The night before Christmas - by Craig Chirinda

'Twas the night afore Christmas, just after I had retired to bed.
Tired after a long flight, I couldn't sleep because of a sound I thought I heard.
I peered out of my window, to investigate the sound I thought I heard;
But I saw nothing but pools of a color I thought was red.
Surely this had to be an illusion; was the red wine starting to get to my head?

Then I heard a loud thud downstairs; it seemed there was an intruder in my abode.
And then there was an eerie silence, which was suddenly interrupted by a harmonious chord.
Reaching for my death-stick, I decided I was going to investigate the chord that was vibrating in my abode.
Stealthy, I crept downstairs; wondering about the intruder who was playing chords in my abode.

The sight that confronted me when I got downstairs, I could never forget.
'Twas a chubby man with a snow-white beard; clothed in a shade of red I might never forget.
His visage looked friendly; though he had an unhappy look I can't ever forget.
My intention to bludgeon him vanished; if I harmed him, I knew I would ever regret.
I walked briskly towards him, with the rhythm of a newly-recruited army Cadette.

"You really exist", I said, "I thought everything they said about your existence was a lie!"
But he never looked up to speak to me; he just buried his face in his hands and proceeded to cry.
"Why do you cry dear Santa?", I said, "Why is your disposition acerbic and dry?"
"I don't mean to pry", I again said to Santa, "but do tell me why you cry when everyone else's spirits are high?"
He didn't answer me until I said, "Speak, or fly back to whichever part of the sky you come from. Goodbye!"

Then suddenly, he said, "The stuff you saw in 'Bad Santa' is all true. There is not a single lie."
"I smoke. I drink. I'm supposed to stop but I can't", said Santa, as he again started to cry.
"I'm a dirty old man", he said as he cried profusely, "Oh I'm tired of living a lie!"
"It's alright dear Santa", I replied indifferently, "Please don't continue to cry. In fact, I can see from your bloodshot eyes that you are indeed high."
"But I'm not going to judge you, Santa", I said intending to cut him short, "Don't worry, I'm not going to ask you why."

"My reindeer got butchered by that moose-hunting hockey-mom", said Santa, "I have nothing to travel with."
"And the elves are on strike. I lost their retirement money in Madoff's scheme", continued Santa, "I have nothing to repay them with."
"Oh, the little angels out there won't be getting Christmas presents from me", he added as he sobbed, "I have nothing to appease them with."
"Oh, poor you", I sympathetically replied Santa, "I wonder what I have to help you with?"

"The SS Chirinda", I thought out loud, "I only board her three times a year!"
"I really don't need that boat" I thought, "I'm going to do something good to help out little boys and girls this year!"
"You can have my yacht, Santa", I said, "Sell it, and use the proceeds to buy toys for little boys and girls, so they have something this year!"
"Oh!", replied Santa, "I couldn't accept your boat. You worked so hard to buy it. Didn't you have to save for it for a whole year?"

I ignored Santa as I dragged him to the harbor, and gave him the keys to my yacht.
He started her and started to sail-off in my seventy foot yacht.
"Where are you sailing off to?", I asked Santa, as he sailed off into the depths of the night.
"Sucker!", yelled back Santa, "Didn't I tell you that I was a bad Santa?"
"I'm sailing-off to the Gulf of Aden, and if you want your yacht back, you're going to have to pay me a ransom!"
"What?", I yelled, "You are a pirate, who steals yachts and demands a ransom?"
"Yes!", said Santa, "I was one of the 'haves', now I am one of the 'have-yachts'!"

"Merry Christmas! Ho-ho-ho-with-a-bottle-of-rum!", he yelled, as he sailed off into the night aboard my yacht.

Gold may be significantly under-priced

I was reading a book titled Rich Dad's Advisors Guide to Investing in Gold and Silver by Michael Maloney, when I came to the conclusion, because of a passage I read in the book, that Gold is significantly under-priced!

Infact, Mostafa's assertion, that gold would appreciate rapidly to a price of USD1500 per ounce between 2008 and 2015, could be eminently cautious/conservative.

The passage that caught my attention was there in the preface, in juxtaposition to words that failed to strike me with the force-of-insight that the following excerpt bears:

"For the last 2,400 years a pattern was continually repeated in which governments debase their money supply", and "as the debasement progresses, the population senses the loss of their purchasing power. Then something miraculous happens. Through the free market system, the will of the public causes gold and silver to automatically revalue"

...What is the enumerative translation of the preceding excerpt?

I searched hard for an answer, and found it in an article by 'The Mogambo Guru', Richard Daughty - COO of Smith Consultant Group, titled Not Quite Like That. Which basically says that, as of September 2008, the United States had in circulation approximately US$829 billion in actual (never mind the electronic money, and 'other cash' securities) US Federal Reserve cash-and-coins, i.e currency securities based on 'physical presence'; whose transactions have a temporal simultaneity. This was against the Fed's aggregate gold reserves of 261 million ounces.

Therefore, if you seek to find out the price of gold per ounce according to the information above, you'd divide US$829 billion by 261 million ounces to get a price per ounce of USD3176.24 per ounce. That is the 'real price' of gold according to US aggregate-currency-in-circulation figures, and US aggregate gold reserves.

Hence, If you convert all 'currencies in circulation as cash' in the world to their USD equivalent, and divide that figure by the total gold reserves held by reserve banks all over the world, you should be able to come-up with a rough estimate of the 'real-price' of gold.

Assuming that the 'will of the public causes gold and silver to automatically revalue' in the future, that is the figure that the price of gold will converge towards!

Interesting stuff!

'Madoff Magic' / 'Madoffia' / 'Madoff-con'

Human beings generally have a difficult time incorporating highly improbable events into their thought-processes. Improbable events, specifically black-swan events - like Madoff's epic fraud, are generally ignored, or regarded as irrelevant before they occur. But after these events precipitate, human consciousness moves to the opposite extreme of ignoring these events; obsession with these 'improbable' events takes-over beyond any justifiable degree of concern; like what is happening right now. Understandably, this current hypersensitivity to extreme-tail-events is being induced by recurrent news stories about the Madoff saga and the uncertainty surrounding it.

Nevertheless, it is important to begin exploring these questions: (1) How did he manage to pull this off for such a longtime?; (2) How did he manage to live with himself, while he was committing those frauds? (Where was his conscience?); (3) Why did he do it?

The answers to those questions will help us prevent similar events from occurring in the future, and will provide direction to the regulatory establishment's efforts to curb illicit activities in the largely-unregulated hedge fund industry.

This Coming Week: Financial Market Armageddon

At around 1715 GMT on Friday (11 October 2008), while I was caught-up in the 'Miss World 2008 Pageant euphoria', I learned of a very unsettling event: the unearthing of Bernard Madoff's (a former Nasdaq CEO) Ponzi scheme which cost the world's elite private and institutional investors an estimated US$50 billion.

As I absorbed the news feed, I recalled an insight I gained from Gerding (2006): The bursting of asset price bubbles always coincides with the discovery of scandals and irregular practices in financial markets. Evidently, Madoff's fraud validates Gerding's assertion, and subtly points towards more impending doom and gloom.

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Among the 'known' institutional casualties are: a leading Spanish bank called Santander; Bramdean Alternatives - a UK-based asset management company with 10% of its NAV invested with Mr. Madoff; Fairfield Greenwich Group - a hedge-fund that invested $7.5bn of its clients' money with Madoff's firm; French bank BNP Paribas; Japan's Nomura Holdings; and; Zurich's Neue Privat Bank.


