A Dynamic Future for Active Quant Investing

I recently put the following article written with my friend Rodney Sullivan on SSRN (I mentioned this effort in an earlier blog).  Without great surprise, this article should appear in Journal of Portfolio Management next year. 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679766

It is about our view on the future of active quant investing.  The current active quant investing model is fatally flawed, just like Euro being a flawed currency.  Take this analogy further, Euro may yet survive the current crisis, because it is more of a political tool to integrate Europe than a product due to economic rationale.  Without a unified fiscal authority, breaking down of cultural and language barriers to allow real free labor movements, it is a doomed currency, with the only uncertainty about its collapse being the timing.

The current active quant investing is similarly flawed.  They are mostly riding on some long-term trends unintentionally (e.g., small, value, and momentum).  If you take these long term trends away, they got little game going.  This means that some smart semi-active ETFs can easily replace them, with the same boom and bust cycle of performance.  This also means that clients should not have paid them that much for doing what they are doing today.

When they are against the trends, they have no clue what to do.  Even more strange is that in the last few years, I talked to quite a few quant firms and mentioned that they should incorporate some quantitative but not systematic analysis to turn around their performance.  Even though some of them made good offers to me, none of them is flexible about their investment approach.  I ended up not taking any of those offers because I thought they are doomed, at least in the long-term. 

Some of them did start to go down the direction that we discussed in the article.  Some of them are looking more into the macro level and try to incorporate more information there.  Even there, the only approach is systematic and pure quant, which essentially doomed the effectiveness of the macro push.

The above article provides a decent, yet somewhat incoherent, guide about how quants should change to make their long term business model viable.  Rodney was instrumental in moderating the tone of the article, but we still get some hate mails, and we understand there could be many more hatred out there.  I am good at making the piece more coherent, but I sometimes cannot hold my punches.  So the current state of the article may be the best constrained optimum, given the hate mails we have already got. In the next revision, we will try to make it more coherent yet still moderate enough, and also incorporate any comments we get.

What surprises me is how close minded many of the quants are.  Even if the article is completely garbage, there is no need to hate, especially given the sorry state of quants in the last few years (which I correctly predicted in early 2008).  At least be open minded and see if there is anything useful there.  I would do that myself.  Further, I am surprised that no one was flexible enough to at least allow me to have an alternative investment approach under their roof in the last couple of years.  Maybe the only alternative is to have a start up to run an independent show, even though that takes a lot of time and preparations.

Is the U.S. doomed if USD is debased?

There is a lot of fear out there, linking the recent weakness of USD to the long-term doom of the U.S.  Even if we do not consider that USD is still not below the level in 2007 on a trade-weighted basis (there was not much of this kind of discussion then), this fear is completely baseless.

We do not have to look far back into history to have so many countries seeing their currency depreciated at some point and then come roaring back to the top of economic form.  Among developed countries, Britain and Canada easily come to mind.  Was Britain cursed when the pound collapse under Soros attack?  One key reason for the recovery of many countries is export driven growth.  That aside, using currency to measure a country’s long-term prospect is misguided.  It is the economy, stupid ;=).  Whenever faster growth and fuller employment happen, either due to currency devaluing or not, the currency is likely to appreciate again. 

So in today’s U.S., anything that could help improve growth and employment, including devaluing USD, should be considered as a viable policy tool, and is likely to result in long-term appreciation of USD. 

My view on Mr. Market, maybe more to follow on this topic

Is market efficient? No.

Is market stupid? Many times.

Is it easy to beat the market? Not really.

Should investors react strongly and positively to Citi's earnings news?

Since one of my friends liked this entry, I will expand it a bit more here.


From WSJ today:

"The bank's third-quarter profit was $2.2 billion, up from $101 million a year earlier, with per-share profit of seven cents coming in just above analysts' estimates. The amount the bank set aside for credit losses fell. Revenue rose 2% from a year earlier, to $21 billion, but fell 6% from the second quarter."

The markets react strongly and positively to the positive earnings news from Citi.  It actually brought up the whole financial sector, and the whole markets.  However, if investors know something about earnings management, the earnings pattern of Citi smells like classical  accrual earnings management.

Generally, firms that announce earnings slightly beating zero threshold (e.g., 1 cent per share) or analyst estimates (e.g., if analyst consensus is 6 cents and the announced earnings is 7 cents) are found to be most likely to have managed/fudged earnings.  See Burgstahler, D., Dichev, I., 1997. Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics 24, 99-126 for further evidence.  The academic literature even find that firms may manage earnings just enough so that it is e.g., 0.5 cents about zero or analyst consensus.  When the number is rounded up, it becomes 1 cent more than zero or analyst consensus.  I am not sure if Citi is using this later roundup tools.

How could firms management earnings?  Generally, they could use either accrual or real earnings management (AEM and REM). In AEM, firms exploit the flexibility under GAAP to classify items differently.  For example, the following paper show the the main forms of accrual earnings management are as follows:

    * Unsuitable revenue recognition
    * Inappropriate accruals and estimates of liabilities
    * Excessive provisions and generous reserve accounting
    * Intentional minor breaches of financial reporting requirements that aggregate to a material breach.

See Healy, P. M. and J. M. Wahlen. 'A review of the earnings management literature and its implications for standard setting', Accounting Horizons, December 1999, pp. 365-383.

So the way that Citi has met and slightly beat earnings expectation is through the third forms above. Although I am not able to check extensively, this pattern makes me suspicious that as one of the masters of the Universe, Citi must know how to do it right so that the trace of earnings management may be less obvious.

Companies also do real earnings management, which include abnormal production to affect costs of goods sold expenses, along with timing sales recognition, R&D and advertising spending, and asset sales.  For example, company could cut the current period R&D expenses to meet earnings expectations.  They could also slash price and bring forward sales into the current period to management earnings.  They could try to realize gains on asset sales to boost up earnings.  Different from AEM, REM 1) involves changes in the timing or structuring of operations, investments, and/or financing transactions; 2) have cash flow consequences; 3) do not necessarily reverse automatically; and 4) are more difficult to detect because it is easily disguised as normal operating decisions.  In a survey of CFOs, the following paper finds that managers prefer to use REM.

See Graham, J., C. Harvey, and S. Rajgopal, 2005, The economic implications of corporate financial reporting, Journal of Accounting and Economics 40, 3-73.

A well known paper by Sloan shows that accrual earnings management can predict future returns.  Firms with more AEM to boost up earnings would subsequently outperform in stock prices.  The main explanation is that investors do not fully understand the impact of accruals and blindly react to the announced earnings numbers (which is partly fudged).  So if that is the case, Citi shareholders are likely to experience some relatively lower returns in comparison to stocks with similar risk/characteristics.  This accrual characteristic has been used by buy-side money managers extensively in the last ten years.

See Sloan, R., 1996, Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289-315.

Similarly to Sloan 1996, I have a recent working paper in which I find that firms practicing more REM to increase earnings would suffer lower future stock returns.  See my paper "Real earnings management and subsequent stock returns: at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679832.  The paper has been presented at the annual meeting of Chicago Quantitative Alliance, a national organization of mostly buy-side researchers and portfolio managers this September.  It has made every top ten downloaded list that fits its category.  Part of the paper is likely to be in most every buy-side managers' toolkit in the future. 

