A Globe and Mail article describing the auction processed used to sell houses in Australia distracted us from our holiday celebrations and hockey tournaments. The article argues that an auction drives prices higher than the ask-offer system commonly used in North America. (Click here for article)
Markets are most efficient when there is a large number of both buyers and sellers all dealing with a homogeneous product. This is typically not true in real estate. Properties are heterogeneous; there is only one seller and multiple buyers. There is also an asymmetric information problem in that the seller knows everything that is wrong with the property and the potential buyer doesn’t. In the North American system, the seller offers the property for sale at a price that is higher than the minimum price they will accept. The potential buyers make offers below the maximum price that they are willing to pay.
Then comes the game. The seller wants to get the highest price that any of the potential buyers would be willing to pay. The seller responds to one of the offers by changing their terms, letting all potential buyers know that there are multiple offers. None of the buyers knows the terms of the other offers. If the sellers can’t come to suitable terms with the first potential buyer, they are free to negotiate with another. Typically, the seller will settle for a price that is less than their initial asking price, and above the initial offer. More importantly, the price will likely be below the highest price that a potential buyer would have been willing to pay. The seller’s agent is supposed to help get the highest price, the buyer’s agent is supposed to help get the lowest possible price. A seller’s agent is considered successful if the property is sold, not if it sold for the maximum price. The marginal benefit to the seller’s agent of getting an extra $1000 for the seller is less than the marginal cost of getting that $1000 and there is no benefit to the buyer’s agent attaining a $1,000 reduction in price. This process is inefficient for both seller and buyer.
An auction works differently. The seller sets a reservation price and multiple buyers bid against each other. The auctioneer is the seller’s agent and works to get the best price possible. As the price rises, potential buyers drop out until two are left. The winning bid will be just above the maximum price of the buyer with the second highest willingness to pay, but below the maximum price that the winning bidder was willing to pay.
The article suggests that the auction process is responsible for the rising prices in the Australian market. People don’t like to lose and therefore bid up prices in a frenzy. This argument requires that bidders behave irrationally on average. We normally assume that individuals maximize utility, or personal welfare. That implies that they know the maximum price that they are willing and able to pay and that rational individuals will not go above this price. An auction increases the price and benefit to the seller, whereas the bid-offer system does not.
Thursday, December 30, 2010
Wednesday, December 22, 2010
Beating the Market
Yesterday, we quoted a Globe and Mail article that commented on a book Zombie Economics: How Dead Ideas Still Walk Among Us by John Quiggin. (Click here for article). That quote read:
"Nothing in the (efficient market) hypothesis can explain the frequent bubbles and busts, strange stock valuations or the inconvenient truth that some shrewd investors do outperform the market." (emphasis added)
Our previous blog sought to illustrate that a "shrewd investor" could beat the market purely by luck. The evidence of investors outperforming the market is not sufficient to dispell the efficient market hypothesis. Today, we take a stab at what "outperforming the market" means, and what is should mean. By most accounts, beating the market implies creating a portfolio that generates a return, after transaction costs, that exceeds the return of a benchmark index i.e. TSX 60, DJIA, SP500, FTSE 100, CAC40, DAX, Nikkei, Hang Seng, MSWI etc.
There are some problems with this method, however, in that simply comparing the rate of return to a market index does not compensate for the risk of the portfolio. In general, the greater the risk, the greater the return. So, for example, if we create a portolio using only the 30 riskiest stock in the TSX 60, we are likely going to beat the TSX.
There are at least three measures of return that do compensate for risk, and beating the market should be evaluated using one or more of these measures.
The Sharpe measure can be used for sufficiently diversified portfolios and is the ratio of the portolio return minus the risk free rate of return divided by the standard deviation of the portfolio return. This ratio is then compared to the same ratio for the benchmark. The Sharpe measure looks to see if the portfolio lies above or below the capital market line. Above indicates that the porfolio beat the market after compensating for risk.
The Treynor measure can be used for single securities as well as a portfolio and is the the ratio of the portfolio or asset return minus the risk free rate of return divided by the beta of the asset. Beta is a measure of risk relative to the market risk. The Treynor measure looks to see if the portfolio lies above or below the securities market line.