...Potential Impact

Firstly, financial service counters, across all major bourses, are going to fall precipitously in value during the coming week; because this development will intensify the crisis of confidence that the global financial system is already facing. This will in turn fuel a selling and short-selling spree of financial services counters across all major bourses. Therefore, with some financial counters already trading at anorexic prices; it is reasonable to say that some financial services firms face a great risk of being sold and short-sold to death, over the coming week.

Market volatility is already high and such a shock, when the market is highly sensitive to perturbations - like it currently is, will definitely put a lot of ailing financial services firms in a comatose state which they may never come-out of. Hence, this would undermine all efforts by governments (in most of the developed world) to bolster confidence in the financial services sector by injecting liquidity. Therefore, regulatory bodies and governments need to act decisively to avert from precipitating, an acute second-wave of the market tsunami we've been enduring since August of 2007.

I think it would be prudent for governments to dig deep into their bags of tricks, and prepare to implement tools they have used previously to mitigate the effects of similar crises. To state it more clearly, I'm advocating for the re-introduction of short-selling bans (of financial services counters) until the full-extent of the crisis is understood clearly, as I believe that the fraud is much greater than the stated USD50 billion.

If the bans are not implemented forthwith, the financial services sector will crumble (from being 'short-sold to death'), setting into motion a domino-effect of subsequent events, that will plunge the global economy into a deep recession; one that would prevail for a very, very long time.

Secondly, this development will inspire cannibalistic trading strategies, that will accelerate the downfall of the victims of this Ponzi scheme; particularly the hedge-funds (e.g. Fairfield Greenwich Group and Bramdean Alternatives) that fell prey to what is now popularly known as Madoff Magic.


...What do I mean by this?

Other hedge funds will short-sell the portfolio holdings of funds and 'strategies' affected by this crisis. They'll do this because they'll understandably believe that this crisis would trigger a series of redemption requests in the affected funds; which would then trigger forced liquidation of their holdings to meet the requirements of the redemption requests. This would in turn depress prices of some of the securities in the portfolio of the 'victim-funds'; as forced liquidation of a large chunk of securities, within an environment characterized by high market volatility, generally has a security price-reducing effect. To summarise what I've stated, 'other-hedge-funds' will short-sell the holdings of the 'victim-funds', anticipating to capture easy profits that will subsequently flow from the price reduction caused by the 'forced-liquidation-to-meet-redemption-requests phenomena'.

The net effect of all this market activity (on the broader financial markets), is largely dependent on the extent of overlap between the portfolios of 'other market players' and those of the 'victim-funds'. Where the effect of the crisis on the global financial system, is positively correlated to the degree of overlap between the portfolios of the 'victim funds' and those of 'other players' in the broader financial markets. This means that a high portfolio overlap between 'other market players' and 'victim funds', would translate into cascading of the negative effects of the fraud across the entire global financial system.

Therefore, we could be seeing in the near future a more dramatic replay of: bank collapses; the development of multiple layers of correlation among 'disparate' securities; a credit crisis; the drying-up of liquidity in most security markets and; the widening of spreads. In short the worst may be on its way.

Be prepared because it may be a bumpy ride!

High-End Housing Price Bubble in Egypt

Background Facts:

• Construction of residential housing lots contributes an aggregate 3.6% towards Egypt's GDP.
• Egypt's mortgage market (in terms of mortgages financed, not the entire market) has an aggregate size of EGP 3 billion; a minuscule 0.3% of Egypt's current GDP .
• Egypt has the lowest owner occupancy ratio in the world in 10 years; currently standing at only 32%.
• Egypt currently requires the supply of 5 million low-income housing units.
  

(Note: Facts are according to statistics provided by Mr. Suha Najar, Managing Partner and Head of Research at Pharos Holdings when he made a presentation before attendees of the American Chamber of Commerce's November 23rd Real Estate Conference. )

...Inflating the Bubble

Over the last decade or so, excess liquidity in the global markets resulted in the creation of a paper market for Egyptian high-end real estate: a market that is driven entirely by speculation; a market in which fundamental forces are totally ignored; and a market in which the underlying dynamics of supply and demand are blatantly disregarded.

The supply and demand situation of high-end real estate in Egypt is in a dynamic state of disequilibrium; with the demand for high-end residential units currently standing at 15 000 units per annum, and supply currently standing at 40 000 units per annum. Hence, this means that there is a supply-demand imbalance in the market; which in this case, is an excess supply of housing units.

Supply-and-Demand economics dictates that prices should fall when supply far exceeds demand, but in the case of the Egyptain high-end property market, this law doesn't currently hold: prices are still sky-high; with prices of unfinished properties far exceeding those of finished properties, i.e. high-end properties in Egypt are increasingly becoming more expensive, when they are actually supposed to be increasingly becoming cheaper. A curious situation indeed.

Therefore, if one were to plot the supply curve for the Egyptian high-end property market it would be slopping backwards; consistent with the nature of supply curves when asset price bubbles are being inflated.

The deviation of high-end housing-prices from their fundamental or intrinsic value cannot continue ad infinitum, because this pattern of divergence of high-end property prices from their fundamental / intrinsic value is unsustainable. Therefore implying that the observed market price of high-end units would have to converge with reality at some point: the bubble is guaranteed to burst one day.

The interesting question is when, and what will trigger the burst?

Wither the UK Economy: Boom, Bust or Stagnation?

I recently watched a video of iconoclast fund-manager, Hugh Hendry, of Electra Asset Management UK, in which he uttered the following interesting hypothesis on the near future (starting 2009) of the UK economy:

'The UK economy is due for its worst round of deflation since the great depression.'

I think that I replayed that statement about five times in my mind; contemplating why his hypothesis may be valid/invalid, and here is what I mustered:

The UK is a mature post-industrial or service-based economy, and therefore the majority of its GDP is generated by its services sector; which in this particular case, is its financial services sector. Hence, this implies that state of the UK's economy is a magnified reflection of the prevalent state of the country's financial services sector. Which in turn implies that the UK's economy would be in a bearish state, if its financial services industry is in a state of pandemonium, and/or that the UK's economy would be bullish when the financial services industry is booming.

Currently, the UK's financial services sector is caught in a deadly spiral of evaporating confidence owing to: bank collapses; the development of multiple layers of correlation among 'disparate' securities; a currently-prevailing credit crisis that is exacerbating the economic downturn; the drying-up of liquidity in most security markets and; the widening of spreads.

**********************

Quite a number of United Kingdom-based market players still have toxic and illiquid subprime-mortgage-backed securities on their balance sheets (which would be practically impossible to 'park into' the portfolio of a government-sponsored market stabilization investment fund all at once - because the British government may not have that kind of money; as tax revenue shrinks when an economy is experiencing recessionary pressures, and it would also be irresponsible to finance a bailout of this magnitude through debt issues--just too risky!), and a lot of them have a growing number of asset redemption requests to honor in 2009.

Therefore, investment entities will be forced to sell the 'liquid' securities in their portfolios to honor client redemption requests; setting-off a chain of negative market events.

...Here is why:

Rapid liquidation of a large chunk of securities, in an environment of high market volatility, would move market prices downwards. Which would inturn trigger a chain of margin calls, as the counter-parties of market-players demand more collateral; precipitating another wave of forced-selling of securities; which sets into motion a self-magnifying & self-reinforcing downward movement of prices across an array of 'liquid' securities in the market-player's portfolio. Hence, in such a scenario, forced selling of securities would trigger margin calls; and margin calls would in turn trigger even more forced selling of securities; which would consequentially trigger another wave of margin calls, and so on. Generally, when this positive-feedback loop is at play, observed market prices of securities increasingly deviate away from the fundamental/intrinsic prices of the securities.

