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Tuesday, December 21

Occam’s Razor, the Gordian Knot and the Von Mises Prophecy

The rise in Treasury yields has hurt Our Man’s portfolio in recent months, but there seems to be no consensus as to why they’ve risen with numerous opposing points of view.  Arguments range from the Bond bubble is bursting (and hyperinflation is imminent) to this just being evidence that the Fed’s QE2 is working.

How to untangle such a mess?  Well, 14th century English logician William de Ockham created a helpful ‘rule’ that’s come to be known as Occam’s Razor.  It recommends that when choosing between hypotheses which are equal in other respects, one should choose the hypothesis that makes the fewest new assumptions.

What does that mean in this situation? 
Simply that Treasury yields have risen as a result of people’s perception of the economy improving, something that’s been evident by the broadly better data and by various economists (and Wall Street Banks) upping their GDP growth targets during November/December.  Now, perhaps, time will also suggest that the alternative arguments are true…that QE2 was successful (though for $600bn, or 4% of GDP, you’d hope that the Fed’s aim was to increase actual growth not just people’s perceptions about it), that the bond bubble has burst (though the graph below would suggest “not yet”) or that hyperinflation is imminent (again the CPI, and other inflation measures don’t yet show it).  For now, however, I’m sticking with the guy who lived over 600years ago.



Now, with all these worries about hyper-inflation and QE2’s impact on prices, a reasonable fellow might ask why is Our Man comfortable holding Treasuries and betting on deflation.  Well, regular readers will know that Our Man doesn’t view this as your run-of-the-mill business cycle recession but instead one caused by the level of debt (see graph here) reaching unsustainable levels.  As such, the typical monetarist solutions that are the foundation of central banking have little impact on the economy when contrasted against the size of the deleveraging that occurs as households rebuild their balance sheets.  (While this is, of course, a simplistic overview...for those wanting to know a little more, I’d recommend this piece by Professor Steve Keen, and for the very geeky his entire blog)

This idea of debt-deflation was developed by Irving Fischer during the 1930’s.  What makes it interesting is that it is the Gordian Knot of the economics profession; the traditional and preferred solutions (many of which are being attempted now) have no real impact on solving the underlying problem.  Reductions in interest rates fail to spur businesses or households to relever.  Supplying money to the system, either through fiscal policy (“stimulus”) or monetary policy (“quantitative easing”) produces an initial response which fades and then collapses each time the policy is stopped, and the longer it continues the greater the risk of the economy becoming dependent upon it.  Austerity, while it may help reset the generation of future debts, merely increases the pain by future reducing demand and enhancing the deflationary forces.  The “Alexandrian solution” to the challenge is of course default (in the private/household sector, preferably) but the resultant probable insolvency of financial institutions* is not something the powers that be are currently willing to accept.  Thus for the foreseeable future, unless the household sectors starts to relever itself, Our Man will continue to bet on deflation and disinflation.

As for the long-term; here, Our Man will once again defer to some chap to lived a long time ago.  Ludwig von Mises, the Austrian economist, wrote the following:
“There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”



* The side benefits of bankruptcy on the system are under-rated.  As a simple example, Bank of America is getting sued by a number of investors who are seeking to have BoA repurchase soured mortgages that were packaged into bonds by Countrywide Financial (Bank of America bought them in 2008).  Do you know why we’re not hearing anything about J.P. Morgan getting sued for the deals that Washington Mutual (or why nobody’s suing Lehman Brothers)?  Because when WaMu (and Lehman) went through bankruptcy, the unliquidated claims are trapped there and thus have no impact on JP Morgan.  Therein lies the beauty of bankruptcy for the system -- clean assets with which to regenerate things!

Thursday, December 9

Things from my Google Reader: Dec-10 Edition

As Our Man has been running around interviewing, doing projects and lining up references in his quest for a day job, posting has continued to be light.  To fill the void, here are some of the things that Our Man has read recently, and found rather interesting.

As usual, I’ve put the finance ones at the top and the non-finance (more interesting?) ones at the bottom.

