The Case of the Missing January

            We in the finance major learn about something called the “January Effect”, where an investor can theoretically earn outsized returns by buying securities in January versus other months.  Why is that?  There is a matching phenomenon that there is a big sell off of securities in the previous December because investors are eager to take the tax advantage associated capital losses on investments that are performing poorly.  The intuition makes sense but in the past decade, the market has been down in as many Januaries as it has been up.  In fact, the average month increase when the DJIA was up was a little over two percent (2006, 2007, 2011, 2012, 2013).  On the other five Januaries, where it went down, it fell by over four percent (2005, 2008, 2009, 2010, 2014).  The January Effect seems about a legitimate as the Leading Lipstick Indicator: the intuition is there and “60% of the time it works every time”, as Brian Fantana says.  Yet we would be remiss to make buy and sell decisions citing it as a rationale. 

            As I write, the DJIA has fallen around five percent this year, the worst since 2009…when we (along with the rest of the world) were in a bona fide recession.  What could be the cause of this?  Ironically, though not surprisingly, one of the stabilizers that helped cancel the recession is contributing to the poor performance now.  This is, of course, quantitative easing which has been propping up the stock market as much as the economy.  Now that it is scaling back, down to 65 billion dollars this month, the chicanery of the animal spirits is a little more dramatic and a little more visible than usual.  People have been calling it a “taper tantrum”.  Let’s hope that when Janet Yellen takes the helm of the Federal Reserve on Monday she’ll have the volition to successfully wean capital markets off the easy money they have become accustomed to.

            The other major contributing factor to this month’s poor performance comes from the developing world.  According to Reuters investors have pulled nine billion dollars out of emerging market funds and bonds in the past week. Yikes.  It seems like a lot of the volatility in has been due to weakening exchange rates (Turkey and Argentina, notably), but from reading the news, I get the impression that it largely reactionary as investors see their peers selling off their assets.  Hat tip to the animal spirits.  

From Yahoo Fiance, cue sad music.

Read More...

Bitcoin Redux

I touched on bitcoins in the last post several months ago and had no idea even then that they would take the world by storm as much as they have now. Nearly all the blogs that I’ve read have posted about it multiple times, from tech sites like Wired and TechCrunch to economics ones like the Mises Institute’s blog. It has even come up in mainstream media sources like CNN. You’ve undoubtedly read about them either in my previous post or elsewhere so the exposé is not needed here.

Observe the bitcoin exchange rate in US dollars for the past six months and compare the scales to the chart in my previous post from only a few months ago, when the exchange rate sat around $100/BTC. As I write today, it is over $1050/BTC. It doesn’t take a genus to see that speculators have brought some serious skin to the game as an appreciation of over a thousand percent has taken place in such a short time. Once the playground of computer geeks and contraband smugglers, this digital currency has become the talk of everyone from Wall Street to Main Street. Even the second most powerful man in the world, Ben Bernanke, gave bitcoins a veiled compliment during one speech.

In the past couple months, speculation has become a dangerous game as the exchange rate fluctuates several percent every day, the most dramatic dates being an appreciation of what looks like around 69% on November 17th and a depreciation of 17% on November 30th. The preposterous volatility continues, trending perilously upward while the world sits and watches as the best laid schemes of mice and men succeed…or go awry.

It is important to note that the value of other currencies do not fluctuate this much. Nor it is an exaggeration to say that the world would simply self-destruct from instability if it did. For comparison, the US dollar has been able to purchase .83 euros at its absolute strongest and .67 euros at its absolute weakest, a band of about 24 percentage points, in the past five years.

It is surprising, then, that no one has tackled the issue of why the bitcoin’s exchange rate is so volatile but I will attempt a conjecture today. Take the world of foreign exchange, where currencies like the dollar, euro, yen, and all others are bought and sold for each other. Transactions happen continuously and at the speed of light as perfect information distribution and access to all markets simultaneously keep exchange rates in viciously tight equilibrium. The world’s markets spin on with astonishing stability considering that four trillion dollars worth of currency cross the planet every single day.

I believe that the reason bitcoin has not enjoyed similar stability is that none of the main exchanges offer built-in stability mechanisms. They are only spot markets. In a spot market, one may buy or sell bitcoins in whatever currency he pleases at the prevailing market price. In regular foreign exchange markets, there is not only a spot market, but also a forward market, which allows buyers and sellers to enter a contractual agreement to pay a certain exchange rate at some point in the future. There are also options, swaps, and currency pairs, which are entirely outside the scope of this essay and likely the topic of another. The point is, the existence of derivatives and the forward market self-enforces stability and that “viciously tight equilibrium” from above. Without those checks in the bitcoin market, mutability is the law of the land.

