizumi as saying there should be cooperation and joint efforts among the three countries to stabilize the currencies.

See previous discussion of Bretton Woods II.

VIX and Black-Scholes

OK, humor me here as I continue to think about volatility. Looking at the CBOE white paper on VIX, I see a plot (page 13) indicating very strong correlation between movements in the SP and the implied vol. A change in the SP of about 1% causes a 4% shift in the VIX, but with the opposite sign. Now, SP500 options are widely traded and liquid. They should provide one of the best tests of options pricing theory. But in the usual Black-Scholes model the volatility of the underlying security is a fixed input parameter - it certainly isn't supposed to be path (history) dependent. The simple log normal random walk model has its limitations - for example, there is no reason the vol shouldn't change in time (hopefully slowly) - but I'm surprised to see such clear path dependence. Of course, it's possible that the actual volatility (as opposed to implied volatility) doesn't exhibit the correlations we are discussing. But if so, there is an inefficiency in the behavior of options traders that should be arbed away!

...I've been informed that these issues are addressed using more sophisticated GARCH models. (GARCH = Generalised Autoregressive Conditional Heteroskedastic!)

This paper seems to conclude that implied vol is a good predictor of realized vol, so the correlation between market movements and vol is not a behavioral quirk of options traders (indeed, it is a quirk of the market itself).

Monday, November 29, 2004

VIX thoughts

The VIX index tracks implied volatility, using a basket of options with expirations closest to +30 days to compute an implied probability distribution for values of the SP500 30 days hence. The VIX is often referred to as a "fear gauge" because it is anticorrelated with market performance: when the SP goes up the implied vol goes down, and vice versa.

To characterize the prob. dist. with a single volatility value, one fits to a Gaussian. Historically we know that outlier events are much more likely than implied by a log normal distribution. Deep out of the money options are included in the VIX computation as long as there are nonzero bids (and no intervening zero bids at more probable strikes). Looking at the current prices I see this only goes out about 2 sigma into the tail, so the distortion from mispricing of rare events is small. I know Nassim Taleb (author of Fooled By Randomness) makes his living buying mispriced deep out of the money options - I assume he has to buy these directly by calling up market makers, since the widely traded options don't go too far out on the tail.

Why is the VIX anticorrelated with market moves? I can understand why options traders might be psychologically disposed to expect more vol in a down market, but does the observed, historical vol exhibit this anticorrelation? We could check by crunching the data looking for up/down moves to see if the variation in the following 30 days is correlated with the sign of the move. To put it very simply, are downward moves of the market choppier than upward moves? If not, can't I arbitrage by selling vol when the market goes down and buying it when the market moves up?

Sunday, November 28, 2004

Inflation: goods vs services

If you break the CPI into components, you can see an interesting divergence in the behavior of goods vs services. The former have exhibited deflation over the last 4 years (exported from China?), while services costs have continued to go up. When will outsourcing become widespread enough to affect the rate of inflation in services? Evidently labor still has some pricing power.

(Graph from BusinessWeek.)

BusinessWeek on US-China trade

I picked up the latest issue of BusinessWeek on the flight home, which is largely devoted to US-China trade. The cover story is on the "China Price" that manufacturers are now forced to match.

Meanwhile, U.S. companies are no longer investing in much new capacity at home, and the ranks of U.S. engineers are thinning. In contrast, China is emerging as the most competitive manufacturing platform ever. Chief among its formidable assets is its cheap labor, from $120-a-month production workers to $2,000-a-month chip designers. Even in sophisticated electronics industries, where direct labor is less than 10% of costs, China's low wages are reflected in the entire supply chain -- components, office workers, cargo handling -- you name it.

China is also propelled by an enormous domestic market that brings economies of scale, feverish local rivalry that keeps prices low, an army of engineers that is growing by 350,000 annually, young workers and managers willing to put in 12-hour days and work weekends, an unparalleled component and material base in electronics and light industry, and an entrepreneurial zeal to do whatever it takes to please big retailers such as Wal-Mart Stores (WMT ), Target (TGT ), Best Buy (BBY ), and J.C. Penney (JCP ). "The reason practically all home furnishings are now made in China factories is that they simply are better suppliers," says Janet E. Fox, vice-president for international procurement at J.C. Penny Co. "American manufacturers aren't even in the same game."

An interesting statistic from the article: the US is still the world's largest manufacturer, and 75% of goods consumed in the US (presumably by value) are made here (this is down from 90% as late as the mid-90's). So, very roughly speaking, a 4% trade-weighted decline in the dollar would lead to a 1% increase in inflation, assuming there is no resulting substitution of goods.

Saturday, November 27, 2004

Japan, China, UK and hedge funds(?)

...are the largest holders of US Treasury debt, in order of holdings. Note Japan still dominates all others.

Is it plausible that hedge funds hold $100B in US Treasury debt? A recent JP Morgan report concludes that hedge funds currently account for $900B in capital, out of a world total capitalization of $74 Trillion in equity and fixed income. So, the notes held by secretive Caribbean entities account for only 10% of hedge fund capital.