401k track record from 4/2001-9/2010: 109%

I finally get the 401k statement for some other reason.  I requested that they provide year by year return number so that I can show that there is probably no year with negative returns.  However, it does not have a break down for each year (maybe I will ask them again, which will take a while).  But it does have a total return over the whole period.  The total return from 4/16/2001 to 10/1/2010 is 109% (so over about 10 (9.5) years).  And it is restricted to only a short list of mutual funds (generally the choice is less than 10).  So it is a very constrained investment opportunity set and I do not have full time to trade this that frequently (and it has restrictions against frequent trading).

The annualized return, if you put into excel, is about 8.1% per year.  I hope this does not disappoint my readers given the simultaneous markets' performance.  If 8% annualized a year in the last decade sounds boring, how about no or almost no negative returns in any of the last 10 years ;=).  So the Sharpe ratio, or the ratio of return to volatility, is likely to be quite higher, because of the relatively little volatility in performance.  I also get every trade executed in and out of the mutual funds from this statement.  If you or you know any one who have a chunk of money and would be interested in this kind of performance (or better), I would happy to provide the service.  I have my own company to take care of the administrative stuff.  The investments will be in highly liquid securities (or pure mutual funds, like my 401k), and will have relatively low risk exposure and low correlation with market performance through my 'impressive' asset allocation.

The reason for little volatility or negative performance in my performance is because I had everything in cash in 2002 and 2008, the two big market down year.  There is no long-term T-bond fund in the 401k account so there is no way to capture the upside in those down years.  But zero return is still way... better than 30-50% downside, right?

Another thought, I wonder how many are educated enough to recognize, this kind of long-term performance would be quite attractive in any environment (either at the start of 2000, when bull markets are raging, or at the depth of the bear markets in 2008).  These are equity like returns with bond like risks.  That is close to heavenly investing.  I hope I can repeat this performance for the years to come.  The paranoid survives. 

Confirmation about my predictions on US and Chinese trade balance

As I mentioned earlier, this will be the case for the quarters to come

http://xlpartners.blogspot.com/2010/08/preoccupation-on-nominal-exchange-rates.html

until we have some serious threat of trade war or maybe actual trade war.  This is the single most important threat to the smooth rise of the emerging markets.  This is confirmed again with the latest data


http://online.wsj.com/article/SB10001424052748704361504575551811511078860.html?mod=WSJ_hps_LEFTWhatsNews


"The U.S. trade deficit with China grew to $28.04 billion from $25.92 billion in July. Imports from China grew 6.1% to a record $35.29 billion. Meanwhile, exports fell $92 million to $7.25 billion."

If you want to see what it means by pyramid builders, look at this

"Four of Bank of America's top 10 shareholders have sold 10% or more of their holdings since March, and the bank's shares are down 34% since reaching a 52-week high of $19.86 in mid-April."

I did not check those holders specifically. Since a few top hedge funds earned an enormous profit from loading a huge amount of shares of BOA and other banks, it is likely that some of them are among those four.

http://online.wsj.com/article/SB10001424052748704127904575544161532372790.html?mod=WSJ_hps_LEFTWhatsNews

Are Americans really sour on “Free Trade”

WSJ/NBC poll shows that about35% of Americans are for and against free trade around 2000.  Now above 50% of people are against free trade, whereas less than 20% of people are for free trade. 

http://online.wsj.com/article/SB10001424052748703466104575529753735783116.html?mod=WSJ_hps_LEFTWhatsNews

In comparison, in the policy circle, the majority of pundits are still for free trade.  What's the problem here?

The problem is about the definition of free trade.   Trade is not free unless your trading partners do not manipulate exchange rate, repress compensation, run ultra low or negative interest rate, subsidize exporters with substantial sums.  I am not hinting at just China, but all the whole East Asian region and Germany.  If the current trade system is "free trade" system, Americans are rightly rejecting this fake system.  Without righting the wrongs in this system to make trade really free, this current trade system is bound to collapse in less than 10 years, and likely shorter period of time. 

When that happens, the bulls on emerging market stocks and debt should be ready for some real rock and rolls.  That is the weakest link of the whole recovery thesis and emerging market emergence thesis.  If there is some way to bet on this collapse, I would be most interested in it. 

Sheer determination is neither sufficient nor necessary to make a great nation

(This is a post that I wrote about a month ago but did not have to post.  I have added a news article that confirms my predictions.)

Many great nations of the world today and in the past (not necessarily big nations) seem to share a common characteristic: sheer determinations (for example, the determination to succeed against all odds and the determination to endure in the face of great sacrifice).  Many aspiring nations thus try to instill this seemingly intuitive concept in their population.  However, I want to argue that sheer determinations in fact are neither sufficient nor necessary for a great nation.  On contrary, when combined with wrong policies, they could lead to a tragic end.  For example, the great experiment of communism failed not due to a lack of sheer determinations.  It was executed and implemented with sheer determination paralleled only by religious zeal.  However, this utopia was unable to produce workable policies, which lead to not only its own failure, but also extreme human catastrophes and sufferings. 

Today I fear that nations such as Ireland or Spain are making the same mistake.  Their mistakes are so similar that understanding the correct solutions to their problems would have profound implications to large, and particularly small nations in the Western world. 

Take Ireland as the example.  With the determination to succeed, the Celtic tiger achieved tremendous growth in the last couple of decades.  However, this growth also induces a huge property bubble.  With the bubble collapsing through the Great Financial Crisis in 2008, Ireland made two mistakes that are being repeated by almost every developed nation, large or small, in the world. 

First, Ireland bailed out the stakeholders in Irish banks and put all the liabilities on the public balance sheet.  Since Irish bank's liabilities are very large in comparison to Irish government balance sheet, this approach puts tremendous burden on the Irish people.  This burden is the root cause of the extreme austerity practiced by Irish government today.  At the same time, since this approach does not completely unclog the financial system, the wobbly Irish financial institutions are still reluctant to provide sufficient funding to the Irish economy.  This movie is being played in most Western nations today. 

Second, as if Irish people have not suffered enough in the last few centuries, the Irish people not only needs to repay the debt that went sour but also suffer severe cuts in their welfare.  The Irish government, and many wrong-headed policy advisors, have so far cast a cursing spell on the Irish people by successfully arguing that the sheer determination to endure in the face of great suffering is sufficient and necessary to solve the problems and that growth can result from severe cuts of government budget in the face of a quasi depression.

Both approaches are completely mistakes.  In the first situation, the correct approach should have been wiping out the shareholders, forcing bondholders to take a big haircut and to convert their remaining stakes into equities, and inject government funds as debt (and equities if necessary) in the failed financial institutions.  The reformed financial institutions could easily raise further equity and debt financing on the public markets given their clean balance sheets.  These institutions would also be willing to lend for the same reason.  I have suggested this approach since the fall of 2008. 