- Is QE printing money or not? (Video)
Who knows, not Fed Chair Ben Bernanke who thought it was 2-years ago but doesn’t think it is now.  It’s a little sad, that John Stewart not the “real” media was the one to call him out on it.

- Buy the Dip (Video)
Some fine ‘advice’ proffered to Our Man, by a good friend (and reader) after a recent post.

- What 311 Reveals about New York
If you’re a New Yorker then you’ve probably used 311.  Not only is it surprisingly helpful and efficient, they are actually trying to capture all of the data and find ways to use it productively! (Wired Magazine)

- Some Thoughts on Harry Potter
To Mrs. OM’s chagrin, Our Man decided not to venture to the cinema to see the latest in the Harry Potter films.  Instead he read this fine article by Joe Posnanski about his Harry Potter reading experience (both alone, and reading it with his young daughter).  Mr. Posnanski’s a sports writer, hence there’s also a nod towards the debatable scoring system in Qudditch. (Joe Posnanski Blog)

- Roads Gone Wild
Making driving seem more dangerous could make it safer.  So argues Hans Monderman, one of the leading traffic engineers in the world, and you do that you start by getting rid of traffic signs and then let human behavior (and the survival instinct) take over!  (Wired Magazine)

- Later
What does procrastination tell us about ourselves?  Even those who know about behavioural biases, and the downside to them, find themselves unable to escape their trap.  (New Yorker)

- You Get What You Pay For?
Healthcare has been prominently debated over the last few years, but Dr. Rob nails it when he says "your system is perfectly designed to yield the outcome you are currently getting"! (Musings of a Distractible Mind)

And finally,
- An Irrational Guide to Gifts
In a nod to the impending arrival of Christmas, here are a Behavioural Economics Professor’s suggestions on the best type of gifts. (Dan Ariely's Blog)

Thursday, December 2

November Review

Performance Review
November was a strange month for the portfolio, which spent the majority of the month mired in negative territory before benefiting from a mixture of the troubles surrounding Ireland and a company specific events (THRX, in the Value Equity bucket) to end up 7bips (putting the YTD at +6.97%)

The Treasury Bonds bucket was the big negative performer during the month (-69bps) as we saw continued appetite for risk for the majority of the month, before concerns about Ireland’s fiscal stability led to a late rally in yields.  The Bond Funds (-10bps) also posted a small loss, which was constrained largely due to their exposure to shorter duration instruments.  The concern surrounding Ireland’s fiscal debt situation resulted in some weakness for the Euro, something that benefited the Currency bucket (+39bps).

With the equity markets largely flat to down slightly, a number of the equity buckets failed to contribute.  The NCAV (-24bps) and Other Equity (-13bps) buckets both posted small losses, which were broadly spread amongst the underlying positions, and the neither the Puts/Hedges (-1bp) nor the China bucket (-<1bp) had much impact on the portfolio.

 The portfolio was however, pushed into positive territory by the Value Equity bucket (+83bps) but even here performance was mixed with DRWI being a slight negative contributor.  The same could not be said of THRX, which was the key to this month’s performance, adding almost 100bps after the stock rallied over 20% during the month.  The key driver came late in the month when GlaxoSmithKline (GSK) announced it would increase its stake in THRX to 19% through a private placement.

Portfolio
42.2% - Long Treasury Bonds (20.1% TLT and 22.2% in the Aug-29 Bond)
14.6% - Long Bond Funds (6.8% HSTRX, and 7.9% VBIIX)
7.7% - Value Idea Equities (5.5% THRX, and 2.2% DRWI)
4.1% - NCAV Equities
3.0% - Other Equities (1.5% NWS, 1.5% CMTL, and 0.0% SOAP)

-0.0% (delta-adjusted) - China-Related Thesis (<1bp premium in FCX put)
-2.3% (delta-adjusted) - Hedges/Put Options (1bps premium in S&P 2010 puts, 68bps premium in S&P 2011 puts and 7bps premium in a GS put)

6.3% (leverage-adjusted) – Currencies (3.2% EUO)

24.5% - Cash