Furthermore, a portfolio's structure morphs (in an environment of; limited asset inflows - the UK fund management industry's aggregate AUM has fallen 11% to 339 billion pounds year to date, high-volatility, and increasing market illiquidity) when 'liquid' assets are continually being sold-off to meet client redemption requests and counter-party demands for more collateral. This therefore implies that the original investors of a portfolio will eventually end-up with an unbalanced portfolio; which is structurally different to the portfolio they invested in, and is largely comprised of illiquid assets.

Hence, this may set into motion, a second wave of redemption requests (who wants to keep what they don't like?), which triggers an acute pernicious cycle of: sell security - > margin-call + redemption request - > sell security - > margin-call + redemption request, and so on. This sends markets into a tailspin that is difficult to arrest.

Continual forced security liquidations, against the backdrop of a volatile market, generally have a security-price-reducing multiplier effect, which iterates itself across different security markets in an economy, and (in the case of the UK) may culminate in the manifestation of a secular economic downturn.

The duration and intensity of this downturn is largely dependent of the extent of overlap between the portfolios of entities that trade the entire spectrum of UK-issued securities; where the extent of overlap is positively correlated to the magnitude, intensity and length of the economic downturn, i.e. the greater the overlap, the more protracted the economic downturn.

Investment strategies of different market players are increasingly becoming homogeneous because of two factors; 1) investment entities that invest in UK-issued securities generally have common lineage (or the same DNA) which leads to an overlap of investment focus, and 2) Increasing imitation of strategies of alpha-entities (by beta-market players) that invest in UK-issued securities also results in a growing level of portfolio overlap.

Therefore, from a systems theory perspective i.e when we postulate that financial markets are engineered systems, UK securities markets can be considered to be deterministic i.e. they are not stochastic, although they generate what may at times, appear to be random behavior. Deterministic systems are generally slower (than stochastic) systems when it comes to dissipating extreme perturbations, and are therefore prone to entrainment. Otherwise stated: the economic downturn in the UK may be protracted, and the downturn may increase in intensity!

Therefore in my view, Hendry's hypothesis is correct!

Wither the UK markets? Answer: Secular bust!

Increasing correlation of 'disparate' markets

"I think the world is vastly more complicated today than it was in the past. You see in the past, say 50 years ago, or a 100 years ago... whenever they built the 'Mickey Mouse Economic Theories'; you would not think that going to the store to buy a shirt, would cause the cost of food to rise in the supermarket (you see?)... And the world is too complicated; you cannot forecast what is going on, because you cannot see the link between action and consequence very easily. So it is getting more complicated; the world is more interconnected... And again, you go buy anything made in China, you're causing the price of protein to go up (okay?): Who thought of that!?!"

—N. Nassim Taleb (Verbatim transcript of Taleb's opening remarks in his 14th August 2008 Bloomberg interview with Tom Keene)

In the post titled Regional Integration Increases Correlation of Regional Stock prices, I enunciated that the risk-management benefits of intra-regional diversification of a share portfolio, diminish as regional (political and economic) integration increases. In this post, I'll briefly explore the dynamics of securities' & market correlation. I'll start with a brief discussion of a factor that increases market interconnectedness: a capitalist explosion. I'll proceed by showing how exponential growth of hedge funds can be seen as evidence of a capitalist explosion. Then, I'll illustrate how crowding-out of investment opportunities, forces hedge funds to invest in other disparate markets: acting as a linking mechanism that connects different markets and securities (through portfolio positions). I'll conclude with a brief answer to the question 'What is increasing 'global inter- linkage'?

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...Capitalist Explosion

Nassim Taleb says that the 'world is more interconnected' than it was 50 years ago. Question: What is increasing this 'global inter- linkage'?

The causal factors of increased 'global interconnectedness' are multiple and often pervasive; it would be too cumbersome to identify, and list them exhaustively. However, I have noticed that global interconnectedness is intensified by propellants of asset price bubbles. Nonetheless, for the sake of brevity, I'll briefly expound on just one--which I believe is a key factor--of the augmentative factors of 'global interconnectedness'.

According to Robert Shiller's book titled Irrational Exuberance, the following factor, is a propellant of asset price bubbles (and according to me, this factor also increases the level of global interconnectedness):

Capitalist Explosion: Bloomberg.com defines hedge funds as 'private, largely unregulated pools of capital whose managers can buy or sell any assets, bet on falling as well as rising asset prices, and participate substantially in profits from money invested.' I like the Investorwords description of a hedge fund, which describes it as: 'A fund, usually used by wealthy individuals and institutions, which is allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, leverage, program trading, swaps, arbitrage, and derivatives. Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allows them to accomplish aggressive investing goals. They are restricted by law to no more than 100 investors per fund, and as a result most hedge funds set extremely high minimum investment amounts, ranging anywhere from $250,000 to over $1 million. As with traditional mutual funds, investors in hedge funds pay a management fee; however, hedge funds also collect a percentage of the profits (usually 20%).' The key phrase in the latter definition is 'wealthy individuals and institutions'.

If the media's sociological projection of hedge-funds is anything to go by, then hedge funds are synonymous with capitalism. Therefore, one should be able to decipher the evolution pattern of capitalism (read as 'investment patterns of wealthy individuals') through a continual analysis of the hedge fund industry.

Between the first quarter of 2008 and the second quarter of 2008, (according to a Channel Capital Group report titled HFN Hedge Fund Industry Asset Flow/Performance Report, Second Quarter Ending June 30, 2008) the total assets managed by the hedge fund industry increased by 4.41% to a total of US$2.973 trillion! This compares to an increase of 9.82% in the second quarter 2007 and a decrease of 1.39% in the first quarter 2008. Evidently, the growth rate of hedge funds (in terms of AUM) is slowing, but it is not in negative territory as most would reasonably believe, i.e. the hedge fund industry isn't in a state of atrophy (in terms of AUM).

Interestingly, the hedge fund industry registered the AUM growth (through a combination performance gains and asset inflows) against the backdrop of; spectacular hedge fund implosions, weak global equities markets, bank failures, the drying-up of liquidity in most securities' markets, the exposure of deficiencies of risk-management systems employed by hedge funds, the development of multiple layers of correlation between 'disparate' markets and securities, deteriorating credit default quality, accelerated widening of spreads, the debacle of the mortgage-backed securities market and a global credit binge!

This is quite peculiar; I expected the hedge fund industry to contract (in terms of aggregate AUM) during this time period. The only plausible explanation I could muster for this strange phenomenon: high net worth investors STILL believe that the benefits of investing in hedge-funds outweigh risks associated with investing in these investment vehicles. Could this just be a prodrome of the 'untrammeled, morbid intensification of laissez faire capitalism', that George Soros wrote of in his essay titled The Capitalist Threat: a capitalist explosion? (Side-Note: Sounds like I'm about to blabber commie rhetoric, doesn't it? Read Soros's essay for illuminating insights on the 'flip side' of laissez faire market economics!). The notion of a currently-precipitating capitalist explosion ceases to seem mythical, and assumes greater plausibility when you consider that aggregate assets under the management of the hedge fund industry stood at US$875 billion in 2005 (according to Eric Falkenstein's 2005 article titled The Hedge Fund Advantage in Equity Management); and that now, the figure stands close to US$3 trillion (which translates to an aggregate growth rate of 243% over 3 years; or a growth rate of 81% per annum)! Therefore, we could be in the middle of a capitalist explosion, without even knowing it!

...Crowding out

Economic pundits from different walks of life, who are usually antagonistic, share a unified opinion on one thing; they all concur that the prospects for the global economy are bleak. Their forecasts of the foreseeable future of the global economy lie on a continuum that ranges from; "the global economy will experience positive, but lower-than-usual growth rates", to, "the global economy will sink into a deep, protracted, never-seen-before, 'black swan-esque' recession". As time passes, each analyst's forecast is progressively approaching a deleterious level of cynicism, and, empirical evidence is increasingly validating the conjectures of the analysts with extremist notions!