After Ireland committed missteps in the first situation, the correct approach for a small nation like Ireland would be to replace Euro with Irish pounds and devalue its currency substantially in the process.  Ireland suffers from a loss of competitiveness problem from the collapsing property bubble.  Its problem could be solved through either internal deflation or currency devaluation.  Since it shares Euro, currency devaluation is currently not available.  Internal deflation is much more painful and does not guarantee success.  In the recent years, as Ireland cuts benefits and services, the magnitude of GDP shrinks, due to the cuts directly and the increased saving by the population as a response to the cuts.  The double-digit fall in GDP actually leads to an increase in total debt to GDP ratio (due to the sharp fall in GDP) and the credit spread between Irish government bonds and German Bunds (the benchmark risk free securities in Europe).  See this new article here:

http://online.wsj.com/article/SB10001424052748704029304575526190591102772.html?mod=WSJ_hps_MIDDLEThirdNews

The sheer determination to endure in the face of great suffering is not sufficient to solve the problem of a small nation like Ireland.  In fact, it is not sufficient for big nations like the U.S. for the same reason. 

Since Ireland is a small nation (its GDP is less than 5% of the European GDP), the sheer determination to endure in the face of great suffering is not even necessary to solve Ireland's problem.  Instead, if Ireland replaces Euro with Irish pound, and devalues its currency substantially in this process, the export-driven growth would be able to pull Ireland out of the current slump, just as in any similar crisis in the past, especially for emerging markets.  The smaller Western nations in deep slumps should understand that the sheer determination to endure in the face of great suffering is neither necessary nor sufficient to solve their current problem.  Adopting the current approach would help solve their problem sooner.  (Unfortunately, the second solution will not apply to large nations). 

Pyramid Builders

It is a little surreal that stocks were poised for substantial further gains after September.  All the risk factors are there, and the warning signs getting louder.  However, thanks to people like John Paulson, who are "naïve optimist" as phrased by Wall Street Journal (not me, see Paulson and the bulls bounce back at http://online.wsj.com/article/SB10001424052748704380504575530394039883672.html?KEYWORDS=john+paulson), and David Tepper, who is opportunistic in taking Bernanke put (http://www.ibtimes.com/articles/20100924/video-appaloosas-david-tepper-ben-bernanke-will-make-everything-go-up-in-the-cant-lose-environment.htm), the market got back to life in September.

What these hedge fund managers, and many other institutional managers, are doing is simply building pyramids.  The liquidity is very low (http://online.wsj.com/article/SB10001424052748704380504575529983796910668.html?KEYWORDS=low+volume+september), with most investors sitting on the sidelines.  So the strategy of Paulson & Co. is to push stock prices up to get a good return number for their own fund.  More importantly, by pushing up tock prices, they create the fear in the weaker mind of some investors about missing any potential rally.  If they could push hard enough, they may be able to build a pyramid scheme, and then get out before every one else, making some handsome sum for themselves.

If we do not have enough weaker minds, then these pyramid builders may have trouble holding the bag on the top of the pyramids by themselves. I sincerely hope they do not succeed in luring the weaker minds, because that is likely to make those weaker minds suffer another serious blow in their personal wealth when these weaker minds find themselves holding the bag at the top of the pyramids. 

How stretched is the market? We could look at every major economic number and they are still trending down. I would post the US PMI data along with stock data here, and the European number is the same.  PMI usually have strong predictive power for stock returns during the recessions.  This relation may break up during recovery, because stock prices would bounce back much more quickly.  However, what we see is that the US PMI is trending downward again after a good recovery later last year and early this year.  The stock price and PMI have the largest diversion (stock prices sharply up and PMI down at intermediate level) since a long time.  This only smells trouble for stock prices for months ahead, especially the likely trend for PMI is further down.

What's different from the last Bernanke put early last year and the current situation is the one-legged nature of stimulus.  Last year, the monetary stimulus, aka the last Bernanke put, jumped start the rally.  The rally probably would have fizzled out quickly without the substantial fiscal stimulus.  The fiscal stimulus also helps sustain and amplify the inventory restocking cycle.  That is probably the main reason that we could have such a long rally up to today.

However, this time around, we have no fiscal stimulus to sustain the rally.  The current fiscal stimulus can only provide drags on the economic growth (I talked about this in earlier posts).  There will be some small fiscal package here and there, but there will be no 800 billion package any more.  Although some would still have some delusion about Republican sweep in the House, and potentially Senate, the only consequence of that outcome will be a divided Congress that does not function at all.  With Republican's eye set for White House in 2012, do not expect any stimulus, unless the economy has already fallen into abyss again, similar to late 2008.  They would not appreciate any real recovery, which can only benefit Obama, and derail the Republican political goal in 2012. 

Mr. Paul cannot say it better about wisdom or insight

I said similar thing when I discussed why you may be interested in my blog. 

"This is what you need to know: important people have no special monopoly on wisdom; and in times like these, when the usual rules of economics don’t apply, they’re often deeply foolish, because the power of conventional wisdom prevents them from talking sense about a deeply unconventional situation."

http://krugman.blogs.nytimes.com/2010/09/27/the-power-of-conventional-wisdom/

Defining Global Macro Quant Equity

In strictest terms, quantifiable information is that which investors can back test and assign a statistical significance level and then systematically implement.  A broader definition would include that which is quantifiable but cannot necessarily be assigned statistical significance or systematically implemented.  The broader definition is where I believe a new opportunity for global macro quant equity lies. 

Most of self-ascribed quant equity investors today use only the first set of quantifiable information, and mostly from the bottom up perspective.  My friend, Rodney Sullivan, and I have a new paper suggesting that quant investors should seriously consider applying a global macro approach that use the broader set of quantifiable information.  This paper can be found at the SSRN.  Both he and I have been keen to this approach for several years now.  I summarize this paper by way of an analogy. 

Before 2008, the quant ocean liners were faster the other ocean liners.  In particular, the pure quant ocean liners have the most systematic implementation and strictly rely on the quantifiable information that can be back tested with statistical significance.  They are the fastest of all.  These pure quant ocean liners are our focus. 

As a result of their success, the captains of the pure quant ocean liners hired many superb engineers and kept all of them under the deck tooling the ocean liners.  These captains made the rule that no one should waste any time above the deck.  This worked as long as the luck is on their side, i.e., the weather is great so that there are no icebergs, and all the undercurrents are flowing in the same direction as these ocean liners. 

From 2008, the weather starts to change.  Icebergs start to appear in the ocean and undercurrents start to turn against these ocean liners.  If these captains or his crews have been above the deck, they would have noticed this.  However, the under-the-deck rule prevents them from seeing that.  These ocean liners almost all hit the first iceberg, suffering significant damage. 

However, the captains of these ocean liners thought that this is just an anomaly and no iceberg will appear again.  So he insisted that his men mostly continue doing what they did, with the under-the-deck rule still strictly enforced.  What he and his crews did not know is that icebergs are popping up all around them this time, quite different from any difficult periods that they had before.  And the undercurrents are totally against them.  Soon enough, these ocean liners all hit icebergs again in 2009 and were severely damaged this time.  Undercurrents were initially against them strongly, pushing them backwards substantially in 2009, but then showed no direction in 2010.  With the engine sputtering and no clear direction of undercurrents, these ocean liners start to float with currents with no clear direction in 2010. 

Should the pure quant ocean liners do something drastic about it?  Just think about Euro.  It is a flawed system that may survive for a while, but its death is certain under large standard deviation events unless backed by a united fiscal authority and active efforts to bring down the culture and language barrier (so that labor and capital could flow freely within the Euro Zone).  The pure quant ocean liners are in the same situation. 

The captains of some of these ocean liners did start to order his crews to do something different, under the pressure of their passengers.  They gathered information about the history of the last two large iceberg accidents and maybe some smaller iceberg incidents in the past.  They want to use the information to predict the positions of any future icebergs.  This is a great improvement, and is part of what we advocate. 