Finally the Jensen measure, or alpha, is similar to the Treynor measure in that is makes a comparison based on beta. Alpha is calculated by taking the difference between the actual rate of return of a portfolio minus the return predicted by the capital asset pricing model (CAPM). If alpha is positive the portfolio beat the market on a risk adjusted basis.
Yesterday, we showed that beating the market can be a matter of pure luck. Today, we showed that beating the market may be a result of taking on excess risk. Our intent is to show that having some shrewd investors that outperform the market is not sufficient to dismiss the EMH.
"Nothing in the (efficient market) hypothesis can explain the frequent bubbles and busts, strange stock valuations or the inconvenient truth that some shrewd investors do outperform the market." (emphasis added)
Our previous blog sought to illustrate that a "shrewd investor" could beat the market purely by luck. The evidence of investors outperforming the market is not sufficient to dispell the efficient market hypothesis. Today, we take a stab at what "outperforming the market" means, and what is should mean. By most accounts, beating the market implies creating a portfolio that generates a return, after transaction costs, that exceeds the return of a benchmark index i.e. TSX 60, DJIA, SP500, FTSE 100, CAC40, DAX, Nikkei, Hang Seng, MSWI etc.
There are some problems with this method, however, in that simply comparing the rate of return to a market index does not compensate for the risk of the portfolio. In general, the greater the risk, the greater the return. So, for example, if we create a portolio using only the 30 riskiest stock in the TSX 60, we are likely going to beat the TSX.
There are at least three measures of return that do compensate for risk, and beating the market should be evaluated using one or more of these measures.
The Sharpe measure can be used for sufficiently diversified portfolios and is the ratio of the portolio return minus the risk free rate of return divided by the standard deviation of the portfolio return. This ratio is then compared to the same ratio for the benchmark. The Sharpe measure looks to see if the portfolio lies above or below the capital market line. Above indicates that the porfolio beat the market after compensating for risk.
The Treynor measure can be used for single securities as well as a portfolio and is the the ratio of the portfolio or asset return minus the risk free rate of return divided by the beta of the asset. Beta is a measure of risk relative to the market risk. The Treynor measure looks to see if the portfolio lies above or below the securities market line.
Finally the Jensen measure, or alpha, is similar to the Treynor measure in that is makes a comparison based on beta. Alpha is calculated by taking the difference between the actual rate of return of a portfolio minus the return predicted by the capital asset pricing model (CAPM). If alpha is positive the portfolio beat the market on a risk adjusted basis.
Yesterday, we showed that beating the market can be a matter of pure luck. Today, we showed that beating the market may be a result of taking on excess risk. Our intent is to show that having some shrewd investors that outperform the market is not sufficient to dismiss the EMH.
Tuesday, December 21, 2010
Probabilities and the Efficient Market Hypothesis
An article in the Globe and Mail got us interested in a book entitled Zombie Economics: How Dead Ideas Still Walk Among Us by John Quiggin. (Click here for article) We currently have the book on order from Amazon and will report back once we have read it in full.
In the meantime, we thought we might do a few blogs on the efficient market hypothesis and this one is based on a single line from the Globe and Mail article that suggests the EMH must be false because:
"Nothing in the hypothesis can explain the frequent bubbles and busts, strange stock valuations or the inconvenient truth that some shrewd investors do outperform the market." (emphasis added)
A little experiment. If you flip a fair coin, what do you believe the likelihood of it coming up 'heads' 10 times in a row? If it did, would you suggest that the coin wasn't balanced properly? Most people would. Now, however, lets start with 1024 people and ask them all to flip a coin. Those that come up tails must leave, and those that come up heads can stay. After the first toss, we should have about 512 people left. Repeat a second time and about 256 people should be left. On each successive toss, about half will be tails and half will be heads. After three tosses 128 people are left, then 64, 32, 16, 8, 4, 2 and finally, after ten rounds, only one person is left. That person just tossed 10 consecutive heads. (The probablility of doing that is one in 1024)
Lets do the experiment again with 1024 "shrewd investors" who build a portfolio by choosing any 59 stocks in the TSX 60. The one stock they don't hold is chosen by throwing a dart at the list. If the stock they omit underperforms the TSX then their portfolio will outperform the market. The omitted stock is chosen at random and thus has a probability of beating the index of approximately one half. After one year, those investors that beat the index can stay, they rest leave. At the beginning of each year, the survivors choose a new portfolio in the same manner. By the same logic as the coin game, after 10 years one of those "shrewd investors" beat the index 10 years in a row ... by throwing a dart.
