It’s A Small World : Part One, ‘The Bacon Game’

This is the first of two blogs that will show you why it is a small world after all.

The world and its economy is far more connected that you might imagine. And while that does have some negative consequences, it also provides considerable benefit for the general growth of the economy and that is particularly rewarding for long term investors.

It might be my least favourite ride at Tokyo Disney Resort, but it is a small world after all.
It might be my least favourite ride at Tokyo Disney Resort, but it is a small world after all.

Normally, I tend to go a little ‘off-piste’ at this point in the hope that I can maintain your interest. However, in this case I am fortunate that, 20 years ago, three Albright college students did that for me when they dreamt up a game that very effectively demonstrates how complex systems, like the economy, benefit from a network effect. It is known as the ‘Six Degrees of Kevin Bacon’.

The aim of the game is to discover how connected any Hollywood actor is to Kevin Bacon – the hero of such cinematic treats as ‘Tremors’, which I admit is only good because it is so bad. The idea is to work out the shortest number of links or ‘degrees’ between any random actor and Kevin.

If the actor and Mr Bacon have appeared in the same movie, that’s one degree of separation. If the random actor was not in a film with our star, but appeared in another movie with an actor who has appeared with him, that’s two degrees – and so on.

So, you might ask, how well connected is the movie world in this way?

In his excellent book, ‘The Origin of Wealth’, Eric D. Beinhocker describes a study using data from several US universities that show the highest degree or ‘Bacon’ number for any American actor is 4. He goes on to state, ‘90% of the roughly 570,000 actors in the world had some connection to Bacon, the highest Bacon number in the world was ten, and 85% had a number of three or less.’

Those are pretty amazing numbers. And it shows that the movie world and, by extension, the economic world is far more ‘connected’ than you would expect if the links were just random.

Why is this the case?

When you have lots of different clusters of people linked by different themes, such as their profession and then have random links between those clusters you get much better connections than by random chance alone.

It is possible to quantify this mathematically and two gentlemen Newman and Watts have shown that in a population of 1000 people if each person has 10 friends and 25% of them are random, then the average degree of separation is only 3.6. If each person has 10 friends and none are random, it’s 50!

In light of those numbers, it’s easier to see how social media companies like Facebook grew so quickly using the biggest economic network, the internet. And Facebook uses its considerable knowledge of its own network structure and its connectivity to entice advertisers. It also, in part, explains some of the extraordinary valuations of companies in the sector and why a simple application like Snapchat spurned a $3 billion offer from Facebook – but I stress, only ‘in part’. Some of these companies are priced as though they will achieve networking perfection and late investors are very likely to be disappointed.

And, of course, not all network effects are beneficial – the recent financial crisis laid bare the dangers of contagion and that in extreme environments, different types of investment are far more linked that we would like or that traditional theory suggests. Which leads me back to my previous blog about volatility. Simply put, market prices and movements are showing real signs of complacency.

I’ll leave you with a short video of Kevin Bacon, who given his networking credentials fronts the current advertising campaign of the EE mobile and broadband network. Here he is challenging Jamie ‘never wash your hands’ Oliver to make the best bacon sandwich.

And I’d really appreciate it If you could help me add to the ‘small world’ network effect by clicking the ‘like’ button at the end of this blog.

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing

An Introduction to VIX – the Fear Index


If I said to you the word ‘Vix’, chances are you would be thinking that I was talking about ‘Vaporub’. However, in this case I am referring to one way in which we measure how ‘fearful’ financial markets are.


Not that Vicks Vaporub doesn’t have its uses in life. Aside from the obvious one of relieving nasal congestion it also serves as a reasonable clue to the health of a marriage. If you are happy sharing a bed with a sniffling partner covered in the stuff, chances are you’re both onto a good thing.

The Vix measures emotion between these two extemes. Pick a button.
The Vix measures emotion between these two extemes. Pick a button.

To give it its full title, VIX refers to the Chicago Board Options Exchange Market Volatility Index. That sounds very grand and a bit complicated, but as ever, I’ll try to break it down into a simple concept that is easier to understand. And I’ll leave most of the mathematics to those of you who want to contact me directly for a much fuller explanation.