However, trying to predict future icebergs purely with the limited information faces insurmountable challenges.  It is important to eliminate the under-the-deck rule so that the weather and current conditions can be taken into consideration in future navigation to avoid future icebergs even though those conditions cannot be back tested with an assigned significance level or systematically implemented.  After all, even the best dedicated surveyors of these conditions such as George Soros could not necessarily produce a statistically significant track record of forecasting (To understand why this is the case, please see my earlier post on global macro investing: http://xlpartners.blogspot.com/2010/08/what-is-important-in-global-macro_4346.html).  We also suggest that these captains should use all useful information instead of throwing some important information out. 

Further, these captains never had any idea about the issue of undercurrents. These captains do not fully understand that even if their ocean liners seems to be tightly constructed with everything based on statistical significance and systematically implemented, these ocean liners frequently have serious unintentional biases.  Some of these biases are persistent, e.g., small size, value, and momentum.  Other biases are incidental and last for a period and then disappear. 

When these unintentional biases are in the same direction as the undercurrents, like in the few years before 2008, they bring significant tail wind to the pure quant ocean liners.  When these unintentional biases are in the opposite direction as the undercurrents, the pure quant ocean liners face substantial head wind. 

The power of these unintentional biases is so large that many times most of the mileages covered by the pure quant ocean liners are due to this power.  Understand and be mindful of these unintentional biases is important to both alpha generation and risk management.  It is dangerous not to fully understand the unintentional bias while navigating the rough seas. 

For one example of unintentional biases, I would refer to one discussion by Jeremy Grantham in his most recent quarterly report (see the last two paragraphs on p5)

http://www.gmo.com/websitecontent/JGLetter_SummerEssays_2Q10.pdf

I have only read less than five reports of his ever due to the lack of time and their lack of short-term timing ability.  However, I find that all the reports are extremely insightful, especially for funds serving long-term institutional investors. 

A similar simple example is about small cap and value in different time periods.  As mentioned above, the pure quant ocean liners persistently have these biases.  In 2000, these segments are undervalued, which gives the pure quant ocean liners substantial tail wind in the last market down turn from 2000.  In 2008, the same segments are quite overvalued, which gives the pure quant ocean liners substantial head wind. 

So by global macro investing, we argue that the captains of these ocean liners need to add the top down quant models to systematically incorporate any global macro information that they can incorporate this way.  These captains also need to use quantifiable fundamental global macro information even if they cannot systematically implement it.  These reinvented ocean liners will be global macro quant equity ocean liners. 

Most of the issues discussed above are in three papers that I wrote in the past.  The first two papers are free for circulation if I am invited for presentation.  Feel free to contact me at xli5@hotmail.com if you are interested in these papers.  The last paper is only available for a handsome sum.  If you are interested in the last paper, you can learn about the first paper before you decide about the third paper. 

Li, Xi, 2007, Unintentional bets of pure quant investing, Working Paper, XL Partners, Inc.

Li, Xi, 2009, No religion in quant investing, Working Paper, XL Partners, Inc.

Li, Xi, 2008, Why does pure quant investing have unintentional bets, Working Paper, XL Partners, Inc.

What is the next big number to watch?

To me, the next big number would be ISM to be announced on October 1.  Given the contradictory number of ISM and regional surveys in the last couple of months, seasoned forecasters like David Rosenberg and Roubini.com have argued that it is highly likely that ISM will be corrected downward in the subsequent couple of months.  Let's see if they are right in the first month after their forecasts. 

Academic literature and quant investing

I would be interested in any of your comments here.  My experience is that most buy-side quant managers get most of their ideas from academic literature.  There are different variations but the quant managers really do not have too much fundamental innovations of their own.  However, the problem for quant managers and academic literature is that the academic literature really had nothing really new in the last 10 years.  We got lots of papers published claiming substantial abnormal returns, but there is nothing really that have longer-term efficacy and relatively low correlation with the previously discovered ones.  Maybe your experience is somewhat different?  

The flation debate

There are extreme arguments on the both ends of the spectrum in the flation debate.  Since I advocate T-bonds for the next six months, many may perceive me as a permanent deflationist.  But I am not.  All I argued was that in the short term the danger of deflation is clearly a magnitude greater than inflation.  The reasons are listed in my earlier blog on the stimulus debate. 

http://xlpartners.blogspot.com/2010/08/future-intellectuality-of-stimulus.html

For example, in a liquidity trap, which the U.S. have not faced for the past 70 years, no matter how much money you print, it would have no effect on inflation.  Money will not become toilet paper, and they will hold value pretty well.  The only exception is a catastrophic inflation shock like the oil crisis in the 1970s (I also mentioned this in the above-mentioned blog.  In fact, I could have easily expanded each sentence in the above-mentioned blog to a couple of paragraphs, but I thought to save readers some pain). 

The most likely scenario is that we will bounce around zero inflation for quite a few years.  Whether we can get out the liquidity trap is more about politics than economics.  If the two parties can unite, and if we can educate Americans about the very large numbers that I argued in the above-mentioned blog (another two trillion fiscal stimulus and Fed balance sheet totaling 10 trillion through inflation and exchange rate targeting), we will get out of the liquidity trap in no time.  However, the political situation, and the lack of education on this aspect, makes liquidity trap the most likely scenario.  Fed, for example, will only likely step in after deflationary scares (when we have mild deflation) and will likely take away the support prematurely before mild inflation can take root.  A modern democratic society is nearly impossible to use the brutal liquidationist approach that Hoover initially adopted in the face of the market crash.  However, the same society is likely to be balanced by the little Hoovers so that it cannot adopt drastic stimulus. 

So my suggestion of investing in long-term T-bonds or shorting equities in the next six months is based on deflation scare, not permanent deflation. 

http://xlpartners.blogspot.com/2010/08/it-is-still-not-too-late-to-join-party.html

Even if Fed would step in to save the market, they would only act when market is in real danger, and you probably should have taken profits before that time.  I admit that I may have been somewhat early on this trade.  Q4 2010 and Q1 2011 are the earliest periods that we are likely to have significant double dip scares in GDP growth.  Later next year are the periods when we are likely to have significant deflation scares.  I recommended this trade in early August because you would have thought that markets are not as short sighted or overly optimistic as they are now.  In retrospect, it seems to me that the significant T-bond appreciation before September may also be partly due to some prominent hedge funds rewinding their losing bets against T-bonds.  A few were actually closed due to this losing bet. 

So if the U.S. could adopt more stimuli as I suggested, my recommended trade would hurt badly.  I sincerely hope that the U.S. government could follow my policy recommendations, even if this will prove that my trade recommendations are wrong.  Another reason to adopt the inflation approach is because it eliminates substantial amount of debt even at very low levels (e.g., 3%).  Although morality is intuitively attractive, the reality teaches us that we have to forgive the debt anyway, either through defaults (either mass defaults as in the Great Depression or slow burn defaults as in the Great Recession) or inflation. 

http://blogs.wsj.com/economics/2010/09/18/number-of-the-week-defaults-account-for-most-of-pared-down-debt/

However, the political gridlock are only likely to increase more after the mid-term election, and the cautious style of Obama proves that he is more of a politician than an idealist in comparison to FDR.  Maybe we need another disaster before the U.S. can get a more idealistic president in the Oval Office. 

