Market Volatility vs Market Saturation

A popular saying within the world of finance goes something like this: "stock markets have predicted 10 out of the last 3 recessions". This is quite a statement however it does explain the notion as to why we are currently seeing an explosion of volatility  within our financial markets.

With many people expecting the collapse of the Euro zone, and the SA Information Bill  (a little closer to home) providing foreign investors plenty of excuses to take their money out of risky developing markets, trading screens  must inevitably be flashing red and green more often than the traffic lights at a busy intersection.

With that being said; due to the overall global climate turning rather pessimistic, we see large capital outflows out of 'risky' developed economies.  This has left me with a thought...



When considering the rise of Africa in the future, looking at the current developing economies can we learn from the current market trends? Although I am lacking sufficient data, a thought process follows whereby as a market develops, more and more people transact within a market, yes? This causes more buy and sell opportunities and ultimately instruments such as equity will change hands more often, leading to more price volatility and hence more overall market volatility.

I agree, it may seem speculative however chatting to people familiar with other African markets, it has led me to believe the JSE is more volatile than, for example, the Nigerian or Kenyan market. With more market participants it seems only fair to assume more volatility, up until a certain level. One cannot however apply the same logic and try disprove this looking at the volatility of our big western friends, one needs to take into account the 'law of diminishing returns' into this idea of mine... a sort of plateau will be reached where the growth of a market and its volatility will eventually find some resemblance of an equilibrium, provided market conditions remain stable.

With the BRICS currently flying the flag for the developing nations, can we look at correlations between their growth and market volatility and try to apply it to the rest of the african nations waiting in the wings?
After all, Africa is only untapped market left. Surely there is something we can learn from the development of the BRICS and previously, our Western friends!

The Young Economist. 

Value is like Traffic

Bear with me for a second...


Imagine stocks of individual companies as lanes, on our many highways, city streets and urban areas.


Now imagine value as the utility we get from using the roads, empty roads obviously yield high utility as no one is stopping us from using the roads. We go where we need to, no stops or traffic and thus our utility is maximized.
Conversely if we look at a road which is littered with cars, bumper to bumper traffic and possibly a few accidents we see utility being minimized as we cannot use the roads for what they are meant for - travel.

Back to finance - as more and more people demand a certain share (or lane), traffic ensues and value (utility) is diminished as this demand rises the share price, often creating asset bubbles or even industry bubbles(traffic - in my opinion).
This is commonly seen today, where companies in the social networking industry are suddenly listing for IPO's and are doubling their listing price in days (or even hours).
Lets take Linkedin for example, going public on the 19th May 2011. Listing at $45 a share, climbed to $122 in a single day. It must be said, the share price did stabilize and is currently trading at $86.40 BUT.... looking deeper we see a PE ratio of 2375.31 - utterly ridiculous!
Even still many of the major banks in the USA are recommending "BUY" signals for Linkedin- and they arent the only ones.

The Wall Street Journal reported today "Facebook shares have traded on private-company exchanges  valuing the company at $70 billion to $80 billion".


To put that in perspective, 'Seeking Alpha' reported, when Goldman Sachs valued Facebook at $50 billion, "Giving Facebook that valuation puts it amoungst the likes of American Express, Kraft, and Boeing".

Facebook had $1.2 billion in revenue for the first nine months of 2010, resulting in $355 million net income, At Facebook's current $50 billion valuation, that puts its Price to Earnings Ratio greater than 100. That is insanely high.
A feeble argument that come into existence regarding these outrageous valuations include exponential earnings growth however;


If we consider the high level of technological development and current increased capital mobility within financial markets, and according to the World Bank global growth is projected to ease from 3.8 percent in 2010 to 3.2 percent in 2011, before picking up to 3.6 percent in each of 2012 and 2013, can we really assume that growth in earnings is really going to be that high? And even if growth does pick up, with Africa the only untapped market, why don't we think about market saturation or in fact global saturation.
Innovation is key to growth, but can we really price future innovation into a share price? If so, I don't believe its worth what some people are paying today.

The Young Economist

Probability Theory

The corner stones of quantitative finance are extremely statistical, and obviously along side it mathematical. Using various techniques involving intense probability theory such as Markov Chains- strategies are developed, whether it be StatArb (statistical arbitrage being long on certain securities and short on others), price pattern detection or using the infamous Monte Carlo Simulation to calculate random sample paths of a given security based on underlying fundamental conditions such as interest rates.
Seemingly most of these methods are used today by massive hedge funds that are often leveraged more than 15:1 on the sole basis of a "superior model" or a "cant fail" strategy, lacking the adequate risk management to protect them from any "black swan event".