The ‘options’ referred to in the title are essentially just price guarantees that can be traded for a fee. Some allow you to guarantee the price at which you can buy the stock index – others give you a guarantee to sell at a certain price.

And it’s the fee, or premium that you have to pay that gives us a clue to how relaxed or fearful the overall stock market is.

Why? Well if I am going to provide you with any form of guarantee, whether it’s on a household good or perhaps the insurance on a car, I need to work out how likely it is that I will have to pay out that guarantee and whether, on average, it will cost more that the fees I am charging.

When it comes to a stock index, the chance that I will have to pay out depends largely on one factor, how volatile that stock market is, or more importantly, how volatile it is expected to become. The more wildly it is moving around, the more likely that I will have to pay out on the guarantee and therefore the more I want to charge upfront for providing it.

And that is what the VIX attempts to do. It looks at the prices being charged in the market for a variety of options or price guarantees and comes up with a value that tells us how volatile those prices are telling us the stock index is expected to be. And that number is a percentage of the current stock index price.

A figure of 20% means that there is almost a two thirds chance that the market will remain in a range up or down 20% in the next year. A lower figure would mean that expectations are for a much calmer market, a higher figure for a more volatile market.

And at the moment the figure is a mere 11%, which is very low – the lowest level in fact since the start of the financial crisis in 2007. Then it was a spectacular misjudgement given what happened over the next two years.

 

But are current levels justified?


There are all sorts of indicators that are suggesting the financial markets are having one enormous ‘goldfish’ moment where they have completely forgotten the last business cycle. And the reason for this is extreme confidence in the actions of the central banks.

I am nowhere near as sure as to the level of their competence, but low expectations of volatility can last for a long time – you know that it will increase but it is very hard to say when. As I’ve mentioned several times, it suggests it’s time to be a bit more cautious. It also means that I am finally prepared to look at some defensive structured products, but that will be on an individual client basis.

And I repeat that if you’re into natural logs (mathematical not fire wood), rules of dispersion, letters of the Greek alphabet and want to pick the brains of a volatility watcher since 1985 – I’d be happy to answer your questions.

 

 It’s all part of the service.


Answering your questions is all part of the service, and living eight years in Asia gives you an insight into great service. Here is a short topical story about the service I received during the 1990 Italian World Cup, while staying at the Oriental Hotel, Bangkok.

My wife and I were there to spend a delayed honeymoon in the splendour of this fine hotel. Our original honeymoon was just a couple of days in Bournemouth and as exotic as that location is, we felt we deserved another break.

The problem was it was during the World Cup and given the time difference between Bangkok and Rome I needed to know the Oriental Hotel was putting the games on in the early hours.

I needn’t have worried. The Thais are fanatical about football. And I realised this when on the day of England’s first game against Ireland I entered the designated room at the hotel.

There was a huge projector screen at one end and about one hundred chairs in front of it and about the same number of staff standing around the edges of the room that refused to sit down even when I invited them to – and I was the only hotel guest there.

It was a rather bizarre environment. As the game started none of the staff made a sound, so nor did I. Then a senior looking member of staff came over to me and said, ‘excuse me sir, are you English or Irish?’

I replied, ‘English’ and he returned to the other staff to let them know.

The next time England got the ball, they all cheered, and when Lineker scored after 8 minutes I could have been on the terraces. It finished 1-1, but believe me when I tell you it’s hard to match Asia for service!

Sex & Drugs & GDP

On a trip to the coast a fortnight ago, I went inside a café to order a couple of ice-cream cones. Ahead of me in the queue was a father, who was looking a little stressed. He was waiting for a few burgers and hotdogs for his family and it was taking a little longer than expected.

He wasn’t the only one who was a little tense. The staff were feeling the heat of the kitchen as well – and I was wondering how I managed to get on the wrong queue again. His order did finally arrive and everything seemed to relax a bit as the lady behind the counter entered his order into the digital till.