For the longer term, it is crazy to me to only believe in extreme arguments on either end of the flation debate.  I was quite concerned about inflation for a little while too.  But the baseline scenario to me now is near zero inflation for a long while with relatively small inflation risks from potential catastrophic price shocks (e.g., disasters in food supply maybe due to further global warming or conflicts with Iran). 

Some may argue that the U.S. is different from Japan in demographics, which reduces the deflation pressure.  The birth rates and immigration are both higher in the U.S.  The latter may not be of much help because fewer people would come to the U.S. due to the relatively stronger growth outside of the U.S. and because the potential escalating hostility against immigration due to the high unemployment. 

BTW, I understand that PIMCO made some inflation hedges.  The absolute number seems big, but it is tiny in comparison to PIMCO’s overall bond portfolios.  I also understand that import price have jumped, but that is only for a month and the external exposure of the U.S. economy is very small, with imports only being around 16% of GDP.  In fact, the U.S. probably has the lowest external exposure among developed countries and most large developing countries.  I also understand that food and energy prices have increased, but that will take a while to affect the core price index, and they usually do not persist given the generally elastic supplies. 

Sharp Worded Me

Some readers of this blog may find that the blogs to be somewhat blunt, and sharp tongued.  Well, I apologize if you are not used to the style.  However, I feel that bluntness is the necessity of any blog.  I may be wrong, but it seems to me that readers generally are more attracted by the sense of epic battles. Also, if you make ambiguous wordings and references, and going in circles in terms of logic, to avoid offending any one, you are likely to lose your readers.  That would be a disservice to the readers, because they deserve a clear explanation.  I will always try to be objective.  This virtue should never be compromised.  You can count on me that I will always be true to reasoning, recognize where I am wrong, and will not be affected by dogmatism and religion in anything.  Remember this blog is called "Eclectic Investors ;=)"

In daily life or work life though, one should be much more tactical because bluntness may achieve exactly the opposite effects.

A touching story told by the author of Harry Potter at Harvard Commencement

http://harvardmagazine.com/commencement/the-fringe-benefits-failure-the-importance-imagination


Please see the above link for a touching story that we as part of the humanity could all learn some.  If you can not find some echos here, you may want to have some reflection on yourself and your life.  My tears dropped when I read it, and I am not a very sentimental person.

One-Legged China

 One of my friends challenges me with the following question:

In our last discussion, you insisted that Chinese export contribution to its GDP growth is at least 40% to 50%, far more than the 30% or so I mentioned.  Here is a link to a BW article: Why the Export Slump Won't Doom China's Economy.

http://www.businessweek.com/globalbiz/content/apr2009/gb20090420_581968.htm  

The authors stated that Chinese export counts 12% of GDP, contributes to 3% of the11~12% GDP growth.  I largely agree with them.  Are their data wrong?  If they were grossly wrong, then your bearish arguments about China and bullish arguments about the US long bond would carry a lot more weights.  Would you mind pointing out the Chinese economic data sources that you use and deem reputable?
 
I do not remember that he actually mentioned 30%, and I mentioned current account surplus, instead of export.  And my common sense tells me that Chinese export is far greater than 12% of GDP.  It is also such a laughable article that Business Week, a seemingly respectable Magazine, seems only to be able to serve the entertainment purposes today.

So now let’s look at the numbers by comparing the GDP growth rate and current account balance using data from IMF.  The idea here is that if current account surplus as a percentage of GDP is about half of the GDP growth, then current account surplus contributes to about half of China’s GDP growth.

The data seem to even surprise me.  The first graph shows the GDP growth rate, and current account balance as a percentage of GDP, whereas the second graph shows the later divided by the former.  The graphs, especially the second one, say that almost all the Chinese GDP growth is from current account surplus in recent years (from 2005), hence my blog title “one-legged China.”

Since the 2009 number from IMF is just an estimate, we probably should obtain the final number instead.  However you calculate it, my argument stands.  For example, a Google search shows that the media generally quotes a 2009 current account surplus of about USD 290 billion for China.  If you divide that by the Chinese GDP of about USD 4.5 trillion, that is about 6.4%.  So current account surplus would be about half of Chinese GDP growth.

And pay attention that this is not always the case.  Current account balance was negative for many times in earlier years, and current account surplus was never as large share of GDP growth as it is now.

People like Steve Roach still argue that it would be a smooth cruise for China to switch from export driven growth model to domestic consumption driven growth model (see The new lesson for resilient Asia, Financial Times, June 8, 2010).  I hope that these people would finally come to senses about the reality of the one-legged China and the difficulty, along with the grave danger, facing China and the world in this transition process.  Even if China starts the transition process voluntarily soon, it could easily take China more than a decade, with significant bumps in between.  If China still drags its own feet while the world all suffers from diminishing demand, any sensible Americans should vote for trade war by the end of next year with unemployment likely staying around 10%.  Those who argue today that it is a silly idea to blame East Asian countries for any problem facing the United States are themselves blind.  Those who still make the same argument by the end of next year are just stupid.

And if you would like to challenge me on facts, you should bring your facts and data, instead of asking me to prove against some entertainment story ;=).

Would raising competitiveness solve the world's problem?

In the new world of globalization, a fashionable phrase after the financial crisis is raising competitiveness.   A lunch tale from my own experience exemplifies how catchy this phrase is.  As the European sovereign crisis unfolded in April, I was having lunch with a large group of financial industry professionals, many of whom have master and Ph.D. degrees and at least a few years of experience in the financial industry, as well as the CFA designations.  At the time, the Greek sovereign CDS shot out of the roof, and our discussion inevitably touches on the crisis in PIIGS countries.  The sentiments at the table are that these countries deserve to suffer unless they can raise their competitiveness through internal deflation and that these countries are too small to affect the global economy and we can just leave them alone. 

I was the lone dissident.  I tried to explain that in today’s world of deep globalization, “no man is an island.”  When the bell tolls, be prepared to help instead of standing aloofly.  I also tried to explain that the problem for the world today is not a lack of competitiveness, but an unbalanced growth.  In fact, a lack of competitiveness cannot exist for the world as a whole.  After all, competitiveness is always in relative terms. 

A few days later, the unfolding events quickly proved that we couldn’t stand aloofly while the crisis spreads.  At the time, the possibility of contagion started to shake up the whole European markets, as well as the U.S. markets. 

It is the other point that is more difficult to prove, and I think it deserves some explanations.  Take Europe as an example.  It is well known that Germany raised competitiveness related to the other European countries during the last decade after a painful post-unification digestion period in the 1990s.  As a result, the unit labor cost, which is the most important cost for most developed countries, is lower in Germany than in other European countries.  As a result, even though Europe has a largely balanced trade with the rest of world, countries like Germany run a large trade surplus against the rest of Europe.  The unbalanced trade and growth within Europe is the root cause of today’s European crisis. 

Even though PIIGS countries could catch up the German standard of productivity, it does not solve the world’s problem.  Rising competitiveness in these countries might balance the trade within the Euro Zone, which is currently the biggest problem.  However, it also would transform the Euro Zone as a whole from a region with balanced trade with the rest world to another East Asia.  That would be a nightmare for the whole world. 