Given the current economic turmoil in global financial markets, and the heightened level of uncertainty that is concomitant to the economic pandemonium; it is reasonable for one to ask if exploitable, alpha-generating trading opportunities are still/will still be available in financial markets (?)

My answer to that will be: There are very few alpha-generating opportunities in most markets, and that opportunities will continue to dwindle (at accelerating rates) over time.

Here's why:

In Australia, The United Kingdom and The United States, financial market regulatory authorities have new weapons in their arsenals: short selling bans and their variants. Ostensibly, these legal tools are used to stabilize markets by protecting strategically important, but ailing companies from being 'short-sold' to death (remember what killed/massacred Bear Stearns?). Currently, there is on-going debate on the pros and cons of short selling bans; with the hedge-fund industry echoing more of the 'cons': Hedgies say that 'short selling bans rig the markets in favor of inefficient companies that should not be allowed to survive another day!', some even go as far as calling the bans 'weapons of mass market manipulation'. On the other side, is the Archbishop of Canterbury who has taken it upon himself to pontificate on the ills of short selling (side note: his 'short selling' sermons are heart wrenching). On who is right or wrong: time will tell. But, from my vantage point, it looks like other countries are going to be following suit SOON.

Short selling bans are, by definition, only enforced when the market is bearish. Hence, when regulatory authorities enforce them; hedge funds are prevented from short selling the stock of 'vulnerable' companies when it is most lucrative to do so. Therefore, this has the effect of contracting the alpha opportunity-sphere available to hedge funds; which (potentially) turns hedge funds into beta-generating asset pools with high fees (expensive hybrids of mutual funds). Furthermore, 'bans' (within an environment of; steady growth of the hedge fund industry's aggregate AUM, and a recession which limits the opportunity-set of 'long' trading opportunities), also increase the probability of 'crowding out' of limited lucrative trading opportunities. Hence, this causes the distribution of individual hedge fund alphas to shrink over time: a scenario that is consistent with the hedge fund capacity constraint hypothesis. Otherwise stated: the profitability of hedge funds might progressively deteriorate over time because of short selling bans. Zhaodong (Ken) Zhong wrote in detail about this in his research paper titled Why Does Hedge Fund Alpha Decrease over Time? Evidence from Individual Hedge Funds.

...Cross-Country Market Interconnectedness

The crowding of hedge fund strategies and positions; the progressive decline of aggregate hedge fund alpha over time; are in essence, push factors, that will force hedge funds to either, (1) close shop, or, (2) to search for opportunities in new territories - where strategies and trades are not crowded not.

In the latter scenario, funds will have to reinvent their strategies to allow them to invest in other markets and other geographical locations. This might entail transformation/evolution into a multi-strategy asset management company with a global macro component; a scenario that is analogous to Goldman Sachs' transformation from an investment bank, into a bank holding company (i.e. transformation into a more diversified entity that's perceived to be 'less risky').

When the 'diversified' asset management entity is set up, it takes positions in the new disparate markets, in addition to lucrative alpha-generating positions in markets it operated in previously. This has the effect of linking the 'new disparate markets' to the markets the asset management entity operated in previously: the markets become correlated, albeit subtly, through the asset management entity's portfolio. Any position-specific extreme event that wipes-out the value of the respective position, will have a negative impact on other seemingly disparate positions (in other markets) by stressing the portfolio. Hence, in an abstract sense, the asset management entity's portfolio is a shock transfer mechanism, that transmits shock from one market to other. Therefore, it is evident that global flows of capital are the linking-mechanisms of disparate markets.

So whats causing interconnectedness that Taleb spoke of? Answer: Diversified capital flows

Emergence of 'Super-Quant' Funds

'We’ll get to a point where technical progress will be so fast that unenhanced human intelligence will be unable to follow it.'

—Ray Kurzweil

Is it possible for mankind to (directly, or indirectly) create synthetic intelligences that supersede human intelligence?

Before answering that question consider the following:

• Quantum Computers: What are they? Author of The Fabric of Reality, Dr. David Deutsch's abbreviation of quantum computers: 'Quantum computers have the potential to solve problems that would take a classical computer longer than the age of the universe'. From Deutsch's description, one can conclude that quantum computers are vastly more powerful than any classical computer that has ever existed. But what are they? Answer: They are computational devices that solve intractable problems by utilizing distinctively quantum mechanical properties (including entanglement and superposition) to represent and structure data. Their computational power gives them the ability to perform accurate simulations of any physical system of comparable complexity, i.e. they can perform exact predictions of how a simulated system will behave in nature e.g; mapping the exact mutation pattern of a drug-resistant virus, or, prediction of the behavior of cells in unnatural environments, like zero-gravity-zero-oxygen-environments, or, solving hard optimization problems like the traveling salesman problem. From early 2009 onwards, quantum computing solutions (both hardware and software) will be available commercially from companies like D-Wave (a spin out from the University of British Columbia with partners from a diverse range of disciplines including; physicists, chemists, electrical engineers, cryogenics experts, mathematicians, and computer scientists). Since 1999, D-Wave has been creating a processor that uses a computational model known as adiabatic quantum computing (AQS), to solve complex search and optimization problems. This processor will hit the marketplace place in 2009!
  

• Continuation of Moore's Law on a non-silicon semiconductor substrate: In 1965, Intel co-founder Gordon Moore observed that the number of transistors that can be inexpensively placed on an integrated circuit exponentially doubles every two years. This observation--exponential compounding of technological power that's uncorrelated to the state of the economy--is what is known in the field of computing as Moore's Law. Moore's Law is mainly driven by constant transistor shrinkage every two years... But there's now a fundamental barrier to the continuation of Moore's Law in the future: the limits of optical lithography. Photo energy is used to engrave patterns of the circuits (on the silicon semi conductor material), and (According to Gordon Moore) "we're now approaching a point where the wavelengths are getting into a range where you can't build lenses anymore." This means that it is tougher to pack more memory onto current CMOS processors, and that there is a memory bottleneck. Fortunately, Zettacore created/is creating ultra-dense, low-power, lower-cost molecular memory technology that can be improved, using existing capital equipment, over multiple generations. Hence, this means that the acceleration of technological progress will be driven by a new hardware technology: molecular memory. This implies that Moore's-law-like progress will continue, albeit on a new substrate.

• Emergence of hardware functional equivalents to the human brain: According to Ray Kurzweil's book titled The Singularity is Near, a hardware functional equivalent to all regions of the human brain, should be able to handle approximately ten quadrillion (10¹⁶) calculations per second (cps). Currently, the most powerful supercomputers in the world, perform approximately a hundred trillion (10¹⁴) calculations per second. Kurzweil says that 'several supercomputers with one quadrillion cps are already on the drawing board, with two Japanese efforts targeting ten quadrillion cps around the end of the decade'. Hence, in consonance with his calculations, it is reasonable say: 'computers that perform ten quadrillion (10¹⁶) cps should be readily available for around a thousand dollars by 2020.' Therefore, the notion of super-intelligent computers seems feasible, from a hardware-performance perspective.

• Convergence of the Microcosm and Telecosm: In his book titled Telecosm, George Gilder observed that the law of the microcosm is 'potentially converging with the law of the telecosm'. The law of the microcosm ordains that the value and performance of a network rise in direct proportion to the square of the increase in the number and power of computers linked on it. Currently, computational power is increasing exponentially (in accordance with Moore's law) and world usage of the internet is growing rapidly (between December 31 2000 and now, world internet usage grew by 305.5%). Therefore, it is evident that there is a fusion between the microcosm and the telecosm. Hence implying (as Gilder says) that the 'world of computers and communications can ride an exponential rocket' of progression. Thus in the future, as Vernor Vinge suggested in his essay titled The Coming Technological Singularity: How to Survive in the Post-Human Era, 'large computer networks (and their associated users) may "wake-up" as a superhumanly intelligent entity'. 'Wake-up' in this context means to 'gain consciousness'.
  

