International Investing and China in the NBER Digest

I came across a couple of interesting items in the July issue of the National Bureau of Economic Research's NBER Digest.

The first item that caught my eye was The Declining Gain from International Portfolio Diversification (by Les Picker). That article describes a NBER Working Paper by Karen Lewis, a financial economist at Wharton, where she examines the puzzle of why investors tend to disproportionately weight their investment portfolios to domestic securities and assets. This tendency is a 'puzzle' because this tendencymeans that investors forego the possible gains -- including lower correlated risks, higher returns from riskier foreign investments, etc. -- from international diversification.

Prof. Lewis finds that (a) international equity markets have become more correlated over the years (although she didn't find them to be as highly correlated as others have suspected them to be), and (b) foreign stocks that are listed on U.S. exchanges have become highly correlated with the U.S. market(s) over time. Thus, the potential gains from international portfolio diversification have been declining, and there seems to be relatively little to be gained in the way of diversification from investing in domestically listed foreign stocks.

The second item of interest in the NBER Digest is The Return to Capital in China (also by Les Picker). This article discusses research by professors Bai, Hsieh, and Qian, on what affects (if any) China's high investment rate (over 40% of GDP) has on returns to capital. The researchers found that (adjusted for various factors) China has relatively high returns to capital. It should be noted that this is an interesting finding because high investment rates can often mean lower returns to capital.

One of the plausible reasons why China's return to capital seems to be higher is -- despite misallocation of capital in many cases -- that China's economy has been moving rapidly toward more capital-intensive industries and techniques and away from purely labor-intensive industries of the past.

Do Investors Have Too Much Information?

A recent Buttonwood column (July 12) in The Economist magazine made the case for the idea that investors may have too much information to make good financial decisions. As the late, great Fischer Black pointed out, much of the 'information' -- whether they be news items, data, or even valuation models -- that is consumed by financial decision makers are essentially noise. As the article suggests, an increase in the amount of noise (in the guise of information) that investors are exposed to increases the level of confidence in their investment decisions. Unfortunately, this 'confidence' is over-confidence; various studies in the social sciences have pointed out that having more information does not correspond to improved performance in decision making and/or prediction of uncertain events.

This problem is referred to as 'noise trading' (I believe Fischer Black was one of the first finance intellectuals to rigorously study this idea). The ways investors try to 'solve' the problem of financial decision making in the midst of noise often lead to anomalies that are the bane of neoclassical financial economists (but are a boon to their 'behavioralist' brethren). For example, one study Buttonwood cites found that American mutual fund managers tended to favor investing in companies where senior officers went to the same universities as they did. Obviously, this is a silly and simplistic 'solution' to a complex problem, but silly and over-simplistic heuristics are what human beings often gravitate towards in the face of complexity.

Buttonwood suggests that a better solution to the problem of noise trading would be to exercise discipline in financial decision making. Rather than (over-)reacting to the latest bit of news on the financial wires, take the information (usually, noise) with a grain of salt and base decisions in a more equanimous manner. Sadly, this is easier said then done.

Timber! Money Can Grow on Trees

A few years ago, I came across an alternative asset class that institutional investors -- especially university endowments -- that struck me as being really out-of-the-box: timberland. At the time, I asked myself, "Why are sophisticated investors investing in trees and forests?"

A recent New York Times article, For Some Investors, Money Grows on Trees (May 27, 2007), answered many of the questions I had about this alternative investment. In a nutshell, investors are counting on revenues from sales of timberland products to lumber, paper, and other companies, along with potential gains from the underlying real estate. Rather than investing in individual lots (which would make little sense for large institutional investors like pension funds and university endowments), investors invest through TIMOs (timber investment management organizations) and timber REITs (real estate investment trusts).

Historically, investing in timber has done well. An index of returns on timberland investments since 1986 (when the index was created) to the first quarter of this year rose at an annualized rate of 15.09%. In the last three years, the return was 14.63%, which is higher than the returns on the S&P 500 over that period (12.25%).