In anticipation, the dad stood there with a twenty pound note in his hand and I doubt he expected much change. However, the final total on the till suggested he had under-clubbed it a bit. The price for some soft drinks and a few burgers and hotdogs? £26,000.

A bit pricey for a few burgers and drinks.
A bit pricey for a few burgers and drinks.

 

He quite calmly said, ‘I wasn’t thinking of spending that much’. And from the back of the kitchen came a distant voice, ‘has the till gone wrong again?’

They settled on an amount nearer £15 and my own bill was a more moderate £3.20 as we resorted to the old analogue system of a notepad to record the trade and cash to pay for it.

I mention it because, for a fleeting moment there, the Gross Domestic Product (GDP) of the UK was artificially raised by approximately £25,985.

I am jesting, of course, but last week we learned that the Office for National Statistics will attempt to add the oldest industry in the economy to their quarterly estimate of how the economy is faring. From September, as part of other changes that will lift GDP by 2.3%, they will include the value of drugs and prostitution.

It’s important to emphasise the word ‘estimate’. GDP figures are reported and debated in the media as though they are factual, but they are subject to revisions as some parts of the economy are far harder to assess than others and not all the data arrives at the same time.

In this case, the Office for National Statistics kindly give us a separate Excel spreadsheet that shows us their assumptions. In total, it amounts to £9.7 billion, based on 2009 prices, or approximately 0.7% of the then GDP – and it breaks down as follows:

Prostitution        £5.27 billion        54%

Drugs                  £4.43 billion        46%

In the case of prostitution they reached that number by estimating there are 60,879 prostitutes in the UK – each with 25 clients a week paying £67.16. If £67.16 seems ridiculously precise, it’s an old figure of £50 adjusted for inflation. Take off costs of £44 million, which were borrowed from a Dutch estimate and you get the final figure.

And for the drugs industry, cocaine in its various forms represents 71% of the total (42% crack, 29% powder). Those numbers allow for the cost of importing it, so the sales figures are even higher with cocaine accounting for 77% of the grim total.

So why are they attempting to do this?

Ostensibly it is to meet European Union rules to establish common practice among member countries. The Dutch, for example, have reported parts of these figures for years as prostitution and certain drugs as are legal. However, the overall changes are also in line with international guidance from the likes of the US and Australia.

It’s hard to argue with the idea of trying to measure all areas of the economy and some countries have a lot of work to do. In April the IMF endorsed a near doubling of Nigeria’s GDP to $510 billion as new industires were added and prices updated. As the Economist newspaper pointed out, the new numbers aren’t fiddled, it’s the old numbers that were wonky.

So what’s most important is that the numbers as a whole are regarded as credible. And the numbers of two countries stand out as being questionable.

The government of Greece, endorsed by some economists, justified higher levels of national debt before the recent crisis due to the estimated size of its black economy. At the time, as now, it wasn’t even collecting normal levels of tax on its legitimate one. We know how that one turned out.

And then there’s China, where the GDP figures miraculously meet official annual targets near 7%, despite the sheer scale and complexity of their calculation. Mathematically, continuous growth of 7% is a notable number – it means the economy is doubling in size every ten years. And if an economy of that size is really growing at that rate, they are more likely to bump into problems – especially rising levels of debt.

Michael Pettis, a professor of finance at Peking University, whose blog we have followed for some time, now makes the case that it can’t continue that way – the country needs to rebalance towards lower growth nearer 3 or 4%. I’m not sure the investment world fully appreciates that.

I’ll leave the final comment to the lyrics of Ian Drury, from whom we borrowed the title of this blog. He knew a thing or two about simple explanations of complicated subjects. My favourite has to be these two verses about two well known gentlemen from ‘There Ain’t Half Been Some Clever Bastards’ –

Van Gogh did some eyeball pleasers

He must have been a pencil squeezer

He didn’t do the Mona Lisa

That was an Italian geezer.

The next verse isn’t quite as factual, but brilliant nonetheless

Einstein can’t be classed as witless

He claimed atoms were the littlest

When you did a bit of splitting-em-ness

Frighten everybody shitless