According to the Chartered Financial Analyst Website, there are currently 90,113 individuals that hold the CFA designation. These are the people that manage portfolios and are well trained in what they do. If they all build portfolios in the game above, 88 will beat the market 10 years in a row, and one will be expected to beat the index for 16 consecutive years.
The existance of investors that outperform the market is not a sufficient reason to dismiss the efficient market hypothesis. As just shown, even with efficient markets, given a big enough pool, it is possible to beat the market entirely by luck.
Next time we look at the meaning of "beating the market".
In the meantime, we thought we might do a few blogs on the efficient market hypothesis and this one is based on a single line from the Globe and Mail article that suggests the EMH must be false because:
"Nothing in the hypothesis can explain the frequent bubbles and busts, strange stock valuations or the inconvenient truth that some shrewd investors do outperform the market." (emphasis added)
A little experiment. If you flip a fair coin, what do you believe the likelihood of it coming up 'heads' 10 times in a row? If it did, would you suggest that the coin wasn't balanced properly? Most people would. Now, however, lets start with 1024 people and ask them all to flip a coin. Those that come up tails must leave, and those that come up heads can stay. After the first toss, we should have about 512 people left. Repeat a second time and about 256 people should be left. On each successive toss, about half will be tails and half will be heads. After three tosses 128 people are left, then 64, 32, 16, 8, 4, 2 and finally, after ten rounds, only one person is left. That person just tossed 10 consecutive heads. (The probablility of doing that is one in 1024)
Lets do the experiment again with 1024 "shrewd investors" who build a portfolio by choosing any 59 stocks in the TSX 60. The one stock they don't hold is chosen by throwing a dart at the list. If the stock they omit underperforms the TSX then their portfolio will outperform the market. The omitted stock is chosen at random and thus has a probability of beating the index of approximately one half. After one year, those investors that beat the index can stay, they rest leave. At the beginning of each year, the survivors choose a new portfolio in the same manner. By the same logic as the coin game, after 10 years one of those "shrewd investors" beat the index 10 years in a row ... by throwing a dart.
According to the Chartered Financial Analyst Website, there are currently 90,113 individuals that hold the CFA designation. These are the people that manage portfolios and are well trained in what they do. If they all build portfolios in the game above, 88 will beat the market 10 years in a row, and one will be expected to beat the index for 16 consecutive years.
The existance of investors that outperform the market is not a sufficient reason to dismiss the efficient market hypothesis. As just shown, even with efficient markets, given a big enough pool, it is possible to beat the market entirely by luck.
Next time we look at the meaning of "beating the market".
Tuesday, December 14, 2010
Price controls and black markets
Something that Venezuelan President Hugo Chavez has never understood is the economic effects of the price controls that he imposes - or if he does understand them, he ignores them. The latest incident is reported in the Miami Herald. (Click here for article)
Price controls are implemented to prevent prices from rising to market equilibriums. At prices below equilibrium, the amount that people want to purchase exceeds the amount that firms want to sell. Normally, this would cause prices to rise inducing firms to produce more and consumers to want less until the market was in balance. When prices are held below the equilibrium price by government decree, a black market is created. A shortage of the product exists and buyers bid the price up above the equilibrium price, to the black market price, where the number of buyers is equal to the production amount that is legal.
In resource markets, the price will normally be equal to the value of the marginal product (the additional amount of output from one additional unit of input multiplied by the price of the output) Efficiency requires that resources are used in the most productive way possible.
