The NaMo Trap

Came across this flowchart on the net. The poignancy had to make me reblog it after all!! Should one really care??

NaMo Block

Risk and Uncertainty

Risk Ignorance and UncertaintyI have been reading about risk and uncertainty in my hotel room in the US even as more than 30 tornadoes lash out in and around the central part of the US. The Weather Channel has been playing on and off throughout the day on my idiot box. Now yesterday, there was uncertainty around the exact location of these twisters which is now gone as the images of collateral damage and the swirling debris comes out from the north east of Oklahoma City. From the perspective of the residents of this area, there was (and actually still is even as I type) a risk of serious injury to life and limb. As the messages on the Weather Channel keep on advising, that risk can be minimised by heading down to the lowest level of your house (preferably a brick/stone/concrete structure and keeping one’s curious eyes away from the glass windows. That is risk and uncertainty. Well, almost!

The major difference between risk and uncertainty is that uncertainty is the lack of faith in a situation while risk is to put yourself in that uncertain situation. Risk can be measured and therefore probabilities can be calculated. With finite probabilities in place, strategies can be devised to minimize them – in the world of investing these would be hedging, collateral posting, diversification etc. When airplanes were introduced, people would have been scared to fly due to the risk involved and they surely must have been right. However, with technological advances that risk has greatly come down. Initially, when the first automobiles ran the streets of London, the Locomotive Act of 1865 sought to control the severe risks of running the iron horse carriages on the streets:

  1. Speed limit of 4 mph on country roads and 2 mph on city roads!
  2. Each beast must have a crew of three – the driver, the stoker and the red flag man.
  3. The red flag man should carry the pennant and walk 60 yards ahead of the vehicle warning people to get out of its way.

So there was risk and it was being minimized. Further, as the harnessing of steam became more efficient, the risk reduced and the law changed accordingly: in 1878 via the Highway and Locomotive Act which reduced the offset of the red flag man to 20 yards. Obviously, the railway and horse carriage lobbies were at play but their arguments must have been eventually blunted by the fledgling auto industry’s demonstration of risk control. Finally, in 1896, the new Locomotives on Highways Act made the following allowances to vehicles less than 3 tons in weight:

  1. speed limit of 14 mph
  2. no need to have the three member crew including the need to have the red flag man announce the arrival of the vehicle.

Finally, in 1903, the speed limits were further increased to 20 mph and then the law was eventually repealed.

To measure and thereafter control risk, the presence of historical data is required to assign probabilities to various outcomes and construct a probability distribution of the known outcomes. Uncertainty exists when the decision maker has no historical basis from which to develop a probability distribution and must make intelligent guesses to develop a subjective assessment of outcomes and their likelihood. So many folks confuse risk and uncertainty and use them interchangeably. Let me take a topical example to bring out an example of how most people confuse the two terms. Let’s say an insurance company might be willing to take on a certain amount of tornado risk in Oklahoma state. That company might price that risk based on 100 years of past data studying the number, severity, duration, locus, clustering (of tornadoes) and collateral damage. But will the insurer write policies with such large nominal amounts so as to bankrupt the company if any or all of these parameters were exceeded (i.e. on the worse side)? That would be a case of ignoring uncertainty – i.e. the future may not look like the past. Another example from further west of Oklahoma: from the perspective of the individual gambler, betting on activities like roulette or blackjack involve finite probabilities and therefore one can say that playing in Vegas is risky. From the perspective of the house though, while there may be data dating right from the ’30s, they always operate under uncertainty. What if someone comes along and breaks the house? Which is why The Strip strips away a slice of chance from their games (the ‘house advantage’) and keeps itself in the game. Now leaving the events of the Sin City in the Sin City, let me turn my thoughts to how retail rats view investing in equities. There is a whole lot of historical data, no doubt but can exact probabilities be assigned to future stock prices? Subjective assessments are done via various models. Investing is about uncertainty, not risk. Gambling is about risk, not uncertainty. Do you gamble or do you invest? 😉

Gold’s Identity Crisis

A very significant development took place in the US early last month which could perhaps turn out to be very bullish for gold. The OCC (Office of the Comptroller of Currency) and the FDIC (Federal Deposit Insurance Corporation) circulated a public note asking for comment on their proposal to change the risk weightage of gold from the current 50% to 100%! It’s even more pervasive – the BIS’ Basel Committee for Bank Supervision are not only contemplating  increasing the amount of regulatory capital that banks must set aside through the forthcoming Basel III rules but they are indeed contemplating giving gold a Tier I asset status (i.e. a 100% risk weight). In other words, they propose to make gold a zero risk asset. Banks have to risk weight their assets and have to set aside regulatory capital for the more riskier assets that they hold. If gold becomes zero risk weighted then this will release a lot of steam from the banks’ balance sheets. This move (as also the proposal to ask banks to put aside more regulatory capital going forward) if implemented from 1Jan’13 onwards, will effectively put gold on the same pedestal as US treasuries and it logically seems that the yellow metal will see a run to catch up with the handsome gains that US treasuries have witnessed in recent times.

To investigate myself, I studied the correlation between the gold and equity prices (Gold in $ terms vs. the DJIA). The result (blue line) is shown below. The red line shows whats happening in India by comparision – the difference, of course is due to exchange rate fluctuation. It’s clear from the charts that both gold and US equities have been moving in step since July 2011 and going by the oscillatory nature of the plot, it looks likely that this positive correlation will continue for some more months to come.