The most appealing aspect of this asset class is that it has had low correlation with the performance of stocks and bonds. 'Low correlation' is important to risk management under conventional financial economics portfolio theory. I should note that that I am usually highly skeptical and suspicious of claims of 'low correlation' between asset classes and markets since 'correlations' are (a) dynamic, and (b) there might be less obvious links between investments that simple measures of correlation don't pick up. However, in this case, this idea does seem to pan out at this point in time.

Note: The best books I'm aware of dealing with the role that alternative assets can play in managing an investment portfolio are the two books written (thus far) by David Swensen. I'm not sure if Yale's endowment invests in timberland, but I would be shocked if they didn't. I am aware of other university endowments that do invest in timberland, e.g., Caltech.

Greenspan chimes in on Chinese stockmarkets

I've written a couple of posts lately about the possibilities of a stockmarket bubble in China (More signs of a Chinese stockmarket bubble, 5/13/07, and Makings of a Chinese Stockmarket Bubble?, 4/29/07) . According to the New York Times (5/25/07), former Fed Chairman Alan Greenspan has chimed in as well. According to the Time article:

Mr. Greenspan, now 81, struggled to contain the tech stock boom, issuing his famous “irrational exuberance” warning in December 1996 only to watch the American market keep rising and finally collapse in early 2000. He tried his hand at forecasting Chinese stocks on Wednesday, telling an audience in Madrid by satellite that the Chinese market was “clearly unsustainable” and could undergo a “dramatic contraction.”

After setting records on Monday, Tuesday and Wednesday, the A shares, those traded in yuan, fell 0.47 percent in Shanghai and 0.6 percent in Shenzhen on Thursday as investors responded to the warning.

But the warning was not news to Mr. Zhou and other Chinese officials. The central bank, securities regulators and prominent business executives have all been cautioning investors that buying stocks is not a guaranteed path to riches — all with less apparent effect than Mr. Greenspan.

To reiterate my earlier warnings, developments in China can (and has) effects on an increasingly inter-linked, globalized financial markets.

The Foresight Saga Revisited (or How Much Money Can You Make If You Had Perfect Foresight?)

So what is the 'Foresight Saga'? The Foresight Saga was a gedanken (i.e., thought experiment) conducted by The Economist magazine in its fin de siecle (1999) Christmas issue. The Economist magazine created an imaginary character named 'Felicity Foresight' who was able to perfectly predict the performance of financial markets -- across different asset classes and across borders -- for each and every upcoming year from January 1st 1900 onwards.

Starting with an initial investment of $1 in January 1st 1900 (and by reinvesting any dividends and/or interest income in the coming years), Felicity Foresight would decide at the beginning of each year which investment would bring the highest return (capital gain plus income) for that year and put all her wealth into that single asset. She would repeat this process year after year, shifting her funds to match her new forecast for each and every year starting from the year 1900.

How did Felicity do? By January 1st 2000, she managed to turn $1 into $1.3 quadrillion even after deducting transaction costs and taxes. Compared to the $9,000 she would have earned had the $1 been invested in a broad collection of American stocks, Felicity Foresight's performance is truly staggering! The last time The Economist checked in on Ms. Foresight (January 2, 2003), her investment acumen more than doubled her portfolio (to $2.7 quadrillion). [Note: All figures in this paragraph are the revised figures from the 2003 article, and not from the original 1999 article.]

In addition to Felicity Foresight, the Foresight Saga also included two ancillary characters (and potential suitors) -- Henry Hindsight and Charlie Contrarian -- that added zest to this tale of predictive perfection. Unlike Felicity, neither Henry nor Charlie were able to perfectly foretell the future direction of financial markets.

Henry Hindsight follows the same investment process that Felicity does with one major exception: Henry invests in the previous year's best performing asset. In other words, Henry Hindsight is like most investors, following 'fashions' and 'trends.' Henry's initial $1 invested at the beginning of 1900 would have only grown to $783 -- much less than either Felicity's portfolio or investing in a broad index of American shares.