President Chavez has subsidized the cost of urea, a chemical fertilizer, in an attempt to increase food production which is subject to price controls. In neighbouring Columbia, there are no price controls on the production of coca, the plant from which cocaine is derived. As a result, the value of the marginal product of urea is higher in the Columbian coca fields than it is in the Venezuelan corn and rice fields.
Not surprisingly, Venezuelan subsidized urea is not available to the rice and corn farmers of Venezuela, but appears to be available in sufficient quantities to satisfy the demands of Columbian coca farmers. Like it or not, Sr. Chavez, markets will prevail.
Price controls are implemented to prevent prices from rising to market equilibriums. At prices below equilibrium, the amount that people want to purchase exceeds the amount that firms want to sell. Normally, this would cause prices to rise inducing firms to produce more and consumers to want less until the market was in balance. When prices are held below the equilibrium price by government decree, a black market is created. A shortage of the product exists and buyers bid the price up above the equilibrium price, to the black market price, where the number of buyers is equal to the production amount that is legal.
In resource markets, the price will normally be equal to the value of the marginal product (the additional amount of output from one additional unit of input multiplied by the price of the output) Efficiency requires that resources are used in the most productive way possible.
President Chavez has subsidized the cost of urea, a chemical fertilizer, in an attempt to increase food production which is subject to price controls. In neighbouring Columbia, there are no price controls on the production of coca, the plant from which cocaine is derived. As a result, the value of the marginal product of urea is higher in the Columbian coca fields than it is in the Venezuelan corn and rice fields.
Not surprisingly, Venezuelan subsidized urea is not available to the rice and corn farmers of Venezuela, but appears to be available in sufficient quantities to satisfy the demands of Columbian coca farmers. Like it or not, Sr. Chavez, markets will prevail.
Wednesday, December 8, 2010
Articles on the European Debt Crisis
One day after I post my thoughts, the newspaper articles all show up. Here are a few of interest:
From the New York Times: Speculators vs the European Central Bank.
From Deutsche Welle: Is the bailout fund large enough to save the euro?
From Reuters: Higher yields on German bonds and the arguments against joint euro zone bonds.
From Bloomberg: Bank exposure to sovereign debt and stress tests
From Bloomberg: Yield spread between US and european bank debt and the cost of credit default swaps
From the Daily Telegraph: Iceland and Ireland
From the New York Times: Speculators vs the European Central Bank.
From Deutsche Welle: Is the bailout fund large enough to save the euro?
From Reuters: Higher yields on German bonds and the arguments against joint euro zone bonds.
From Bloomberg: Bank exposure to sovereign debt and stress tests
From Bloomberg: Yield spread between US and european bank debt and the cost of credit default swaps
From the Daily Telegraph: Iceland and Ireland
Tuesday, December 7, 2010
Thoughts on the euro
Ireland looks like they will be able to pass a budget that will allow them to pay down their international debt although Irish citizens will be paying the price. Greece still appears to be in denial with protests every time a politician even thinks about raising taxes (or enforcement) or cutting government transfer payments. Portugal is hanging on … just. Spain has a 20% unemployment rate and will find it difficult, if not impossible to pass a contractionary budget. Italy? Well, same story, different language.
Portugal will be the next country to need a bailout, and Spain won’t be far behind. Of the two, Spain is much larger and a much bigger threat to European stability. Angela Merkel, Chancellor of Germany, has rejected any notion of increasing the size of the bailout fund. What happens next?
First, Portugal accepts a bailout and the bailout fund runs dry. The cost of credit default swaps on Spanish debt, and Italian debt, starts to rise. The rest of the world starts unloading debt of the weaker European countries and, afraid to reinvest in France or Germany, move the money out. This puts downward pressure on the euro. This increased supply drives bond prices down increasing yields and further exacerbating Spain and Italy’s refinancing problems. A falling euro increases the cost of imports for France and Germany which slows their economies and kindles inflation. The European central bank must raise interest rates to fight the inflation, but at the same time needs to buy up sovereign debt to prevent a run on any particular country. The quantitative easing is, itself, inflationary.