Friday, November 26, 2004

Sino-French TTE largest producer of TVs

WSJ covers TTE, created from the takeover of French TV maker Thomson by Chinese company TCL. This may be the first example of a major western technology company and prominent brand (RCA) taken over by a Chinese firm. TTE produces 20M televisions a year, in a dozen factories worldwide (China, France, Mexico, Poland, Thailand and Vietnam).

The agreement between Thomson and TCL was highly ambitious and seemed to be clearly necessary. TCL, with just 11 years in the TV-making business at the time, produced more sets than Thomson and was profitable as well. But the company was virtually unknown outside China and had little expertise in global marketing. Thomson, keeper of the 85-year-old RCA brand, was being squeezed by cost pressures in developed markets and posting losses in North America. It also had only dabbled in China, which two years ago passed the U.S. as the world's biggest TV-set market in terms of unit sales.

One of the obvious difficulties, covered briefly in the article, is the huge salary differential between TTE employees (including top executives) in China and France.

Thursday, November 25, 2004

Kings of capital

The Economist has a nice survey on private equity funds (which include venture capital and traditional buyout funds). For those unfamiliar with the details, most funds have a "2 and 20" reward structure, taking a 2% management fee each year and 20% of profits. For example, a $1 billion fund, run by 5 partners, would split $20M per year in fees, and another $20M in "carry" assuming a 10% return on the fund. (Hedge funds work similarly.) No surprise that everyone in finance these days wants to be in private equity or at a hedge fund. Sadly for investors though, private equity and hedge funds often underperform indices like the SP500, even though they take on greater risk. Jon Moulton of Alchemy, a British private-equity firm, is puzzled: “A lot of people in the industry already make several million a year without having to perform. I can't understand why investors haven't put more pressure on fees.”

One interesting statistic is the divergence in performance by investor class: it seems that some limited partners (LPs, or investors) are much better than others at picking funds. University endowments have been particularly successful, while banks have performed dismally.

Wednesday, November 24, 2004

Minimum length and quantum gravity

There is strong evidence for a minimal length in nature: the Planck length L = 10^{-33} cm. On this scale, quantum fluctuations of the metric are large, and the meaning of spacetime breaks down.

Recently, I and two collaborators at Caltech showed that no device (not even a gedanken experiment) is capable of measuring a distance less than the Planck length. (The paper is published in Physical Review Letters.) By "measuring a distance less than the Planck length" we mean, technically, resolve the eigenvalues of the position operator to within L. (Previous work on this problem had not been very careful in defining minimum length, and to obtain a clean result we had to be a bit careful.) The only assumptions in our argument are the uncertainty principle from quantum mechanics and a dynamical criteria for gravitational collapse from classical general relativity called the hoop conjecture.

An implication of the result is that there may only be a finite number of degrees of freedom per unit volume in our universe - no true continuum of space or time. This means that there is only a finite amount of information or entropy in our universe (or at least in any finite patch of it).

One of the main problems encountered in the quantization of gravity is a proliferation of divergences coming from short distance fluctuations of the metric (or graviton). However, these divergences might only be artifacts of perturbation theory: minimum length, which is itself a non-perturbative effect, might provide a cutoff which removes the infinities. This conjecture could be verified by lattice simulations of quantum gravity (for example, in the Euclidean path integral formulation), by checking to see if they yield finite results even in the continuum limit.

Peg will hold, for now

Financial Times interview with Li Ruogu, deputy governor of the People's Bank of China, who said the country won't be pressured into revaluing the yuan and warning the U.S. not to blame others for its own problems: "Under heavy speculation, we cannot move [toward greater flexibility] and under heavy external pressure we cannot," Mr. Li was quoted as saying. "So the best environment for us to gradually move towards a more flexible exchange rate is when people don't talk about it."

University Ave, Palo Alto

I'm in the bay area for Thanksgiving right now. Today I was in Palo Alto for some meetings with venture capitalists (VCs). The density of funds near University Ave in Palo Alto is only exceeded on Sand Hill Road near the Stanford Accelerator Center (SLAC). You can't have dinner (I wanted Coppola-Niebaum but we ended up having tandoori) or go into Starbucks without overhearing deals discussed by 40ish guys wearing khaki pants, or the interview of a potential VP of sales by a CEO. Activity is still nowhere near peak bubble levels of 2000, but things have been steadily improving since the crash :-)

VIX hits low

VIX - an index computed from the implied volatility of a basket of SP500 options - is at a 9 year low (Jan 1996). Perhaps the SP hitting new highs after Bush's election has led to option selling to lock in gains - this would depress the price of volatility. If you are bullish on equities, now is the time to buy cheap call options. Interestingly, bank value at risk (VAR) is reportedly rising even though the volatility input has gone down - meaning more money at play chasing returns.

Tuesday, November 23, 2004

China climbing value chain

WSJ profiles Matsushita's (Panasonic) activities in China: ...built or invested in five high-technology product development and research centers across China, hiring hundreds of local engineers to work in areas ranging from car electronics to mobile technology, mostly for cellphones... Matsushita President Kunio Nakamura has called China the company's future "engine of growth."

