Archive for September, 2012

Date: September 28th, 2012
Cate: Finance

Flashback 1973: The OPEC shock from a 2012 perspective. $356/bbl oil by Xmas 2012.

Studying history is vital to keeping things in perspective. Big shocks etc. come around all the time and various capital flows, political responses and fiscal and monetary policy responses can’t be predicted but may be guessed at based on historical precedents. Fiscal and monetary policy from the 1950’s to 1980’s provides an interesting look at how things change while staying the same. The oil shock is highlighted below.

I just finished reading Paul Volcker and Toyoo Gyohten’s 1992 book, Changing Fortunes which gives first hand accounts of US and Japanese monetary policy with the regime ups and downs from the post World War II era to 1991.  The book is based on a series of lectures and reads like a long narrative.  The amazing thing one finds while reading it is how capricious seeming policy can be.

The appendix provides a chronology of events. The 1973 OPEC price shock can truly be called a Black Swan. The events unfold in 1973 in the following way: (from the book)

1973: Oct 6. Yom Kippur war

1973: Oct 16. OPEC raises the price of crude oil 70% from $3.01/bbl to $5.12/bbl. [my comment (The equivelant in late sept 2012 would be going from $92.06/bbl to $156.50/bbl.)]

1973: Oct 20. OPEC imposes an oil emabargo on the United States, and later the Netherlands. Oil companies shuffle shipments to ensure steady supplies.

1973: Nov. 12. Central bank governors, meeting in Basel, terminate the two-tier gold agreement.

1973: Dec. 23. The oil price is raised again, nearly quadrupling from its level of early October, to $11.65 a barrel. [my comment (The equivelant from late sep 2012 base would be a Dec. price of $356.07]

Now that is sticker shock. Amazingly US inflation using govt. CPI figures reported increases of only 8.86% in 1973, 12.09% in 1974 and 7.05% in 1975. GDP is reported to have only fallen 3.9% during the recession.

And for fun here is Nixon in 1971 spinning the dollars decline and blaming”international money speculators” instead of poor fiscal policy while jumping off the gold standard. Reading Volcker’s book is a great inside lesson about the machine.

Date: September 20th, 2012
Cate: Finance, Risk & Stability, Systems

Organizationally induced catastrophes by Charles Perrow

Charles Perrow is an excellent and original systems thinker.  Perrow’s book Normal Accidents should be required reading for engineers, designers and anyone responsible for the safety and risk management of a large system, physical, financial or social.

Perrow’s understanding of tight coupling, contingency, complexity and hidden paths in systems is top notch. He uses real world examples to bring these concepts to life.  One thesis posited by the paper is that as small systems integrate and become tightly coupled they form a larger discrete system which becomes prone to collapse and catastrophe than the original smaller isolated systems. Integration of this type in pursuit of economic efficiency, power and influence leads to the ultimate collapse of a large system.

The implicit argument is that decentralized (federated/discrete) systems are longer term stable and resilient than monolithic systems.  Historical and contemporary study of overly centralized homogenous governments, banking and social systems tightly coupled acting in unison provide numerous examples of this critical failure thesis.

My personal concern is the global unified banking risk system known as Basel 3.

Here is a paper Perrow posted many years ago. Some other of his papers can be found here.

Date: September 7th, 2012
Cate: Finance, Systems
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Lottery stocks, horse races and the human love of the long shot.

In my book, “The Nature of Value” (Columbia University Press Summer 2014), I show how “hot” sectors work like lotteries enticing people in with big promises.  Hot sectors are often in exciting product lead innovation spaces.  Unfortunately great products don’t mean great businesses. Competitive dynamics determine the eventual business margins, not “great products”. You loved Facebook, but must learn the product is not the business model. This is the same as understanding that price is not value. Confusing great products with great businesses gets lots of people in heaps of trouble.

So lets pull a Charlie munger and think about the 2nd order effects of the entrants attracted to a hot product space. In a Lottery hot sector many firms are competing for the big fast growing market prize. Often times, each firm is priced to take it all. The result can be disaster as the hot sector matures and competition erodes the margins of even the fully grown survivors.

PV solar cells are an example of this effect. Each potential winning company originally competed with a $/watt product edge. They then discovered their edge usurped, margins crushed and threat of encroaching technologies still present even at large scales after years of growth.  PV solar firms were a classic case of one-trick innovations in a mostly commodity market. Customers needed the cheapest $/watt and as long as the technology was robust didn’t differentiate between businesses.  The best manufacturer with a 10 year history was only as good as the ideas coming out of some garage or university yesterday.

Innovation is deeper than product alone, it is a profound process. Quantified research from The Doblin group, shows that innovation covers 10 separate categories and that sustained margins are held by dominating as many capability categories uniquely as possible. Today’s great new mouse trap isn’t necessarily a business, its just a product innovation capability for some guy to riff on tomorrow. I know. I used to manage 70 science PhDs in Europe’s answer to the MIT media lab innovating in every field of science you can name.

The human desire to make it big fast often leads to disaster. I know this as well through painful personal experience as a software entrepreneur/ founder.  This innate human pattern of betting for the big payoff can be seen in studying pari-mutual horse racing odds and outcomes.  Where long shot bets are placed mostly for emotional kicks more than actual gains.  The insightful blog CSinvesting posted this article on the issue (see middle of post).

I have redacted a few graphics to give a visual summary of the paper by Eric Snowberg and Justin Wolfers.  The data shows the long-shot betting bias over 6.5million horse races. Betting the long shot is just a way to lose faster.

And for the international set, here is 50 years of data. Human nature isn’t changing any time soon.