Therefore, one can argue that a technological singularity is imminent. However, the question of when, is debatable. According to Ray Kurzweil's estimates, the singularity will occur within a quarter century. In his bestseller titled The Singularity Is Near, Kurzweil conjectures that by 2045, 'non-biological intelligence will match the range and subtlety of human intelligence'. He believes that non-biological intelligence will surpass human intelligence because of the 'continuing acceleration of information-based technologies, as well as the ability of machines to instantly share their knowledge', and also, because 'non-biological intelligence will have access to its own design, and will be able to improve itself in an increasing redesign cycle'. This all implies that trans-human intelligence will drive technological progress at an exponentially increasing pace; resulting in a profound, and disruptive, transformation of every facet of our lives

...Possible effects of a technological singularity

In the blog-post titled The Hedge-Fund Strategy of The Future, it was stated, and this is according to Michael Jensen's paper series on Agency Costs, that the agency-gap increases greatly in times of rapid technological (and political) transformation. What does this mean? Answer: As we move closer to the technological singularity, there will be increasing divergence of the interests of shareholders and management teams of corporations. This naturally implies that we could be seeing an increasing number of corporate failures in the near future i.e the fall of the behemoths, or a milder scenario; where companies survive, but continuously decline in terms of profitability and market-share. Is this a bad thing for society as a whole? It is hard to tell. The answer is dependent on a confluence of forces that are too complex to forecast/analyze accurately. However, it is safe to say that that the blue-chips of the future, are probably companies we've never heard of today. [Side-note: To prevent the agency-gap from widening in their firms, top management will have to fire/re-assign more middle-managers than is politically correct (as the skills and experiences of most middle-managers increasingly become redundant). It would be interesting to see how top-management will perform in this respect. This would be the ultimate test of their courage of conviction!]

The key role of information technology, according to Michael Jensen is "taking the specific knowledge previously scattered through a firm and making it into general knowledge usable by all." Therefore, as the pace of technological change increases, specific knowledge scattered throughout a firm will increasingly become general knowledge usable by any member of the firm. When framed within the context of hedge funds: as the pace of technological change increases, a hedge fund's proprietary trading strategies will increasingly become general knowledge usable by its entire staff body (smart janitors included). Hence, increasing the likelihood of exposure of proprietary trading strategies, and the risk of imitation (a secret that everyone knows isn't concealed--it is banal knowledge!). This is something that will cause trepidation among hedgies, and has the potential to culminate in full-scale future shock! [Side-note: How bad can it get? Well, picture in your mind, a Theodore Kaczynskiesque luddite-hedgie-type.]


...Emergence of 'Super Quant' Funds

Quantitative hedge-funds (quant funds) will be among the early adopters (in financial markets) of trans-human artificial intelligences. But firstly, what are quantitative hedge funds? Investopedia defines a quantitative fund (quant fund) as 'an investment fund that selects securities based on quantitative analysis. In such funds, the managers build computer-based models to determine whether or not an investment is attractive. In a pure "quant shop" the final decision to buy or sell is made by the model.' Quant funds are the most secretive of hedge funds; their investors have no clue about exactly how their money is invested (they invest based on faith!). This is why they are known as black-box funds; you can't see what is inside.

*****************

When viewed in abstraction, algorithms--used by quant funds to analyze market behavior and select stocks--are essentially market paradigms that produce market-hypotheses/trades; when they are run on computers. Algorithms can also be termed as computational equivalents of a human trader's cognitive abilities, knowledge, character and experiences. They (the algorithms) are also as diverse as individual human beings are different, and, are just as fallible as we are (after all, they are a human creation!).

Interestingly, quantitative funds first emerged in the financial industry during the 1970s (their algorithms usually ran on the Cray 1 - one of the fastest computers then), and became more popular as computational power increased over the decades. According to promoters of quant funds, their trading systems operate in a 'disciplined, non-emotional manner' (hyperbole!). Currently, and this is according to a study conducted by the Aite Group, approximately 38% of all equity trades (in the United States) are automatically executed by quantitative trading systems. By 2010, the trades executed by quant trading systems will sum to approximately 52% of all equities traded.

Therefore, in the near future, quant funds are certainly going to influence market events in a big way!

When the technological singularity occurs, trading systems used by elite quant funds--since they are the only ones who'll be best positioned to acquire the super-human technologies--will exceed human intelligence, and will be capable of; reasoning, continuous real time self-improvement (of algorithms), trading at ever increasing speeds, and operating without the aid of human beings. They will have all the combined strengths of the best traders in the world, and none of the traders' human weaknesses. Hence, they'll outperform human qualitative traders in markets.

This will be the harbinger of a market crisis of apocalyptic proportions; everything that can go wrong, will go wrong.

The passage below will put the preceding assertion into perspective:

'Biological species almost never survive encounters with superior competitors. Ten million years ago, South and North America were separated by a sunken Panama isthmus. South America, like Australia today, was populated by marsupial mammals, including pouched equivalents of rats, deers, and tigers. When the isthmus connecting North and South America rose, it took only a few thousand years for the northern placental species, with slightly more effective metabolisms and reproductive and nervous systems, to displace and eliminate almost all the southern marsupials.

In a completely free marketplace, superior robots would surely affect humans as North American placentals affected South American marsupials (and as humans have affected countless species).'

—Hans Moravec from his book titled Robot: Mere Machine to Transcendent Mind

Do the maths! :-)

P.S I'm not a luddite

...To be continued

Imitation risk

...Europe During the Middle-Ages

"The whole world admits unhesitatingly; and there can be no doubt about this, that Gutenberg's invention is the incomparably greatest event in the history of the world”

—Mark Twain

During the Middle-Ages, Europe was made-up of a series of squabbling fiefdoms. The biggest single landowner was the Roman Catholic Church, and most of Europe's wealth was concentrated in the hands of the church. Together with the feudal aristocracy, the church monopolized knowledge and influenced all the Political, Economic, Social and Technological events that precipitated in not only Europe, but the whole world.

European society was hierarchically stratified: with the church and the monarchs at the upper-echelons, the aristocrats occupying the second-tier (in terms of influence), the merchant-class occupying the mid-strata and the peasants occupying the lowest-strata. However towards the end of the Middle-Ages, the rigid class boundaries and the church's monopoly on power collapsed because of one thing: Johannes Gutenberg's movable printing press.

It helped to break the church's monopoly over access to knowledge, and, empowered the masses with knowledge that undermined, albeit indirectly, the status quo.

...Media Communications Technology

From the historical account above, one can see that communications media technology has the potential to improve the welfare of the masses: an upside. But it also has a downside: the potential to harm.

Technology is in itself neutral, it is neither negative nor positive. It is like a surgical knife that is a life-saving tool in the hands of a seasoned surgeon; in the hands of a psychopath, the same life-saving knife becomes a life-threatening tool. By the same token, communications media technology is in itself neutral; neither negative nor positive. Its usage is shaped by prominent social values and 'in-season' societal trends.

Currently, society has an insatiable hunger for information on hedge funds; people are conscious of the enormous fortunes being made by alpha-hedgies (e.g Paulson, Cohen, Griffin, Soros, Simmons e.t.c), and naturally, the general populace (and beta-hedgies) want(s) to know exactly how those fortunes are made. This leads them on a search for 'position-level' details on the activities of alpha-hedgies; which is where communications media technology comes in.