...Matsushita's efforts to go upstream also are partly an attempt to win support from the Chinese government, which is eager for foreign companies to transfer more high-end operations and technology into China.

"Right now, the real competition in China is for human resources," Matsushita HR manager Mr. Nakamura says. As foreign companies engage in more sophisticated activities such as software development and product design, and local concerns try to raise their levels of expertise, companies are fighting over graduates of the top universities.

And then there is the uniquely Japanese hurdle of a reputation for low salaries, long hours and slim career prospects. A survey conducted by ChinaHR, a major online recruiter, ranked Matsushita No. 46 among the most popular companies to work for in China. U.S.-based International Business Machines Corp. and Microsoft Corp. ranked No. 2 and No. 5, respectively, while the highest-ranking Japanese concern was Sony Corp. at 26.

A related article discusses how the Korean government is actively concerned about "essential technologies" like LCD or plasma screen manufacturing finding their way to China via acquisition or industrial espionage.

As discussion usually centers around China's growth as a low-wage manufacturing base, I believe many will be surprised at the rate at which China climbs the technology value chain. Recent WSJ articles have covered Siemens moving parts of their cellphone R&D to China, as well as Vodafone's likely decision to start sourcing 3G equipment from Huawei and others. The Matsushita article makes it clear that foreign companies are under pressure to demonstrate technology transfer and R&D activities in China. Yesterday's WSJ had a piece on outsourcing pharma research to Chinese labs. Korea and Taiwan are in danger of losing their leads in key areas like LCD or semiconductor fab, and other developing countries (SE Asia, Mexico, etc.) have already been leapfrogged.

Monday, November 22, 2004

UBS FX report

Received from one of our correspondents, this UBS report is skeptical of the Bretton Woods II hypothesis. There is quite a lot of interesting data on the US balance of trade, historical FX rates, etc.

The conclusion is similar to my own view - the Asian dollar bloc will persist for a year or two at least, with the euro bearing the brunt of dollar depreciation pressure.

G20 statements and renminbi peg

They seem to be preparing the way for a gradual removal of the peg. As reported by one of our correspondents in finance:

G20 on exchnge rate:
* "We understand the importance of medium-term fiscal consolidation in the United States, continued structural reforms to boost growth in Europe and Japan, and, in emerging Asia, steps towards greater exhcnage rate flexibility, supported by continued financial sector reform, as approprate."
* "Experience has shown that countries seeking domestic monetary autonomy while substantially liberalizing their capital account should increase the degree of exchange rate flexibility accordingly."
Next G20 meeting is in Beijing

China's comments:
Mr. Zhou, the PBoC governor:
* On possibility of exchange-rate changes: "You can read October 2003 Chinese government documents that already clearly mentioned we are going to reform our exchange-rate regime and to try to set our exchange-rate at an equilibrium point and also we are going to gradually reach capital-account convertibility. This is the general direction.'' "Recently, I think, at the end of September and the beginning of October, our premier Wen Jiabao mentioned the policy orientation of that related to the exchange rate. And this is basically all the new progress so far.'' "We are reviewing all our foreign-exchange control systems." (comment: Mr. Wen's view here alluded to is that China had a more flexible currency regime before the breakout of Asian financial crisis and would consiser to have more flexibilty now that the crisis was over).

President Hu's comment after meeting President Bush at APEC meeting:
* China will "push for reform of the exchange rate while maintaining stability in the economy,'' Hu "expressed appreciation for Bush's rejections of applications of some people within the U.S.'' on the yuan exchange rate.''

Saturday, November 20, 2004

The face of battle in Falluja

Powerful writing by Dexter Filkins of the Times. Reminds me a bit of Hemingway's war correspondence.

...This intimacy of combat, this plunge into urban warfare, was new to this generation of American soldiers, but it is a kind of fighting that they will probably see again: a grinding struggle to root out guerrillas entrenched in a neighborhood, on streets marked in a language few American soldiers could comprehend.

...In eight days of fighting, Bravo Company took 36 casualties, including 6 dead, meaning that the unit's men had about a one in four chance of being either wounded or killed in little more than a week.

...For all the death about the place, one inescapable impression left by the marines was their youth. Everyone knows that soldiers are young; it is another thing to see men barely out of adolescence, many of whom were still in high school when this war began, shoot people dead.

...Like many of the young men in Bravo Company, Corporal Ritchie said he joined the Marines because he yearned for an adventure greater than his small town could offer. "The guys who stayed, they're all living with their parents, making $7 an hour," Corporal Ritchie said. "I'm not going to be one of those people who gets old and says, 'I wish I had done this. I wish I had done that.' Every once in a while, you've got to do something hard, do something you're not comfortable with. A person needs a gut check."

...Time and again through the week, Captain Omohundro kept his men from folding, if not by his resolute manner then by his calmness under fire... A little later, Captain Omohundro, a 34-year-old Texan, allowed that the strain of the battle had weighed on him, but he said that he had long ago trained himself to keep any self-doubt hidden from view. "It's not like I don't feel it," Captain Omohundro said. "But if I were to show it, the whole thing would come apart."

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