In nominal terms, the Euro Zone GDP is close to that of East Asia as a share of the world’s GDP.  Combined at today’s exchange rate, these two regions produce close to half of the world’s GDP.  Intuitively, for the whole world, we know that the total amount of exports and imports should equal to each other, and the total amount of trade surplus should equal to that of trade deficit.   Thus, if the Euro Zone were to run a level of trade surplus as a percentage of its GDP similar to that of East Asia due to their newly gained competitiveness, the rest of world will have to consistently run at least as high a level of trade deficit as a percentage of GDP.  In the long term this is mathematically impossible, unless we can export to Mars. 

More importantly, a single-minded focus on raising competitiveness would threaten the current globalization process, which has been largely peaceful to date.  The first half of the 20th century is a period when nations focus single-mindedly on raising competitiveness.  We all know that the outcomes were trade wars and World Wars.  Instead, for globalization to stay its course going forward, the fashionable phrase, and the only solution, should be balanced growth. 

What is important in global macro investing?

Global macro investing has a few unique characteristics (This will be a continuously updated post given the importance of this topic and the difficulty to be complete at one shot. Looking for updates in the future):

1.    It would be silly to talk about t-statistics in global macro investing.  The breadth, or the times that you can place bets, through global macro investing is very small.  Generally, there is no way to measure statistical significance here.  Instead, you have to do thorough investigation to magnify the odds of winning in each situation.

2.    As a result, unless you are really sure of the probability of winning (e.g., 90%), it helps not to place the bets, even if the alternative is zero yield cash investments. 

3.    As another result, you should not be overly greedy by leveraging up too high.  If a strategy with limited leverage can make 20% during a short period of time within a year with little or even negative correlation with the market returns, stay with this strategy instead of leveraging up n times.  Otherwise, a sudden market swing against you could deal a disastrous blow, and you may lose a lot of money instead of making a lot of money, even though you get the strategy perfectly right.  After all, a consistent 20% each year would easily put you within the category of legendary investors.

4.    Global macro investing requires patience.  Once committed, you should give it at least six months to a year to work out.  And you should leave yourself the flexibility to hold the line in any reasonable cases in this horizon.  For the same reason, you should also resist the urge to time the market by increasing the bets substantially within a short period time in the hope of achieving astronomical returns.  This is related to the discussion in point 3.

5.    Determining the right instruments, as well as the right leverage, is at least as important as determining the right strategy. 

6.    If you are doing both longs and shorts, you do not have to rewind the positions at the same time. 

7.    Global macro investing is more about the ability to analyze and interpret the information than collecting new information.  After all, most of the relevant information is publicly available and is released to most people at the same time.  The ability to synthesize the information and draw the correct conclusion is crucially important and is a personal gift. 

8. Debate and discussion are very helpful in global macro investing to certain extent.  At the end of day, you have to put the money at where your mouth is.  Frequently you will find people all hold on to their own believes, right or wrong, without ever being able to be persuaded.  And most people are all cheap talk, with no ability to invest and make money.  It is better to force them to make the investment decision according to their believes and see about the outcomes.  After all, you should only invest when you have strong believes in global macro investing, and at the same time, you cannot always miss opportunities while others can consistently make money. Too much debate is a total waste of time. There is an old Chinese saying: whether it is a horse or mule, the easiest way to tell is to take it for a ride. 

9. People who make correct global macro calls are generally generalists, not specialists or experts.  In the last two years, there was a bit soul searching in the annual meeting of America Economic Association why few economists foresaw the Great Financial Crisis.  The investment industry should have done the same thing.  But the fact of life is that those few economists may be able to call the Crisis even if they are not economists.  They are just insightful generalists with common sense who can synthesize information well and be courageous enough to point out the nakedness of any emperors, and they just happen to be economists.  In general, people’s tendency to consult experts, unless there are generalist experts like Roubini, would yield nothing valuable in terms of preparing for global macro events, be it risk management or speculation. 

How do these characteristics fit in the context of the simple global macro strategy that I advocated a couple of weeks ago?  There I suggested investing 100% in long-term U.S. Treasury bonds and short selling 100% equities.  Let’s use ETFs to illustrate.  iShares has TLT for long term T-bonds and IVV for S&P500 index.  When I suggest the strategy, TLT is at about 104 and IVV is at about 110.  If you have 1 million dollars, you can buy 1 million dollars of TLT and short 1 million dollars of TLT. 

People may ask what information that I have that other people do not have.  My response, related to point 7, is that all the information that I have is available to most people.  But information cannot tell its own story, especially to the people who are blind to it even if it is under their noses.  For example, in March, I have already told many people that double dip is almost a sure thing by the end of Q1 2011 without substantial further stimulus.  The pundits have only come out recently to argue for a likely double dip.  I have only less, not more, information than them, but that does not mean that they can predict better. 

I would not place this bet until very recently after I am quite confident about the direction of stock markets in the next six months.  Once getting into position, do not necessarily try to leverage up further, even if markets seem to drop quickly like at the start of the last two-week period.  No markets go up or down in a straight line and the reversal effect could be quite nasty if you leverage up too much at the wrong time, like on last Friday of August 28, 2010.  Limited leverage would help you hold the line and wait patiently for the expected returns in the next six months.  I choose the above two instruments because they do not have minimum investment requirement, are fairly liquid and have plenty of short availability, and can help leverage up to a reasonable amount without excessive risks.  Whenever TLT appreciates by about 10% from 104 or whenever IVV drops by about 10% from 110, you can start to rewind either position depending on your judgment and risk appetite.  Of course the chances are that much higher returns may be achieved than 20%.  So you can wait to rewind either position at much higher returns. 

So far, you would have made about 4% returns from this position, which is not too bad for two weeks of time.  There will be more to come in the next few months.  The GDP is quite in inline with my prediction of a range of 1.8-2.2 and then subtracting some for the reasons that I mentioned in my global macro call. Fed has very limited effective options (other than inflation targeting) by now and the market just wants to find an excuse to relieve itself at some point.

Even though I have had the luck to predict the market direction correctly in the last few years, it would impossible to get a significant t-statistic from my calls unless I keep doing this until maybe my death.  And even there, it is just a MAYBE. 

Why you may be interested in my blog?

As a new blogger, I guess that I have to do some advertising for my blog.  However, this blog space allows only minimum flexibility in terms of adding anything other than blogs.  So I apologize for using a blog for the purpose of self-advertisement.  Here I list a few reasons why you may be interested in my blog on global macro and quant equity.  I always wonder what if any entity could have provided the opportunity for me to implement any of these insights.  The entity aside, I could certainly have retired by this time.  Even though I feel that credential shingles are far less important than actual insights, I find that many people just feel more comfortable with shingles on the roof.  When I have more time and space, I will put up some credential shingles somewhere on the blog.

NOTABLE ACHIEVEMENTS AS A QUANT PM AND GLOBAL MACRO STRATEGIST

§    Predicted the market crash at the start of 2008.
§    Predicted the bear rally from March 2009.
§    Predicted quant equity underperformance for >2 years at the start of 2008; reconfirmed the prediction in early 2009. The experience of 2008-09 has confirmed these predictions.
§    Recommended remedies to quant models and processes at the start of 2008. The experience of 2008 confirmed the correctness of these remedies.
§    Predicted significant underperformance of momentum factors and features in the subsequent five years at the start of 2009. The experience of 2009 has confirmed this prediction so far.