I daresay that the world is witnessing the growing pains of bitcoin, that it has become more popular than existing institutions can handle. Yet when someone has the volition to make a robust market with the same features other currencies enjoy, and if it becomes popular enough, the exchange rate instability will largely end. Bitcoins will be, from an investment standpoint, rather indistinguishable from their government-backed peers.

By the way, if you're a bitcoin user and would like to make a donation to my site, my wallet's address is  1GSCJTsYLEaBF2HX6WmnXDF9QuNezGo4v1 and it'd make my day to see something show up.

Read More...

What's the Big Deal with Bitcoins?

            Bitcoins…bitcoins...bitcoins!  It seems like the world has all of the sudden, or at least as of early this year, become entirely enamored with bitcoins as evidenced by the overwhelming press coverage they have been getting recently.  I don’t know how I managed to get this far in the year without writing about it because it has been a fascinating phenomenon to watch unfold.

            Recall from the end of my last post that bitcoins are an open-source fiat money that is backed by no government or bank, but rather the citizens of the internet.  It is the most fiat of money for that very reason.  Bitcoins have been around for several years, beginning in 2009 and growing slowly in popularity since then.  The exchange rate of dollars to bitcoins began 2013 at around $13 and rose to an all-time high of $230 by April and then dramatically crashed before leveling off around the hundred dollar mark where it sits now, several months later.  What happened in those months that caused the sudden bubble and bust?  I have a theory: an educated guess, if you will based on a little reading and some mental puzzle-solving.

            Bitcoins have been used primarily for ecommerce transactions of illegal goods because they are, by design, international and anonymous (or at least very difficult to track).  Drugs, firearms, fake IDs, and rather significantly more unsavory goods are dealt through illicit marketplaces with bitcoins being used as the medium of exchange, internationally and anonymously like the buyers and sellers themselves.  Hold that thought in the back of your mind.

            What was going on in the world in early 2013, culminating in March?  The European financial crisis had hit Cyprus pretty hard.  I even wrote a post about the whole incident when it was happening.  Cyprus is a tax haven for Russian business magnates and so one of the things that was suggested by the ECB/IMF/European Commission during the early weeks of March (March 16^th to be exact) was to confiscate 40% of the bank deposits of uninsured accounts with a value over 100,000 Euros: essentially targeting the Russian businessmen.  This idea was eventually dropped on March 25^th, but during the days between the 16^th and 25^th, the fate of those deposits were up in the air.  

            Before looking at the exchange rate graph below, take a wild guess as to when the bitcoin boom started, recalling that bitcoins are the de facto underground market currency and that a substantial portion of Russia’s economy is built on the dealings in such markets…and that Cyprus was a tax haven.

            If you guessed that the dramatic boom started in the third week of March, you’d be correct!  Bitcoins had been increasingly in the public eye since the beginning of the year but the major step up began when the deposits were threatened by seizure.  I suspect that the rest of the world noticed the inflation and speculators carried the bitcoin’s value to its highest point even after the deposits’ threat had gone away.  Examine the graph for a while and see if you can’t extract more insight from it.  The events of the past few months on the web and in the rest of the world are more interesting than ever and I suspect we can learn about how humans deal with booms and busts by seeing the bitcoin crisis as a microcosm of what has happened, and maybe will again, for other securities and currencies in the rest of the world.

By the way, the exchange rate chart can be made here where you can manipulate the time frame as well as several technical indicators.

Read More...

The Story of Money Part 2

            As promised, I am back with a sequel to the last piece about the story of money.  I mentioned that the main features of money are durability, divisibility, and wide acceptance as having value.  I also mentioned that these have not always been the case and that there is at least one notable exception that comes to mind, in the area of divisibility.  But this story in turn will take us to the more valuable insight about the nature of money in modern times, the concept of fiat money.    

"I'll need some help with getting this to the grocery store."

              There is an island in the South Pacific called Yap which until recent times has used large round blocks of stone as their currency, called Rai.  The origin of this money is unknown but essentially the scarcity of these stones (quarried and milled on another island), the difficulty associated with transportation (20+ men were required to move the largest ones), and the propensity for the movers to die with stones in tow when storms struck on the open sea made them sufficiently valuable to use as currency.

              While not all stone money items were gargantuan, it does not take much imagination to realize that having stone money of any size is not conducive to easy commerce between citizens.  This is where the story becomes even more interesting.  Once people realized that moving the Rai around was not practical, they started writing promissory notes that entitled the bearer to a particular stone stored in some location on the island.  Tangentially, the parallel between this kind of money and gold or silver certificates is easily seen.  This allowed easy transactions between people since a stone could be retrieved by anyone bearing the certificate.  Theft was out of the question because of the level of trust on the island and the fact that stealing boulders is no mean feat.