Charlie Contrarian, on the other hand, invested in the previous year's worst performing asset (apparently believing in a sort of 'mean reversion'). Charlie did somewhat better than Henry -- turning his $1 into $1,730 in a century of investing -- but not as well as either Felicity or a broad index of U.S. equity.

The following chart lists the investment choices that Felicity Foresight made over the last century (you can click on the image to enlarge it).


Needless to say, no one has perfect foresight. So inventing 'Felicity Foresight' may, at first blush, seem a rather pointless exercise. However, I believe that we can learn a great deal from gedankens / empirical studies like the Foresight Saga.

One of the things we can learn from this thought experiment is that financial experts often underestimate the effects of taxes and transaction costs. If Felicity's porfolio had been constructed without those costs, it would have grown to $27.5 quintillion; i.e., 99.99% of potential investment wealth was eliminated by transaction costs and taxes (along with effects of compounding). Many experts tend to think of these kinds of costs to be negligible and readily dismiss them, but this extreme example demonstrates that investment costs can add up -- or, more precisely, compound -- to a sizable amount in the long run.

Another valuable lesson that can be learned from this seemingly fanciful tale is that there has been a fundamental change in the ability to achieve investment performance over the last decade and a half. Until the early 1990s, both Henry Hindsight's and Charlie Contrarian's strategies -- which are the typical strategies used by most investors -- would have led to respectable gains. Since then (or at least until the early 2000s), these strategies would have been less successful and, up until the year 2000 or so, would have led to substantial losses.

What is the nature of this 'fundamental change' over the last decade and a half or so? Could it be a more globalized financial market where poor performance in one part of the globe or in one asset class can reverberate much more readily than prior to the 1990s? Could it be that a more dynamic marketplace has shortened the time frame and/or reduced the opportunities where either of the two traditional investing strategies can profit?

One final lesson that can be learned from the Foresight Saga is that the creator(s) of the story have shown that they -- unlike Felicity, but like the rest of us -- lack perfect foresight. None of the installments of the Foresight Saga (the last one was in January 2003) foresaw with any detail what has happened since then and no one could have profited at the rate that Felicity did by what they could glean from her tale of investment success.

Despite the lack of useful predictions for the future, I do hope that The Economist revives the Foresight Sage in the near future because of the insight that this gedanken gives us about the past's future. What do I mean by the 'past's future'? What I mean by that is that we can use the Foresight Saga -- not as a way to give us perfect foresight (which it doesn't) -- but as a way to put ourselves in the proverbial shoes of those who in the past had been trying to make decisions based on uncertain projections of the future. In other words, we can evaluate the past's predictions about the future ... and see the frustrating nature of such attempts at prediction. For example, anyone who had predicted in 1939 (the eve of World War II) that, by the early 1940s (well into World War II), the French stockmarket would have over a 200% annualized return would have been dismissed as a lunatic ... yet it happened!

The Foresight Saga is more about hindsight than foresight ... gendankens and empirical studies like this one can place us back in time to see how those who came before us (or even ourselves in the distant past, if we are old enought) viewed their future ... and usually got it wrong! The most important lesson to learn from Felicity Foresight's amazing track record as an investor is how all of us, in reality, lack such consistently perfect foresight about our future.

More signs of a Chinese stockmarket bubble

According to the Financial Times [in Bourses in China eclipse all of Asia (May 9, 2007)]: "The value of shares traded on China’s stock markets on Wednesday was greater than the rest of Asia combined – including Japan – helping the benchmark index to breach the 4,000 mark for the first time. Analysts said this was almost certainly the first time that turnover at the Chinese bourses had exceeded that of the rest of Asia." (Although, it should be noted, that the Chinese stockmarkets in Shanghai and Shenzhen are still substantially smaller than the markets in Japan, the UK, and the US, in terms of market capitalisation.)