The neat divergence between the gold/equity correlations between US and India is interesting. The charts below try to show the relationship between these two sets of correlations. The picture on the left below shows all correlation pairs over the past 10 years – it’s truly inconclusive. Perhaps an indicator of India’s closed economy status and the lack of full free float in the INR? On this messy chart, I have indicated where we are today – that position is clearly on the boundary of the plot. If the law of averages holds here, then there are three possibilities for this boundary position to go away: A) the correlation between US equities and gold starts to get positive; B) gold starts behaving like a risk asset in India as well and C) both A & B happen in tandem. The chart on the right covers a much recent period (since start of CY’12). This chart zooms in to the data points pertaining to the most recent 6 months and presents another look at the hypothesis that while gold is behaving like a risky asset in the US, it is very much a safe haven in India!

 

I think what is happening today is that everything is moving in tandem based on “news”: Fed/ECB announce more printing of their respective curriences – everything rallies; jobs report comes out in the US – everything falls, etc etc. Is it that the markets believe that no further QEs will get done? I guess gold better decide what it really wants to be and my hunch is that the day gold’s identity crisis will be resolved will be the day that’ll mark a clear trend for the markets. On the flip side though, I guess the weirdest story would be in the eventuality that gold does get classified as a tier 1 asset, rises in price and somehow equities rise further up as well – in which case would you still dub it riskless?

Rainfall Isochrones

An isochrone is a curve of equal travel time. The monsoon isochrone map shows isolines where each line depicts the arrival (i.e. the presence) of the refreshing and life sustaining S.W. Monsoon. Each point on the line depicting places where the monsoon arrived at the same time. This chart from the Indian Metereological Department says it all. It shows the rainfall isochrones as at June of this year. The dotted red line shows the normal advancement of monsoon while the dotted green line gives you the actual situation this year. Clearly Delhi is still waiting for the rains. Rains have played truant so far this year. It seems that the long summer vacation was not enough for little Johnny and that he wants to play a bit more. Its true – schools in Delhi have extended the summer vacations due to the heat conditions!

Compare this with what happened last year. The chart below is the rainfall isochrone map as at June 2011. Clearly we have an issue. Incidentally the attached press release (dated 22Jun’12) from the India Met office says that “Rainfall over the country as a whole for the 2012 southwest monsoon season (June to September) is most likely to be normal (96% – 104% of LPA).” The markets, meanwhile have been cantering up on news from the Eurozone and the Prime Minister cum Finance Minister’s comments. I think that sometime soon the market may turn its attention to the deficient monsoon. It seems that these days what Angela M says and does impact our markets more than the local economy’s supply side indicators. But if the rain gods remain unkind this year then somewhere the impact will definitely be felt – most probably on the inflation front. There are news of escalating corn and other downstream prices in the US due to the prevailing heat wave condition there which has played havoc with the corn sowing season there.

Value of Employees

How macro economic business cycles influence how some companies regard their employees:

Is the Golden Age Over?

Finally Pranab Mukherjee said it. He is trying to discourage ‘educated middle class’ investors in India from buying this ‘dead asset’ considering that collectively, Indians now throw $60-62 bn worth of good money on the yellow metal!

While nothing has abated about the nervousness we read in financial journals the world over, I do think that the entry point in Gold for handsome returns has certainly passed us many years back. Yes, in the short term there might be volatility and the metal may climb up even more (as this article from The Economic Times points out) but a parabola is a parabola. To sustain Y = A .X^2 kind of a move, continuous energy needs to be supplied – it does snap one day or the other.

Return on Assets: Vizag Promenade

Have not been posting my thoughts at all as I have been travelling – this time to a new city: Vizag! I clicked this picture near the beach where I was staying and couldn’t but help connect this to the fact that Indian companies have one of the highest asset return ratios around. Squeezing the last milliliter of juice from already drained and hopeless lemons is a trick that comes naturally to a land that has many mouths but limited spigots to feed them and a ruling government thats unable to solve for the supply side of the inflation causality.

Greece

If this is Greece, what lies beneath? WYSINWYG. The one piece of ice that’s been drifting around very closely to this beast is Turkey. They should have included it in the Euro zone when things were good. Now, I doubt if the Turks will ever swim close to this thing. Cold Turkey, really. Incidentally, which is the country with the highest per capita holdings of gold? China? India? Greece? Its Turkey. China & India’s consumption may be high but Turkey’s growth in consumption is staggering – according to the World Gold Council, demand rose by 32.6% in 2011 compared to the previous year. Both their government as well as the people there are worried about the future. So while many emerging counties’ central banks are loading on gold as a hedge against inflation that the US Fed exports out to them, India seems to be a little bit too big to do that. Lots of money will be needed to buy more and more of the expensive gold and that would mean printing INR that’s getting cheaper in value (and therefore more costly to print) by the day. Considering that inflation will not be allowed to rise up any more than what it has in the past given we are soon going to be entering into the election year it looks like a catch 22 to me. Is my logic correct?

Skill vs Luck in Trading

Here’s my take on the eternal debate. Let’s indicate the unknown (i.e. what trading is?) by ‘x’. Now, luck and skill seem to be at 90 degrees to each other (i.e. only luck and no skill as well as only skill and no luck will both take you to the cleaners, I guess). Furthermore, since we are talking about successful traders here, it is unlikely that any would be found on the (all skill, no luck) or (no skill, all luck) lines. Which means that every successful trader has to have some modicum of both. Elementary, but I am sure how many of us are humble enough to recognize and appropriately fear the role that luck plays in our fortunes.

Anatomy of a Winner

Missed a flight yesterday – the first time it has ever happened to me. Had to take an alternate flight today morning at 5AM which made me wake up at 3:30AM. Lack of energy results in a very abridged post today. I hope you like the idea behind this quickie infographic I created based on some thoughts that came about via a newspaper article I recently read.

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