               On one fateful voyage, a very large and accordingly valuable stone was lost to the sea.  But as the inhabitants had grown accustomed to dealing in paper that represented stones, and the representative paper was still in existence, the populace agreed that the stone was out there somewhere and that its document was still valid money.  Thus fiat money was born for the island of Yap.

                “Fiat” is the Latin word for “it shall be” or “let it be done” and fiat money is money whose value is not derived from an underlying asset like gold, silver, or stone.  Rather its legitimacy comes entirely from the faith of the people who use it and, more often that not, the government that decrees it as the legitimate currency of the land.

                In modern times, the rise of Bitcoins has been an endlessly fascinating form of currency because it is backed by no government at all.  I recommend reading up on it because it is much too involved to deal with sufficiently here.  Yet even though there is no ruling authority that mandates it as having value, the faith and trust of those who deal in it online has elevated it to the status of money that is widely accepted in many stores (mostly online) across the globe.  But what makes it even more spectacular is the fact that it does not even have a physical presence.  In truth, it is the most fiat of money of all. 

Read More...

The Story of Money

What is money and why do we need it?  How did it come about in the first place?  This is a question that I addressed in conversation recently with a friend after visiting the Hong Kong Monetary Authority, its equivalent of the Federal Reserve.

Everyone knows intuitively what money is: a medium of exchange and permanent store of value.  In other words, one person has coins and bills and another person has coffee beans, guitars, or microscopes.  They trade one for the other and everyone goes on his way.  The permanence of money is also an important characteristic.  It would not do to have currency that decays over the course of time!

Where did money come from and why do people use it rather than just bartering like our ancestors used to, and why do we use paper or metal which have no intrinsic value rather than something that does have value?

The need for money is shown in the following story, as related to our class by my first economics professor.  Imagine that you are a maker of guitars and that you want to get coffee.  So you take your guitar to a coffee farmer and try to work out an agreement on a trade.  The problem arises: what if the coffee farmer does not want a guitar?  Or what if he does not have enough beans on hand to pay you for that guitar?  In modern terms, for example, 45.4 pounds of Starbucks coffee costs the same as a Fender Stratocaster, (if our ancestors had the benefit of price shopping on Amazon.com)! The problem with a pure bartering system is that not everyone wants what you have or perhaps they do but cannot accommodate your requirements for the trade. 

This is where money comes in: a society agrees on something that will be used to facilitate exchange whether it is coins, stones, shells, salt, metal ingots, or any number of other items used by civilizations in the past.  Besides society-wide acceptance of their value, money possesses at least one other advantage over trading goods for goods: it is easily divisible.  You will notice that half of a guitar, a third of a cart, and the base of a microscope are no good to anyone.  In other words, if our farmer from above didn’t have 45.4 pounds of coffee on hand, the trade would not go through.  But with money, the trade can happen between anyone who has money and anyone who is selling something. To recap, these features can be seen in money all over the world: easy divisibility, society-wide or universal acceptance in a country, and usually permanence in the material used to make it.  There are few exceptions but one or two of the most prominent ones deserve to be the subject of the next post. 

Read More...

China Seminar Post 3: The Real Wealth of Nations

            During one of our several university visits the lecturing professor gave us a particularly unique and memorable talk.  The typical speech we’d receive in these lectures tended to involve an economic lesson about some area that was growing such as how the city was planning to develop their infrastructure in this or that industry, or how 300 million people had migrated from rural areas to the cities, or how income has risen dramatically in the past several decades since the late 1970s.  This one, in particular, took a much more philosophical slant. 

            Professor Zhang Yu from Shanghai University spoke to us his philosophy about the reason that a country develops or does not develop.  Having grown up and been educated in an overtly Communist state, he learned that there was strength in unity of thought and belief.  He learned that the government was the benevolent institution to pass down those thoughts and beliefs for the good of the people.  But as he grew older and began to read independently (philosophers like David Hume), he came to a different conclusion.  He began to realize, as he told us, that the government cannot be the entity to oversee all aspects of life.  He told us that if the government controls thought and belief, then creativity and dynamism of the populace will be squelched, and a nation will be cursed with an inability to move forward.  As he said progress cannot be legislated, so he said that the power to transform a nation lies in the minds of its people.  Free thought emanating from the minds of free people is how society can evolve and change for the better.  So this brought him to his terminal point.  These days, those in governance over China’s cities and provinces put so much emphasis on how much is being exported, or how big the country’s GDP is from year to year.  This results in a measure of success being confused for success itself.  In reality, however, the true wealth of a nation is its people.  That country is rich which is blessed with free thinkers, tinkerers, and an environment conducive to the germination and sharing of ideas. 

Read More...