This is more evidence for some of the comments I made in previous posts on China's financial sector ... the latest post being Makings of a Chinese Stockmarket Bubble? (April 29, 2007). A financial bubble (that bursts ... as they invariably do) in China could have devastating consequences for markets (and economies) of other countries (including the US, the UK, and Europe). It's definitely worth keeping an eye on developments in China.

Makings of a Chinese Stockmarket Bubble?

China is in the midst of a stockmarket frenzy. According to an article in The Economist magazine (April 26, 2007), new accounts at stock brokers are being opened at a rate of more than 200,000 a day (e.g., more than 310,000 on April 24th of this year). Many of these punters are relatively new to the market and are often either unsophisticated or relatively low-income (including, students and old-age pensioners).

What is fueling this madness for stocks? Despite a couple of scares earlier this year (February 27, and April 19), phenomenal returns (for now). E.g., the Shanghai Stock Exchange's composite index rose by about 130% in 2006 (and is still rising). (See the chart below.)


Having seen some newspieces from China Central Television's channel 4 news on the latest stockmarket craze, I can see how much the stockmarket has permeated daily life in China.

It's worth noting that another factor, besides hyperbolic returns, is driving this 'investing' frenzy -- consumer technology. By "consumer technology" I don't mean China's equivalent of tech stocks (although I'm sure they are enjoying a boom). Instead, it is the growing availability of communcation devices like cell phones, instant messaging, and broadband Internet connections that have reinforced and further enabled this stockmarket 'madness of crowds.'

So is this a bubble? It certainly has all of the earmarks of a stockmarket bubble that will eventually burst. The recent past has demonstrated that Chinese stockmarkets (in Shanghai and Shenzhen) are vulnerable to market volatility as well as to macroeconomic shocks and policy changes by the Chinese Communist Party.

One of those Chinese would-be investors, when describing China's stockmarkets, quoted by The Economist summed it up best: "It's like a casino set up by the Communist Party." If the CCP isn't careful, they will find themselves in quandry (which they may already be in). A rising stockmarket keeps the public (especially the growing middle class) mollified and gives the CCP more credibility. On the other hand, a bubble that burst could cause widespread anger toward the CCP. As Western capitalists can attest to, it is rather difficult (if not impossible) to reconcile those two agendas.

The Economist on Credit Derivatives and Market Liquidity

The Economist magazine has a couple of interesting (and related articles) on finance and investing.

In its special report, Credit derivatives: At the risky end of finance (April 19, 2007) , The Economist closely examines both the benefits and potential risks of credit derivatives. The pros of credit derivatives include the possibility that they make investing and trading in the bond markets more palatible. The cons are that they might be a ticking financial time bomb -- a "financial weapon of mass destruction" in Warren Buffett's phraseology -- that are vulnerable to shifting market conditions (e.g., a major increase in interest rates).

In this week's issue, Liquidity: Deal or no deal -- A new measure of market health (April 26, 2007), The Economist highlights how the Bank of England is trying to clear up the muddle about how to measure market liquidity. The Bank of England's measures (they have three) of liquidity is based on the "ease of buying and selling financial assets." According to its measures, the markets are flush with liquidity. Why? The article offers many explanations (hedge funds, financial innovations -- like credit derivatives, etc.), but it also points out that this surge of liquidity is a fickle thing. I.e., there will be more liquidity so long as investors are confident; when confidence wanes, liquidity probably will drop as well.

Mimicking Soros, Dangers of Low Volatility, & Collusion in the Music Industry

I've noticed several interesting articles in The Economist magazine recently that are worth noting.

In his/her column, Soros on the cheap (April 4, 2007), Buttonwood makes the case for currency trading as a valuable addition to an investment portfolio. In particular, currency trading based on exchange rate models that take into account the 'carry trade' (an arbitrage technique which is similar to short selling), momentum, and purchasing power parity, have shown themselves to be profitable.

In last week's column, Sting in the tail: Is low volatility making the world too complacent about risk? (April 12, 2007), Buttonwood makes an even more convincing argument that instruments, practices, and institutions in the financial markets that leads to a relatively low volatility environment most of the time may wind up increasing 'tail risk' (i.e., extreme risk). Low volatility may be a 'false dawn' -- or perhaps even a cruel joke being played by the forces of market randomness -- that lull investors and traders into a false sense of security ... suckering people along into making bad financial decisions until catastrophe strikes.

