Risk and uncertainty into 2012

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A very well written article.

THINK ASIAN
By ANDREW SHANG

FOR most investors, 2011 must be an annus horribilis a year of losses for most except the short-sellers.

After a year of losses, you can almost believe anything. According to the Mayan calendar that ends 5,125 years on 21 December 2012, cataclysmic events will occur one year from now. Chinese astrologers believe that the Year of the Water Dragon is a year of fundamental change. If you believe euro-sceptics, the euro will collapse next year and a new order will emerge.

Christmas is a time to slow down for reflection. It is a time to get away from daily Blackberry emails to a world where life seems timeless.

Every year, my wife and I go backpacking somewhere East of Bali. Indonesia is an archipelago of 17,500 islands, exotic cultures and the world's fourth populous country. Here, we travel by local buses, shop in the rural markets, speak only Malay and just wander where our spirits take us.

Indonesia is one country where the Blackberry is still growing in usage, although amongst the more affluent, the iPhone4 is in. Inflation seems to have set in everywhere, but even in remote provinces, hot money has poured into gold and coal mines and building construction is ubitiquous. Indonesia is clearly on the move.

My scenarios for the next year are always defined by what books I bring along to read and reflect on questions I missed this last 12 months.

Why did the financial markets behave so dismally in 2011?

For this, I delved into Benoit Mandelbrot and Richard Hudson's 2008 book on The Misbehaviour of Markets A Fractal View of Risk, Ruin and Reward. The late French mathematician Mandelbrot worked all his life in IBM and invented “fractal geometry”, defined as rough or fragmentary geometric shapes that can evolve into great complexity.

In the late 1960s, Mandelbrot started applying his mathematics to the study of markets. The founder of the widely used Efficient Market Hypothesis, Eugene Fama, was in fact a doctoral student of Mandelbrot.

He argued that stock price movements are unpredictable and follow a random walk. His Hypothesis assumes that prices are independent and are normally distributed, namely, they follow the Bell curve.

In contrast, Mandelbrot, who studied the cotton market, argued that market prices are not independent of each other. Their evolution goes through periods of quiet and then extreme volatility. He felt strongly that power laws (curves with long tails) are more common in nature than “normal” statistical bell curves.

The violent market movements since 2008 suggest that Mandelbrot was more right than mainstream finance theory. The Nobel Laureates that founded the hedge fund LTCM (Long-term Capital Management) never expected market movements of more than four times standard deviation, but the Russian crisis in 1998 moved markets so much that LTCM ran out of liquidity before prices reverted back to normal. The lessons of LTCM were forgotten by market players and regulators alike in the run up to 2008.

How do we use Mandelbrot's insights to look into 2012?

First, markets are far more risky than standard theory teaches us. Second, big gains and losses concentrate into a small period of time. We may be exactly in that window of time when the markets are swinging wildly. No one is certain what is the right direction of the market. Third, prices often leap, rather than move smoothly. We see this in the foreign exchange markets they remain stable for a while, but then adjust dramatically. Fourth, bubbles are inevitable.

The fundamental challenge to central bankers and the public alike is whether there is going to be deflation or inflation.

With advanced-country central bankers printing money at near zero interest rates, many people think that inflation is inevitable. At the same time, inspite of the massive monetary creation, the greater fear is that we are entering into a worldwide depression of slow growth and rising unemployment.

Who is right?

Mandelbrot's work has challenged us to think very differently about time, scale and value. Human beings love to have stability, but nature moves in cycles, some short, some long.

Time has different meaning for different markets. Since companies report results quarterly, management behaviour tends toward short-term responses. The 4-5 year election cycle forces politicians to take short-term policies to gain popularity.

We know that 2012 will be an election year for the US, France, Germany, Hong Kong, Malaysia and perhaps India. We have already seen major transitions in Iraq, North Africa, Myanmar and North Korea. At a time where climate changes are adding to volatility, politics and debt deleveraging has become a heady brew for risks.

Strolling through the markets in Bali, the street chatter is about floods, inflation and traffic jams. Even here, there is a mood, even anticipation, of change.

Mandelbrot's true contribution to our understanding of markets is that intrinsic value is meaningless in a world of ever changing prices.

At the height of a bubble, the astronomical prices transacted bear no relationship to replacement cost. After a tsunami, what was valuable real estate had no buyers. Financial markets operate through arbitrage of different prices that can deviate hugely from the average.

Thus, what we want and value is not what everyone wants, but what we judge to be important at the point of decision. Our value systems are determined by our culture and that is today more determined by mother nature, technology and forces that we do not understand.

The volcanic islands in Indonesia provide rich soils for fertile agriculture, but earthquakes, tsunamis, flood and drought are part of the cycle of nature.

What we know for certain is that 2012 will be a year of major change. As Mandelbrot the scientist said, we can forecast the intensity and path of a hurricane, but we cannot predict how much damage it will do.

We have reached an inflexion point when technology no longer has all the answers to our future.

Crisis has a habit of throwing up new leaders who emerge as heros, whilst others are condemned by history as failures.

Be prepared for both in 2012.

Tan Sri Andrew Sheng is president of the Fung Global Institute.