Communications media technologies are integrated into every facet of our daily lives. They are also interconnected amongst themselves. Which means that every facet of our lives is potentially, within the reach of the entire spectrum of communications technologies. To put this into perspective: a confidential email can, within a matter of seconds, find its way onto a(n) blog/online forum; readers of that forum/blog can quote 'interesting bits' of the email and send them off to their buddies via email/instant messenger/text message e.t.c, and, their buddies will in turn send the quotes to their friends and so on. Within a matter of minutes, references to the 'confidential email', would have circumnavigated the globe!

Has this happened within the context of hedge funds? Yes! The obvious example is of Daniel Loeb's emails, although they had nothing to do with position-level data. One recent example of a widespread leak of confidential position-level information, concerns the email exchange between Hohn and Degorce of The Children's Investment Fund. However, this leak didn't have any adverse effects.

Side Note/Food for thought: Have you wondered why Petroleo Brasileiro SA is the most popular stock (according to Goldman Sachs VIP list of 50 common stocks in hedge-fund holdings) among hedgies? (Hint: Soros Fund Management has an $811million stake in PetroBras, as of July 2008).

...Why should the average person be concerned about the exposure of proprietary hedge-fund strategies?

Let us postulate the Fingale's-Law-Scenario, where anything that can go wrong, goes wrong: In this scenario, position-level data seeps from an alpha hedge-fund to other market participants, including beta-funds that have an operational focus that is similar to alpha-fund's investment focus. When the beta-funds receive this information, they replicate the alpha-fund's proprietary trading strategies and build a portfolio that (structurally) resembles the alpha fund's portfolio. This pattern of imitation results in the formation of a super-portfolio, that is administered by fund managers with a diverse range of skill sets; who are also subject to varying investment circumstances.

The consequential super-structure, made-up of large overlapping portfolios, will be fragile and prone to collapsing when a minor perturbation occurs. In business cycles there are upturns and downturns, and when downturns occur, the 'super-portfolio' unravels and takes the hedge funds (both alpha and beta funds) down with it. When this happens, the globalized world economy goes into distress! In this cataclysmic scenario, return-to-risk ratios of securities held by the funds hover around negative infinity: the securities begin to have asymmetrical relationships between risk and return.

The 1998 debacle of Longterm Capital Management is the closest empirical parallel to the aforementioned Lingale's-Law-Scenario. According to Donald MacKenzie's research paper titled Risk, Financial Crises, and Globalization: Longterm Capital Management (LTCM) and the Sociology of Arbitrage, LTCM experienced outstanding success practising convergence arbitrage in the following markets; US government bonds, bond derivatives, mortgage backed securities (CDOs and CLOs), international stock markets and the equity derivatives markets. When the success of LTCM became well-known, other market-players that operated within LTCM's investment space, started imitating LTCM's investment strategies.

This worked in LTCM's favor during the initial stages of imitation; as pay-off periods of arbitrage positions, that would normally take longer periods of time to become profitable, became accelerated. However, this all changed on Monday the 17th of August 1998, when the Russian government defaulted a scheduled interest payment (coupon) on Ruble-denominated debt, and, devalued the Ruble: a black swan event. This triggered a chain of losses in the Ruble-denominated bond market, where LTCM and its 'replicas' held positions, and, market players began dumping Ruble-denominated bonds to mitigate losses.

When yield-curves inverted and unanticipated losses occurred, value-at-risk models (that marked-to-market) told LTCM and its 'replicas' to enhance liquidity and limit exposure. This triggered a selling spree of securities, including shares, non-bond derivatives e.t.c, held by LTCM and its 'replicas': there was a fire-sale. Eventually, markets were full of buyers and not enough sellers, and securities became unsellable.

Capital was eroded, hedge fund investors withdrew their assets, and, a crisis that seemed minor, now threatened the entire global financial system. Everyone was in panic! What initially appeared to be an idiosyncratic risk factor, now become systematic!

And so on, and so on, etc, etc

The example above illustrates why hedge-funds should be concerned about imitation risk, especially in this era of heightened societal interest in hedge fund strategies; where new communication media technology aids rapid dissemination of proprietary strategies (if they happen to leak out).

Solving Africa's Problems--PERMANENTLY

Roben Farzad's (BusinessWeek columnist) article titled Can Greed Save Africa?, reignited debate on the 'Aid to Africa' imbroglio, and, intensified discourse on the topic of aid-effectiveness.

He quoted the following interesting statistics (from a study conducted by William R. Easterly, an economics professor at New York University):

• Between 1960 and 2007 (a period of 47 yrs), Africa received a 'total of USD625 billion in foreign aid'. This translates to an aid disbursement of approximately USD247 million per country per year.
• Between 1976 to 2000 (a period of 24 years), 'Africa's share of global trade dropped to 1%, from an already negligible 3%'. This shows that Africa is becoming more of a net importer of commodities: a sign of African countries' declining (production) comparative advantage.
  
• 'The U.N.'s scale of human development, which considers health, education, and economic well-being, ranks 34 African nations among the world's 40 lowest'. This means that Africans generally have the lowest welfare in the world!

The statistics clearly imply that Africa has a negative aid-growth elasticity i.e foreign aid has worsened the welfare of African people. This could mean either or both, of the following:

• Aid doesn't influence economic growth: Foreign aid may have a neutral/negligible effect on economic growth in recipient countries. Hristos Doucouliagos and Martin Paldam's working paper titled Aid effectiveness on Growth: A Meta-Study, suggests that foreign aid has an insignificant effect on economic growth in recipient countries. Therefore, this implies that Africa's declining comparative advantage, could be driven by other factors that have no connection to foreign aid; e.g civil strife, corruption, e.t.c
  
• There are flaws in the conception, design and execution of foreign aid programmes: I suspect that foreign aid fails to stimulate economic growth & enhance social welfare in Africa because of inaccurate diagnosis of Africa's problems, and, because the programmes are poorly designed. J. Orlin Grabbe, in his speech titled In Praise of Chaos (presented to the Eris Society on 12 August 1993), stated that 'handing out free food in "refugee" camps in Somalia leads to a greater number of starving refugees, because the existence of free food attracts a greater number of nomads to the camps, who then become dependent on free food, and starve when they are not fed'. This example illustrates the adverse effects of 'poorly designed' aid programmes.
  

...Solutions to Africa's problems (according to me)

Problem 1) Learned helplessness

Decades of racially oppressive colonial rule, civil strife and state failure have had a toll on African Infrastructure, and African people.

Most aid programmes target infrastructure, education and nutrition. Some address health care issues, especially those related to HIV/AIDS... But it seems that there are no initiatives that focus on improving the mental health of African people.

People who go through oppressive colonial rule, civil strife and state failure; are bound to have mental and emotional scars that need healing. These 'scars', if unattended to, may have adverse effects on the well-being of individuals and society as a whole.

New age authors like James Ray, believe that a person's situation in life is a reflection of their mental state. Similarly, a society's collective 'situation' is a reflection of the society's collective mental state. Hence, a contracting economy, increasing HIV/AIDS infections and a galloping crime rate, may be reflections of a society's unhealed mental and emotional scars.

I believe that Africa's problems can easily be solved by average African Joes and Janes, without any external assistance. Why don't they solve their society's problems? Answer; Learned helplessness--a psychological condition in which a person has learned to act or behave powerless in a particular situation, even when he/she has the ability to change his/her unconfortable or even dangerous circumstance.

So, whats the solution for the learned helplessness problem?: Aid programmes should focus the majority of their efforts and resources, on identifying and addressing the underlying psychological causes of Africa's problems i.e heal the mental and emotional scars of African people.