Finally, in the March 29, 2007, 'Economics Focus' column, Silent orchestration: Can record companies act in concert, even without agreeing to do so?, The Economist examines the possibility that there is tacit collusion in the music industry by applying the logic of game theory. This type of analysis is very important to monopolies, antitrust, and competition laws & regulations. As the column points out, it is difficult to hold a cartel together (tacit or explicit), but, using game theoretic methods, it isn't impossible.

Mad Money Gone Mad?

I have already put in my two cents about Jim Cramer (the host of CNBC's 'Mad Money') in a previous blog post: "Mad Money" Should Make Average Investors Mad (March 26, 2006). It seems that Jim Cramer has gone to new levels of madness by revealing how he and other hedge fund managers (Jim Cramer used to be in the hedge fund game) manipulated (either supposedly 'legally' or illegally) market information in order to boost their short-sell positions. One place you can read about this is in the New York Times DealBook blog (March 20, 2007). You can also see the video of the interview at YouTube.

If what Jim Cramer is saying is true, then the Securities & Exchange Commission (SEC) should take a serious look into these practices. One of the tactics, which Cramer calls "formenting," involved feeding deliberately false information into the markets. I'm not sure if this type of activity would fit into the 'fraud on the market' theory of securities law and regulation, but it's worth investigating.

As for Jim Cramer's other comments -- about how he thinks it's a swell idea to basically lie and defraud people as a hedge fund trader -- is so digusting to me that I can't seem to find the words to condemn him. I will say one thing though ... if you notice that my previous blog post warning people about the empirically demonstrated negative impact on the investment returns of those who follow Jim Cramer's Mad Money advice was written about a year ago ... at least my conscience is clear. The Econophysics Blog did a public service in putting up that post. This latest shenanigans by Jim Cramer proves up the wisdom of that year-old warning.

China & Grey Tuesday

As I've stated in the past, I try to avoid making this blog too event-driven. I'd rather let things happen in the markets, see if they are worth commenting on, and, if it is worth commenting on, try to analyze events after the dust has settled and clearer heads prevail.

Having said that, I think it is worth pointing out one aspect of last week's sharp and sudden drop in the financial markets. Dubbed 'Grey Tuesday' by some, the events of February 27, 2007 -- where the Dow Jones dropped by more than 400 points in a matter of minutes (a rate of decline that had been hitherto unprecedented) -- garnered a lot of attention.

A lot of the 'analysis' that was given on television seemed to focus on a lot of things (the terrorist attack in Afghanistan while Dick Cheney was visiting, etc.) that seem to me to be largely irrelevant. The one bit of news that probably did have a significant impact was the sharp drop in Chinese share prices that immediately preceded the drops in Western stock markets.

China had been experiencing eye-popping rise in stock market valuations. This brought the Chinese markets (in Shanghai and Shenzhen) to the attention of wary Chinese policymakers who were concerned about over-heating markets and rampant irrational speculation. These concerns moved Chinese regulators to talk down their stockmarkets as early as January of this year. Apparently all of these attempts to cool Chinese markets came to a head at the end of February ... much to the chagrin of traders and investors around the world.

'Grey Tuesday' -- or whatever one wants to call it -- should serve as a wake-up call to the investing community. This is yet another example of how much global markets are inter-connected to one another. Claims of adequate diversification via a simplistic approach to 'global' investing is -- as the most recent Buttonwood column (in The Economist) points out -- should be met with skepticism. Correlations and covariance between financial markets in different geographic regions are not static ... they are dynamic and market values tend to move together in the most inopportune ways (in downward directions almost simultaneously).

The rapid drop in market prices is also another example of the often 'wild' nature of randomness. Events in financial markets is a lot more jumpy than what most finance textbooks would suggest.