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.

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.