Problem 2) Lack of Access to Capital

My travels across the African continent have given me a valuable insight: Africa's most recent generation, born between 1978 and 2008, is; relatively well-educated, tech-savvy, ambitious, entrepreneurial, smart, passionate and it also has an awareness of global trends and events. I call it Africa's Star Generation, because it has the potential to change Africa for the better through its entrepreneurial drive.

Unfortunately, the transformative effect of this generation may fail to be realized, because it lacks access to risk based capital and specialized business expertise--critical elements for the success of the Star Generation's new ventures. Africa's banking and micro finance industry is highly conservative and lacks innovation: the sector prefers to confine its services to 'blue-chips' that invariably; have collateral (asset rich balance sheets), have a proven track record of success and operate in traditional lines of business e.g mining, agriculture and the manufacture of fast moving consumer goods. This denies the Star Generation access to capital and their right to participate in the economy. Dejected, the entrepreneurial generation relocates to developed countries, where it joins the growing ranks of middle-class immigrants of African origin--that remit hard currency to Africa. This limits the economic development of Africa and restricts Africa from participating in the 'tech-age' economy.

So, how do we solve the capital access problem?: The Democratization of access to capital through legislative instruments and financial technology!

Don't you think I should become the secretary general of the United Nations? :-)

Oil, The US Dollar, Gold, The Vietnamese Dong

Two topics I've been thinking about:

Disclaimer: The following post is not intended as investment advice. Your capital is at risk when you invest in anything – you can lose some or all of your money, so never risk more than you can safely afford to lose. This post is solely for purposes of discussion. Always seek personal advice from your investment adviser, if you are unsure about the suitability of any investment.

1) Oil, The US Dollar

In his article titled US-Dollar Is The Best Looking Horse In The Glue Factory, Steven Syre (Globe Columnist) states a common perception among financial-market-players: 'The value of the dollar and the price of oil move in opposite directions on a dependable daily basis'. This perception is validated continually by empirical evidence -- it can almost be viewed as a law!

According to an article summary on KurzweilAI.net, General Motors is currently collaborating with thirty utilities in 37 states, and, with The Electric Power Research Institute to develop a charging infrastructure for electric cars. After reading that, one thing is certain: fossil fuel powered vehicles will not be a part of our future. This got me wondering: What will happen to the US dollar and the global price of crude oil, when electric cars (or cars with engines that are powered by a non-fossil fuel) become ubiquitous?

The demand of crude oil would be curtailed by wide-spread-global-adoption of non-fossil fuel powered vehicles. Obviously, this would have an adverse effect on the price of crude oil. But does this imply that the US-Dollar is set to appreciate rapidly (ceteris paribus), when electric cars become widely adopted (since 'The value of the dollar and the price of oil move in opposite directions on a dependable daily basis') ? Also, how will this affect Gulf economies, that solely depend on oil as a revenue source? Will their Sovereign Wealth funds have the ability to insulate them from the effects of falling oil prices?

One thing is certain: One can never go wrong by investing (with a long-term focus) in electricity generating ventures and in ventures that develop safe durable technology for electric car charging stations.

2) The Vietnamese Dong, Gold

According to an article on Bullion Vault, Vietnam is 'the second largest market for gold exports in the world, Vietnam has already imported 60 tonnes of gold valued at $1.8 billion so far in 2008, an increase of 100% over the same period last year'

Recently, the Vietnamese government temporarily banned gold imports to contain the country's ballooning trade deficit (which tripped this year).

Will this move help to shore-up the Vietnamese Dong? How will the Vietnamese property market respond to this ban? How will speculators trade the Dong when the ban is lifted?

I'm confident about one thing: the value of the Dong will plummet when the ban is lifted.

Why?

Gold is a US-dollar denominated asset, so when the ban is lifted, Vietnamese market players will scramble to trade in their Dong, for US dollars to purchase gold with. This will cause the price of US dollars to appreciate in terms of the Dong. By what margin? It's hard to tell.

I also believe that the price of gold will appreciate sharply when the ban is lifted; the majority of the price spike will be driven by speculators.

Note: I don't have a position, long or short, on oil futures or the Vietnamese Dong. I may have a combination of positions on Gold and the US-dollar. This post reflects my opinions and NOT the opinions of companies and charities I'm affiliated with.

...Lets see what happens!

Regional Integration Increases correlation of regional stock prices

The Free Online Dictionary (by Farlex) defines a stock market as 'The market in which shares are issued and traded either through exchanges or over-the-counter markets. Also known as the equity market, it is one of the most vital areas of a market economy as it provides companies with access to capital and investors with a slice of ownership in the company and the potential of gains based on the company's future performance.'

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Stock markets, when viewed in abstraction, are essentially non-deterministic dynamical systems (stochastic systems). When these stochastic systems operate, current market prices are iterated from complex mathematical formulas that incorporate, among other things; preceding market prices and events.

Each stock market is a distinct stochastic system, that has its own 'unique formula' for pricing stocks. This 'unique formula' evolves constantly in response to:

• Political events in the country, and, in the wider global environment.
  
• Social trends in the country, and, in the wider global community.
  
• Technological trends in the country, and, in the broader 'global village'.
  
• Economic trends precipitating at a national and global level.

As regional political integration (and economic) progresses, nations within the respective integrated bloc increasingly resemble each other; politically, economically, technologically and socially (i.e countries within an integrated bloc converge towards a common order). Otherwise stated: regional integration 'homogenizes' countries with different traits. This has the effect of standardizing the underlying factors (or the 'unique formula for setting stock prices') that influence share prices within the region.

...What are the effects of this 'standardization'?

As regional integration increases, stock markets (within the respective integrated region) begin to behave in more or less, the same way: they increasingly become positively correlated.

(I suspect that) If you picked any two random shares, on any two random exchanges (within an integrated regional bloc) and studied them over a period of time; you'd find that the correlation of their prices increasingly approaches 1 (the number one).

Mathematically this can be expressed as:

Which reads As time approaches positive infinity, the correlation between two randomly picked share-prices (each from a different stock exchange within an integrated regional bloc) approaches one i.e they increasingly approach perfect positive correlation.

Note: the general assumption of the mathematical expression above, is that regional integration increases with time.

Where:

t represents time.
The 'lazy eight' represents positive infinity.
x1 Represents the price of the first randomly picked share at a specific point in time.
μ1 Represents the arithmetic mean of of x1 during a defined time period.
x2 Represents the price of the second randomly picked share at a specific point in time.
μ2 Represents the arithmetic mean of of x2 during a defined time period.
σ1 Represents the standard deviation of x1 during a defined time period.
σ2 Represents the standard deviation of x2 during a defined time period.

...And?

As stock markets (within an integrated region) approach perfect positive correlation, the (risk management) benefits of intra-regional diversification of share portfolios, diminish proportionately.

To put this into perspective: Intra-regional diversification of share portfolios, in an environment of increasing regional (political and economic) integration, is akin to loading different egg-filled baskets onto the same haulage truck.

Although your eggs are in different baskets, they still have a common environment...

What happens to your precious eggs, when another haulage truck crashes into your egg-carrying-truck?

Your attempt to limit risks by diversifying your eggs into different baskets, would have been an exercise in futility!

...Now think about mutual funds with a European Union listed-equity focus: What does this say about their risk management practices?

You have been warned! :-)

Mitigating the Global Food Crisis

There are 860 million people (~13% of the world's population) who are suffering from chronic hunger. 90% of these people, reside in developing countries i.e: mostly in Africa, Parts of Asia, South America and Eastern Europe.