Eventually, Spain can no longer refinance their debt and must seek assistance. German taxpayers will revolt at the thought of taking on the debt of Spanish taxpayers and Spain defaults. Negotiations will occur and Spain will refinance their debt at 60-70 cents on the euro with restrictions on fiscal policy. This will mirror Iceland’s solution wherein the bondholders are forced to bear some of the loss.
Spain’s banks will be some of the larger holders of Spanish sovereign debt as a form of reserves. A devaluing of the debt will reduce the asset side of their balance sheets and lower their capital ratios. Some may become insolvent. With any luck, the banks will have purchased credit default swaps and with a little more luck, the counter parties will be solvent. Banks in other countries will also be holding Spanish debt and these banks will also have reduced assets and capital ratios.
When Spain defaults, all the world’s banks will be in jeopardy. Spanish banks are linked to German banks which are linked to English banks which are linked to US banks all through the swaps market. It is the counterparty risk that will cause the contagion.
England and the US will be able to support their banks, in a worst case scenario, by guaranteeing the debts, just as the US did in 2008. The numbers will be staggering. England and the US can do this because their central banks have the unlimited authority to print pounds and dollars respectively. Germany and France, on the other hand, have no such authority to print the euro.
There appears to be no mechanism available to force the fiscally liberal nations to abide by the deficit-to-GDP and debt-to-GDP restrictions that they agreed to ten years ago, nor does there appear to be a mechanism to evict them from the euro currency zone. For Germany and France to save the euro, they will be required to guarantee the debt.
There is, however, a different scenario. France and Germany could voluntarily leave the euro and reinstitute the franc and mark respectively. Their debt would immediately be repriced in their own currencies. The remainder of the fiscally conservative countries could follow with the reinstatement of their own currencies. The remaining users of the euro could vote to inflate the debt away. Once the debt has shrunk to a manageable level in real terms, the euro is abandoned and so endeth the single currency experiment.
Portugal will be the next country to need a bailout, and Spain won’t be far behind. Of the two, Spain is much larger and a much bigger threat to European stability. Angela Merkel, Chancellor of Germany, has rejected any notion of increasing the size of the bailout fund. What happens next?
First, Portugal accepts a bailout and the bailout fund runs dry. The cost of credit default swaps on Spanish debt, and Italian debt, starts to rise. The rest of the world starts unloading debt of the weaker European countries and, afraid to reinvest in France or Germany, move the money out. This puts downward pressure on the euro. This increased supply drives bond prices down increasing yields and further exacerbating Spain and Italy’s refinancing problems. A falling euro increases the cost of imports for France and Germany which slows their economies and kindles inflation. The European central bank must raise interest rates to fight the inflation, but at the same time needs to buy up sovereign debt to prevent a run on any particular country. The quantitative easing is, itself, inflationary.
Eventually, Spain can no longer refinance their debt and must seek assistance. German taxpayers will revolt at the thought of taking on the debt of Spanish taxpayers and Spain defaults. Negotiations will occur and Spain will refinance their debt at 60-70 cents on the euro with restrictions on fiscal policy. This will mirror Iceland’s solution wherein the bondholders are forced to bear some of the loss.
Spain’s banks will be some of the larger holders of Spanish sovereign debt as a form of reserves. A devaluing of the debt will reduce the asset side of their balance sheets and lower their capital ratios. Some may become insolvent. With any luck, the banks will have purchased credit default swaps and with a little more luck, the counter parties will be solvent. Banks in other countries will also be holding Spanish debt and these banks will also have reduced assets and capital ratios.
When Spain defaults, all the world’s banks will be in jeopardy. Spanish banks are linked to German banks which are linked to English banks which are linked to US banks all through the swaps market. It is the counterparty risk that will cause the contagion.
England and the US will be able to support their banks, in a worst case scenario, by guaranteeing the debts, just as the US did in 2008. The numbers will be staggering. England and the US can do this because their central banks have the unlimited authority to print pounds and dollars respectively. Germany and France, on the other hand, have no such authority to print the euro.