Here I list a few finance related professionals who should be able to testify for some or all of what I list above, if they have a little honesty. There are many more people who can vouch for me. But as I said, people generally believe in credential shingles. So I only list a few people with reasonably impressive shingles in alphabetic order. (If you need formal references, you should let me know directly.)

Malcolm Baker, Professor, Harvard Business School
John Chisholm, CIO of Acadian Asset Management
Peng Fei, Head of North American Equity Research at SSGA
Huiyu Huang, Researcher at GMO
Tie Su, Associate Professor, University of Miami
Rodney Sullivan, Head of Publications at CFA Institute, Editor of Financial Analyst Journal
Charles Wang, CEO of E Fund Management (Hong Kong subsidiary), Formerly co-head of research in Acadian Asset Management
Zhijie Xie, Professor, Boston College

It is still not too late to join the party: Simple global macro strategies to make at least 20% in the rest of year

About 2-3 months ago, while I was having lunch with a few friends who are on the investment side of large asset managers, I find myself being the only one who would buy long term T-bonds.  Quickly they wedged me to bets against them.  I smiled and said that while I am sure I will win the bet, I am not going to bets against you guys.  First, the bets placed on lunch table will likely be very small compared to the large sum that I will put where my mouth is.  Second, if I made a good amount of money from my investment, I do not feel good to take more money from you guys who would miss the party or even lose money.  At the time, the price of the long term T-bond ETF from iShares, TLT, is about $95, and I said that there would be at least 15-20% upside in the next 6 months.

Last Monday, I wrote to my friends again, urging them to join the party, because I think it is still not too late.  By then, TLT is already up by about 10%.  By the end of last week, TLT was about $106.  I mentioned to them that a simple strategy of buying long-term T-bonds or related funds while shorting stocks, be it U.S. or international markets, will easily yield at least another 20% at some point before the end of Q1 2011, and more likely it could be another 30% before the end of this year. 

I have predicted that this scenario will happen in the second half of 2010 all along (since the beginning of 2010).  Many people with strong financial expertise, including professional investors, can testify for it.  I hope that I have made a good impression on them, especially because some of them heard my predictions while they were still holding stocks for more gains to come at the end of Q1 2010.  I guess the more curious question is how I made this call?  Was it all out of thin air? 

Obviously, I would not bet a large sum of my own money on thin air.  As an example, let’s take a few simple numbers to which every one has access.  After the seemingly phenomenal GDP growth in Q4 2009 and Q1 2010, all that we see is a paltry of about 2% of private demand among the total growth.  The rest are from economic stimulus.  Even among that 2%, a large portion is inventory restocking.  Naturally, we know that economic stimulus and inventory restocking would have zero and then negative impact on GDP growth at some point.  (The only exception is when we have another large dose of stimulus, especially fiscal stimulus, which seems infeasible unless we are already in a double dip, given the madness of bond vigilantes who get it all wrong.)  For example, if you put in $200 billion stimulus into the economy in Q4 2009, the economy will grow by some percentage from stimulus.  If you were to have the same impact on GDP growth from stimulus in Q1 2010, you would have to put in at least $400 billion.  By many estimates made even at the end of Q1 2010, the impact on growth from stimulus and inventory restocking will likely be zero in Q3 2010 and be negative in Q4 2010.  What that means is that even without too much sophisticated help from economists (who also tend to be quite overly optimistic), you can figure out that we will have a GDP growth of about 2% and 1%, respectively, in Q3 and Q4 2010.  That is still the estimate before you taking into consideration the slowing growth in China today, the ongoing sovereign debt crisis in Europe, and the exploding trade deficit of the U.S. with China that will persist and keep exploding (See an explanation why this trade deficit will explode and persist here http://xlpartners.blogspot.com/2010/08/preoccupation-on-nominal-exchange-rates.html).  So even if the initial announcement of Q3 2010 GDP is 2.4%, the revised number to be announced this coming Friday will be more likely to be below 2% than above 2%. 

Although it may still make some sense to speculate for equity market rallies in Q1 2010, armed with these realistic numbers, one should know that that the party for equities would have been long over and the party for T-bonds would have long started by this time of year.  But if you have been absent minded until today, it is still not too late to step away from the rail track of the equity train and join the party for long term T-bonds while shorting equities.  Most news that we will get from now on will be negative news, and markets will be down at least until they incorporate these negative surprises.   At the same time, the Fed has only turned the doorknob for a certain QE2.  Even if they let the door half open eventually in comparison to 2008, say in 2-3 months of time, the upside of TLT is still substantial. 

You may want to say that I just get lucky this time.  However, I have advised many people to take this same strategy before September 2008.  On March 11, 2009, I start to advise many people to take advantage of the bear rally.  I have also always stick to my description of the rally since March 2009 as a bear rally.  I guess that I have to be really lucky in all these historical occasions. 

The fixation on nominal exchange rates and what I really fear for China

While most of the developed world is pondering a possible double dip, China is in the seemingly enviable position of fighting excessive growth.  Although some commentators are concerned about the quality of China’s growth, the overwhelming majority is charmed by its formidable growth.  Then why should I fear for China? 

To explain, let’s start with an introduction of real exchange rate (RER).  RER is nominal exchange rate (NER) adjusted for inflation rate and is more important in determining a country’s current account balances with another country.  However, the current debate on rebalancing global trade, especially Sino-U.S. trade, has focused on appreciating Yuan, the Chinese currency, against USD in terms of NER. 

In China’s situation with the U.S., its NER with the U.S. is largely fixed in the last few years.  Rebalancing global trade can only be achieved through internal inflation relative to the U.S.  Since it is difficult to control internal money flows, internal inflation frequently leads to asset bubbles, which is the reason for the bubbly real estate prices in many Chinese cities and the excessive growth in China today.  However, in China’s situation, internal inflation process may also lead to some peculiar dynamics that effectively depreciate Yuan in terms of RER.  These dynamics are little noticed by now and are what I really fear for China.  I discuss three of the prime examples.  

The first dynamic is related to real interest rates.  The real interest rates in the U.S. today have dropped significantly [i.e., 5-year Treasury bond rate was 1% at the end of 2007 and is 0.17% at the end of July 2010].  In comparison, the real interest rates in China are likely to have dropped much more and are often negative, due to the inflation reacceleration from the massive stimulus in 2009-2010 and largely fixed nominal interest rates.  Despite higher inflation rates in China, this dynamic effectively depreciates Chinese Yuan in terms of RER.  Because investments are above 65% of Chinese economy, much higher than their 35% share of the U.S. GDP, this dynamic means that the relatively more reduced investment costs in China would give a very strong monetary stimulus particularly to China’s investment growth.  This impact on investment also means even faster productivity growth in China, which effectively depreciates the RER of Yuan against the USD, given the largely fixed NER.  As a result, this dynamic would push China backwards on the track to rebalance its economy and trade. 

The second dynamic is related to the first one.  Wage growth relative to productivity growth would also affect RER.  Even if the productivity in the U.S. have been growing at a faster pace than wage growth in the post-crisis period, the productivity growth is likely to be so fast in China that it is growing even faster relative to wage growth during the same period when compared to the U.S.  Despite media attention on workers successfully gaining significant concession from some foreign owned factories, that is still the exceptions instead of the norms.  Most organized labor movements are likely to be prime targets of being crushed. 