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According to the agenda of the June 2008 HIGH-LEVEL CONFERENCE ON WORLD FOOD SECURITY (centered on THE CHALLENGES OF CLIMATE CHANGE AND BIO-ENERGY):

• 'During the first three months of 2008, international nominal prices of all major food commodities reached their highest levels in nearly 50 years, while prices in real terms were the highest in nearly 30 years!' Over the last year, the global mean price of food has risen by 56%, with wheat rising by 92% and the average price of rice rising by 96%.

• The global food crisis 'is provoking social unrest across the developing world'. For instance in Somalia, where thousands rioted during the first week of May 2008; protesting for food. Food riots have also occurred in Indonesia, Haiti, the Philippines and Ethiopia.

It is clear that the escalating prices (of food commodities) threaten to plunge millions into deep poverty. If unchecked, this crisis has the potential to trigger a chain of apocalyptic events: it may draw us closer to extinction...

That's how serious it is!

Below is a graphical illustration showing real and nominal average food prices between 1961 and 2008:

Source: HIGH-LEVEL CONFERENCE ON WORLD FOOD SECURITY: THE CHALLENGES OF CLIMATE CHANGE AND BIOENERGY AGENDA. For more information see conference materials

Explanation of the graphical illustration: The vertical axis shows prices and the horizontal axis shows time in years (between 1961-2008). The navy-blue trajectory shows nominal price movements (of food commodities) between 1961-2008 and the lime-green trajectory shows price movements (of food commodities) in real terms, between 1961 and 2008. From the illustration you can see that real prices and nominal prices of food are equal in 2003. Between 2003 and 2008, both real and nominal prices increase at a pace that was last witnessed in 1974! In 2008 the nominal price of food is at its highest and the real price of food is at the same level it was in 1978.

...What's causing food prices to soar?

World Bank Agricultural Economist, Don Mitchell believes that bio-fuels are the chief cause of the upsurge of food prices. According to Mitchell, the growing use of food crops as raw materials for bio-fuel generation, combined with falling grain stocks, speculation in commodity markets and food export bans; contributed to approximately 75 percent of the 140 percent rise in food prices between January 2002 and February 2008. He also attributes 65 percent of the 140 percent increase in food prices, to the depreciating U.S. dollar, increasing energy prices and associated increases in fertilizer costs. Another factor that's fueling the price escalation, is climate change (caused by global warming). Climate change generally has an adverse effect on agricultural yields.

The above-cited factors generally have a 'reducing-effect' on the global supply of food, which generally causes food prices to increase (assuming constant food demand).

Below is a supply and demand model that illustrates the effect of the aforementioned factors on global prices of food:

Explanation the Supply and Demand Model: The vertical axis represents the global averages of food prices. The horizontal axis represents quantity of food demanded globally and quantity of food supplied globally. The downwardly sloping lime-green line represents the global quantity of food demanded, at various prices. Global supply of food (at various prices) before the bio-fuel revolution is represented by the upwardly-slopping navy-blue line labeled S1. The global supply of food after the bio-fuel revolution has started, is illustrated by the upwardly-slopping navy blue line labeled S2. Point b (Q1;P1) is the point of equilibrium between demand and supply of food, before the bio-fuel revolution. Point a (Q2; P2) is the point of equilibrium between demand and supply of food, after the bio-fuel revolution has started. The bio-fuel revolution reduces the supply of food from S1 to S2 and the point of market equilibrium shifts from Point b to Point a. At point a the aggregate quantity of food supply is Q2 at an increased price denoted by P2.

...How do we mitigate the crisis?

Answer: By increasing food supply (which in turn reduces food prices) through any, or a combination of the following:

• Channeling an increasing proportion of bio-fuel feedstock to the food industry. However, this may undermine the productivity of bio-fuel projects, which would adversely impact Kyoto Protocol-sanctioned pollution-reduction initiatives. In the diagram below, the increase in food production from a reduction in bio-fuel production is illustrated by a movement from Point a to Point b.

• Development and wide-scale implementation of yield enhancing technologies. This would boost global food output. Effective yield enhancing technologies have the likelihood of emerging from the field of Biotechnology (specifically genomics and proteomics) in the form of; high yielding, nutrient-rich, pest resistant, 'all-weather' crops. In the diagram below the increase in food production that accrues from technological development is illustrated by a movement from Points a and b to either Point d or Point e.

• Development of 'food alternatives'. Recent advancements in the field of nanotechnology have given us the power to manipulate matter--at it's most basic level--with great precision. We could use this technology to create chemical substance equivalents of food, that mimic real food in terms of; taste, appearance, nutrition, texture and smell: I believe that in the near future, we'll be able to harness the power of light energy, carbon dioxide and synthetic chlorophyll; to create edible nutrient rich carbohydrate foods in labs (at a lower cost and at a faster speed than nature)... Also, currently, stem-cell technology is used to grow cartilage and skin (for medical patients who need replacements) in petri-dishes. We can use that technology to grow meat (parts of cows, fish, chicken etc) in labs. This will help conserve grain (and land), that would otherwise have been used as an input for animal husbandry projects (which are generally 'grain-intensive'). This would avail more grain for human consumption. (Side Note: Sounds like a florid, quixotic statement; embedded in deep romanticism? Wait and see! The passage of time will validate my assertion). In the diagram below this increase in food supply from food alternatives. is illustrated by a movement from Points a and b to either Point d or Point e.
  

Explanation of the graphical illustration: The illustration above is a Production Possibilities Frontier (transformation curve) model showing the maximal combinations of bio-diesel and food, that the global economy could efficiently produce during a specific time period, with the use of scarce resources. The vertical axis represents various quantities of bio-diesel and the horizontal axis represents various quantities of food. A northward movement from any point on the graph, means that more bio-diesel is being produced, whereas an eastward movement from any point on the graph, means that more food is being produced. The two concave slopes are called transformation curves. They show the various maximal combinations of food and bio-diesel that the global economy can produce efficiently. Each respective transformation curve represents a different level of technology utilization; with the navy-blue trajectory showing the maximal combination of bio-diesel and food that can be produced with the current level of technology. The green trajectory shows the maximal combinations of food and bio-diesel that can be produced if a technological advancement occurs. Point f lies lower than the navy blue trajectory; a movement from Point f to point either Point a or b, means that producers have scaled-up their operations--using the current level of technology--to (efficiently) produce maximal combinations of food and bio-diesel. A movement from Point a to b means that producers who are already producing maximal combinations of food and bio-diesel (using the current levels of technology), are increasing food production at the expense of bio-diesel production. A movement from Points a and b, to either Point d or e means that farmers are using new yield enhancing technology to (efficiently) produce greater quantities of food and bio-diesel.

...How do governments; channel an increasing proportion of bio-fuel feedstock to the food industry, facilitate development and wide-scale implementation of yield enhancing technologies, facilitate development of food alternatives?

I think that the Food and Agriculture Organization of the United Nations should encourage its membership to set voluntary, legally binding food production targets: a food production treaty. The treaty should be an adapted (to food security) 'reverse-engineered' model of the Kyoto Protocol, that among other things, sets specific targets and deadlines for food production. A treaty of this kind will provide the moral impetus for tackling the global food crisis.

A carrot and stick approach has to be implemented to encourage parties to the treaty to comply i.e reward compliance and punish non-compliance. Financial penalties should be set to punish signatories who don't meet targets, and, tradeable 'Food Production Credits' (similar to carbon credits) should be awarded to parties that increase food production beyond a set benchmark.

'Food production credits' have the added benefit of inspiring research into yield enhancing methodologies, and, will encourage producers to adopt yield enhancing technologies rapidly i.e 'food credits' will reduce the 'bottleneck' between (yield-enhancing) technology creation and (yield-enhancing) technology adoption.

And so on, and so on, etc, etc :-) . The academics can takeover from here.