There appears to be no mechanism available to force the fiscally liberal nations to abide by the deficit-to-GDP and debt-to-GDP restrictions that they agreed to ten years ago, nor does there appear to be a mechanism to evict them from the euro currency zone. For Germany and France to save the euro, they will be required to guarantee the debt.
There is, however, a different scenario. France and Germany could voluntarily leave the euro and reinstitute the franc and mark respectively. Their debt would immediately be repriced in their own currencies. The remainder of the fiscally conservative countries could follow with the reinstatement of their own currencies. The remaining users of the euro could vote to inflate the debt away. Once the debt has shrunk to a manageable level in real terms, the euro is abandoned and so endeth the single currency experiment.
Monday, December 6, 2010
Peter Bissonnette, welcome to the rent-seekers' club
It's been a while since we found a suitable inductee into the rent-seekers' club. Previous invitations have gone to Heather Reisman and Dr. Antoinette Dumalo. A rent-seeker is an individual or corporation that attempts to influence government policy to generate monopoly profits for themselves.
Mr. Bissonnette is the president of Shaw Communications. He is trying to pursuade the CRTC, the regulator of Canadian broadcasting, that Netflix needs to be regulated in Canada. The argument is that Netflix does not have to incur the costs of broadcasting Canadian content and thus have an unfair advantage over broadcasters like the Shaw-owned Canwest Global. See the article in Canadian Business.
Netflix is Blockbuster or Roger's video without the bricks and mortar. Instead of going to the store to rent a movie, we can now order it online for immediate deliver. Shaw did not object to the existance of Blockbuster, why Netflix?
Our guess is that using Netflix uses up Shaw's bandwidth and that may slow their internet service. Regulating streaming video reduces Shaw's infrastructure costs. Funny that a company wants to charge for unlimited internet usage, as long as you don't use it.
Notice that Roger's has been silent on this issue since they provide both cable/internet and DVD rental.
Mr. Bissonnette is the president of Shaw Communications. He is trying to pursuade the CRTC, the regulator of Canadian broadcasting, that Netflix needs to be regulated in Canada. The argument is that Netflix does not have to incur the costs of broadcasting Canadian content and thus have an unfair advantage over broadcasters like the Shaw-owned Canwest Global. See the article in Canadian Business.
Netflix is Blockbuster or Roger's video without the bricks and mortar. Instead of going to the store to rent a movie, we can now order it online for immediate deliver. Shaw did not object to the existance of Blockbuster, why Netflix?
Our guess is that using Netflix uses up Shaw's bandwidth and that may slow their internet service. Regulating streaming video reduces Shaw's infrastructure costs. Funny that a company wants to charge for unlimited internet usage, as long as you don't use it.
Notice that Roger's has been silent on this issue since they provide both cable/internet and DVD rental.
Wednesday, December 1, 2010
More on Sovereign Debt Pricing
In a previous blog, I suggested that the pricing of sovereign debt did not accurately reflect the implications of Too Big to Fail. (Click here for blog) If my logic is correct, the appropriate investment strategy is to buy sovereign debt of Portugal, Italy, Ireland, Greece and Spain since they overstate the default risk, and short the sovereign debt of the countries that would likely have to bail them out: Germany, France, Sweden, Denmark and the Netherlands to be sure, England and the U.S. likely, Canada, Australia and New Zealand perhaps.
A pricing correction along the lines I suggested would increase the price of the PIIGS' debt and reduce the price of the other major nations. The bonds in play would be the 10-year maturities. T-bill prices aren't very sensitive to interest rate changes due to their short duration. 30-year bonds just aren't liquid enough.
Some 10-year bond yields courtesy of the Bloomberg app on my iPhone:
Tomorrow we look at the effect of these changes on banks' balance sheets.
A pricing correction along the lines I suggested would increase the price of the PIIGS' debt and reduce the price of the other major nations. The bonds in play would be the 10-year maturities. T-bill prices aren't very sensitive to interest rate changes due to their short duration. 30-year bonds just aren't liquid enough.
Some 10-year bond yields courtesy of the Bloomberg app on my iPhone:
Tomorrow we look at the effect of these changes on banks' balance sheets.
Subscribe to:
Posts (Atom)