Enter Paul Wilmott, a modern day quant genius. He has developed the CQF or Certificate in Quantitative Finance and has for many years warned the market of a "mathematical led meltdown". The 2007-08 crisis springs to mind with specific reference to CDO's and the repackaging of mortgages solely developed by mathematicians.

Post crisis Mr Wilmott has developed a "Financial Modelers Manifesto", containing a hipocratic oath that embodies the problems we face with regards to the power and clout these big hedge funds have, however with power comes responsibility. Taken from the Manifesto, the hipocratic oath is as follows:

~ I will remember that I didn't make the world, and it doesn't satisfy my equations.

~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.

~ I will never sacrifice reality for elegance without explaining why I have done so.

~ Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.

~ I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

One has to agree there is a place in this world for financial modeling, however to confuse the model with real life and try to model human behavior is to assume the human race obeys mathematical rules....absurd!


Again one has to look at success rates of traders. Sure some of them have had a good run, but 98% of them have not been able to sustain a long successful track record and the inevitable blow up occurs. These big players often double up on bets going against them, never practicing sound risk management principles. The phrase 'Stop Loss' springs to mind.


If we consider a sample of 10 000 traders, assuming there is a 50% chance of making a profit or loss per year we find after 1 year we only have 5000 traders left in the black, 2500 traders after two years, 1250 after three years, 625 after four and only 312 successful successful traders after the fifth year. Not very impressive is it?


Survival of the fittest or survival of the safest? 

Great risk offers great reward but it also offers unemployment. There is a culture within financial markets that does not account for risk related returns. Maybe we should change the scale?


The Young Economist

Fantasy Rugby is like Picking Stocks:

They say never mix business with pleasure however this past weekend has led me to believe there are situations where similarities exist. There is a competitive game of Super 15 fantasy rugby between my friends and I, and one can't help notice a correlation between decisions:

Like stocks from particular industries - players are chosen from teams that are performing at the moment as the probability of the player scoring increases with a winning team.
Similarly there is a budget limit - better players who score more often are more expensive. Thus is there a need to balance your team (or portfolio) with relatively cheaper solid performers (blue chip stocks) as well as relatively more expensive but also more risky "star players" (growth stocks).

Similarly in most fantasy leagues, a players performance allows his price to fluctuate (capital growth) and so does the value of your team or portfolio, depending on how consistent the player is each week will define his 'Beta'.

Finally there is a range of statistics to allow one to research players - tries this season, tackles made, assists, points kicked etc. This is the same as researching stocks, their beta, the companies financials, the industry growth and various other tecnical analysis techniques.

One correlation that does not exist is the effect of money - when one is trading, money has a psychological effect on people that makes the human race act irrationally!
The similarities end there - the only money to loose in fantasy rugby is in fact  pride - and mayb a little side bet.

Finally, one has got to remember fantasy rugby is not influenced by supply and demand and thus this market is free from speculation and the price reflected per player and the overall team (portfolio value) is pure book value.

The Young Economist

Quantitive Finance - a Legitimate Option?

In the world of Finance and Investment, there are indeed many given ways to succeed. Where Warren Buffet suggests value investing, meanwhile many people believe trading is the way to go, holding on to securities for short periods of time before selling them off again.

Ed Thorp - arguably the father of mathematics within finance was a maths professor at MIT in the 1950's and was obsessed with probabilities. He soon applied his interests to the game of black jack and managed to crack it, writing a book "Beat the Dealer". Later there was a movie about him - has anyone not seen '21'? Later on in life, he used the same principles to make millions of dollars on Wall Street, he was the first 'quantitative analyst'. Ed Thorp made a few conclusions, namely the market follows a Brownian Motion - completely unpredictable. It was also described as a random walk - a stock or bond will rise or fall is as likely as getting a heads on a coin toss (50%).

Thorp applied his statistical formula's to warrants and quantified their beta (volatility), thus he looked for mispriced warrants where the price has underestimated or overestimated its beta and deduced money can be made.

Over the following years, many 'Quants' have come and gone. John Meriwether and Long Term Capital Management has fallen in style due to too much leverage. Ken Griffin, manager of Citadel Investment Group had a great run before the crash of 2008.

Then there is Renaissance Technologies and its flagship Medallion Fund, with returns of roughly 40% a year for 3 DECADES!!! Many claim this fund as found 'The Truth' or 'Alpha'.
The fund was headed by James Simons, a man who did his undergraduate degree at MIT and sailed through his Masters Programme - all in mathematics. He recruited the top people for the job, from cryptanalysts to computer science wizards.
They used the hidden Markov process model to calculate probabilities in a sequence of events that have no direct relation to one another - a kind of random walk with random variables that change along the way. Nobody knows precisely how they do it, but Simon's once remarked 'patterns of price movements are not random' - hence his supercomputers sift through data for identifiable patterns in prices. The fund also always tweaks its models, accounting for a change in the fundamentals more often than most other quant operations.