The third dynamic is also related to the first one, with the twist of financial repression.  Even if real interest rate are often in the negative territory, with few investment options, Chinese households can only put most of their savings in the bank.  Since this dynamic constitutes substantial erosions in the personal wealth of Chinese households, it keeps consumption in check very effectively. 

These three are just some of the prime dynamics.  The overall impact of these dynamics means that even though China seems to be doing something to rebalance the global trade, they are always behind the curve, and Yuan consistently depreciates against the USD in terms of RER.  To be ahead of the curve, China needs to raise real interest rates drastically, provide many more investment options to its households, substantially appreciate Yuan against the USD in terms of NER, and award its workers much higher wages. 

These dynamics are among the fundamental problems facing China today.  In comparison, things like bubbly housing prices in many Chinese cities are just symptoms of these dynamics.  For example, the bubbly housing prices are due to a combination of negative real interest rates, few investment options, and extremely low carry costs in terms of property taxes and maintenance fees.  Put another way, these prices are a result of internal inflation process and financial repression. 

Without taking the suggested prescriptions, the continued unfolding of these dynamics would yield a few predictions, with some actually being pretty counterintuitive to what most commentators think.  First, Chinese current account surplus and the U.S. current account deficit are likely to explode instead of shrink, as some in the U.S. have wished, even with some mild appreciation of Yuan in terms of NER.  These explosions will happen even if the U.S. consumers retrench significantly by consuming less and saving more.  Because the open border of the capital and trade flows in the U.S., as long as things are getting cheaper and cheaper in relative terms in China, China will be able to force China-made goods down the throat of the broken American consumers. 

Second, China will invest more money into the USD assets, instead of less, because this is only way for them to avoid significant upward pressure on Yuan.  This will likely keep the yields on U.S. Treasury bond low as long as China runs huge trade surplus against the U.S.  This prediction follows from the accounting identity stating that the sum of current account balance and capital account balance should be zero to keep the exchange rates intact.  This identify is taught in any MBA international course but many commentators seem to miss it and still worry about China stopping the purchase of U.S. Treasury bonds. 

The third prediction, which is my fear, is that China is increasingly cornering itself by reducing the RER of Yuan while they should have been doing exactly the opposite.  Given the preoccupation of the current debate on the NER between Yuan and USD, one day, the continuously exploding trade deficit, coupled with likely persistent high unemployment rate in the U.S., means that the only outcome will be the threat of trade war, or trade war itself. 

China’s action against appreciating the RER of Yuan relative to the USD is out of necessity.  Its employment problem has always been the most important political problems.  However, solving employment problem by growing the economy through persistent current account surplus is at the expenses of its trading partners.  In good years, no trading partners get really bothered by it.  However, since the start of financial crisis, the U.S. suffers from sustained and elevated unemployment levels (8 millions of jobs lost) with no end in sight, which is likely to evolve gradually from an economic problem to a political problem.  By then, I am afraid that China may have hit the wall in terms of depreciating the RER of Yuan through the above dynamics, while the pre-occupation of almost every one on NER means that Yuan has to appreciate significantly in terms of NER, with the alternative being a trade war.  This will not be pretty for the whole world but it will probably be even worse for China. 

By then, China will be in a very precarious position, especially because the above dynamics means that China probably has become more dependent on investments and current account surplus to grow its economy instead of less.  I suspect that China may yet become another Japanese growth story with a collapse of its economy or its economic growth rates.  If China has trouble, the most commodity driven economies, which are often emerging markets, will likely experience subdued growth rates as well.  In comparison, the U.S., which control the final demand and may finally realize that this control gives it much stronger bargaining power, may end up as the relative winner.  

The future intellectuality of the stimulus debate in the U.S.

We are at zero interest bound and the economy is in the liquidity trap.  The greatest problem facing the world is a severe lack of final demand.  There is a wall of overcapacity (the output gap between trend and actual growth of about 8%).  The grim employment picture is the worst in the last six decades and will surely last for years to come given that fewer jobs are generated than population growth, which also pose long term risk to the country by making a large percentage of population permanently lose their productive skills.  Central bankers are still burnishing their inflation fighting credentials while the median core inflation is showing a stubborn trend of heading south short of a future catastrophic shock.  Meanwhile, bond vigilantes seem to live in a world in where up is down and down is up (or maybe they keep making the rudimentary mistake of confusing bond yields and prices).  They tirelessly exert gravity on long-term government bond yield to the extent that the real cost of stimulating the economy is trivial if we could actually jump-start the economy to a sustainable level.  With these facts in mind, the argument for “austerity now” in countries such as the U.S. is intellectually naked.  Irish experience is a recent example of “austerity now” gone poorly.  We shall take care of the austerity issue when the economy is on a sound footing. 


Even with the intellectual nakedness of the “austerity now” emperors, this debate is far from a forgone event.  It is important to keep pointing out their nakedness, because they are emperors and thus are in power to make life and death decisions for all of us and because they often think their power means that they have wisdom .  It is important to educate the population to be imaginative enough to get accustomed to seemingly big numbers in the short term (say, e.g., expanding Fed balance sheet to US$10 trillions and another couple of trillions of fiscal stimulus) and to organize pushes for more stimulus from grassroots level.  It is important because the consequence is dire without drastic actions.  Without doing much, we are lucky to be bouncing around in the disinflation or mild deflation environment for a long time with no end in sight (think Japan, the most likely scenario).  If we are really unlucky, we could have severe deflation.  It is also important because once people start to get used to this new normal, it will require even bolder actions to eradicate the deflationary expectation. 


At the same time, however, those of us who agree with substantially more stimulus need to ponder the unthinkable, “If we could obtain enough fire power to attempt jumping start the economy, can we surely generate sustainable growth within foreseeable future and how long that would take?”  The answer may be just as long as it takes.  After all, the greatest problem facing the world now is a severe lack of final demand.  Also, in the aftermath of the current balance sheet recession, households are bound to struggle to save and pay off debt, and the approach of whole-sale bail-outs for most stakeholders guarantees that we are not in a 1930’s world in which households have escaped debt prison through defaults by this time of economic cycle.  In addition, we should not expect another World War to wipe out and suck up all the overcapacity.  Further, short of a trade war, the beggar-thy-neighbor tendency of global governments also makes the coordinated global rebalancing, which should be part of the plan for sustainable future growth, nearly impossible. 


We have to identify the linchpin for sustainable long-term demand growth and plan for its attainment.  I certainly hope it is not another bubble as in the last two decades.  It seems that we need something else in addition to the stimulus (which likely will involve reducing the massive unemployment) and figuring out that something else probably lies in the core of the future intellectuality of the stimulus debate (Forget about China rebalancing its economy soon. Though it should be an important part of the solution, it will probably be too little and too late).  I understand that many times we may have no choice but to improvise as events unfold, and we can attempt navigating the uncharted water with measures such as persistent pursuit of an inflation target.  However, it helps to at least identify and think about the issue.  At this point, figuring “it” out seems to be at the center of the intellectuality of any future stimulus debate.  This shift from the debate with “austerity now” emperors will become much more evidence in the next few months, when the Fed, and maybe even the Congress, starts to injecting stimulus again in the face of certain faltering of economic growth.