It seems many people have different theories on how to find 'The Truth'. Many people have had a good short term run but inevitably have crashed. It seems the funds or companies that last in the volatile world of finance and investment are statistical anomalies - like Buffet or Simon's.
It begs the question, is there a hidden truth to financial markets? Is there an Alpha?

The Young Economist

Speculative Optimism

On the 24th of Dec 2010, South Africa was invited to join the BRIC group consisting of some of the worlds largest emerging markets such as Brazil, Russia, China and India.
China is growing at approximately 9% a year and India has an economy that is about four times the size of 
South Africa. South Africa is the world's 31st-largest economy, according to World Bank data for 2009.

One has to ask what has warranted this invitation?

SA has been extremely keen to get into this elite club for a long time, trying to explore better bilateral trade with China due to China being SA's biggest trading partner.
SA has shown poor economic growth over the years and forecasts sit at around 3% for 2011.

What has SA got to offer the BRIC nations? Is it the understanding that SA is the gateway to Africa? Because SA has the biggest economy on the African continent? It seems many international companies are trying to get into SA, one of the biggest is the 51% of Massmart bid by Walmart.

Along with this new status under the "BRIC" logo, not only do we see M&A deals but also large capital inflows into SA. International finance suggests one of the reason's why the ZAR is so strong is due to foreigners being the net purchasers of SA bonds and equity.

The JSE closed today at 31 837 , off its high but still relatively close to its all time high. With the Fed adopting its quantitative easing policy and many other developed economies trying to stimulate their economic growth it seems all the money is flowing into emerging markets. Along with the new "BRICS" status and all this optimism in emerging markets (as well as pessimism in the developed economies), one cannot deny the fact a new bubble is "emerging". Would value investors like Warren Buffet and Benjamin Graham find any value in the JSE, I think not. The appropriate term would be "overvalued" from the people at Grahamsville.

In the end, is the inclusion of SA within BRIC warranted? Are all the foreingers wrong to invest in such a slow growing economy like SA? Does the developed world see intrinsic value within SA?
Or is it all just speculative optimism...?

The Young Economist

Unemployment: Lack of Skilled Labour? I think Not!

I have just finished my Bachelors degree in Economics and have been looking for employment opportunities everywhere. Jobs in economics, finance and investment seem to be difficult to come by.
With many people I know having graduated as in the same field (as well as others with honours in finance), I beg the question where are all the jobs?

With matric results for the year ending 2010 out, here are some scary statstics:

The number of matriculants who passed rose from 60.6% in 2009 to 67.8% in 2010.
The pass rate in maths increased by 1.4% and in science by 11%

HOWEVER:

Nationally, 69% of the 263034 matrics who wrote maths scored less than 40%. More than 70% of the 20364 who wrote the physical science exam could not manage more than 40%. Only 23.5% of candidates gained a university exemption.

South Africa has one of the lowest university pass rates: 15% (Human Sciences Research Council)

"Lack of a skilled workforce is the biggest constraint to growth for South African business", according to Grant Thornton's 2010 International Business Report's findings.

If there is a shortage of supply of skilled labour, why is there such difficulty in finding employment?

Due to the lack of employment opportunities, South Africans have developed an entreupeneurial culture always looking to fill the gap in the market. People are able to obtain anything they wish from the stalls on the sides of roads, weekend markets flourishing and being handed pamphlets at every intersection is a sign of the times, people are trying to start their own small businesses as the job market is extremely small.

Evidence of this is the "Career Section" posted in the Sunday Times, with the size of the particular handout thinning in every issue.

Sure, as South Africans we are able to state our education system does need improvement however surely the 15% of graduates must be able to find jobs in the field in which they have studied!

I believe the focus should not only be on education, but also employment growth. There is a lack of employment opportunities in SA, which can only be attributed to economic growth.

Stats SA released figures maintaining "Real GDP at market prices for the third quarter of 2010 increased by an annualised rate of 2,6 per cent compared with an increase of 2,8 per centduring the second quarter of 2010".
If our economy is barely growing, how on earth are graduates suppossed to find jobs.
Matriculants see this fact and have no motivation, expressing the belief 'if graduates cant get jobs, why should I study'. This lack of motivation moves all the way down the education system to basic secondary education with people seeing no hope in the job market.

A similiar problem exists with qualified people, finding it easier to find career growth elsewhere in other various countries - contributing to the brain drain problem we face.

In conclusion; Politicians have a valid excuse promoting education however education must eventually lead to employment. Education is a means to an end, and if there is no end why educate yourselves.
Focus must not only be on education but rather things that promote education - job opportunities, career growth and ultimately economic growth.

The Young Economist