November 2008


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Help is at hand. The Doctor is in.

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Just some initial information while I complete the numbers on LTUS. For the context you’ll need to follow the initial analysis and counterpoints from the iBC crew.

Lotus Pharmaceuticals, Inc. (Lotus) operates, controls and beneficially owns the pharmaceutical businesses in China of Beijing Liang Fang Pharmaceutical Co., Ltd. (Liang Fang) and Beijing En Zhe Jia Shi Pharmaceutical Co., Ltd. (En Zhe Jia), collectively Lotus East, under the terms of the Contractual Arrangements.

Other than the Contractual Arrangements with Lotus East, the Company does not have any business or operations. Lotus provides business consulting and other general business operation services to Lotus East. Liang Fang is engaged in the production, trade and retailing of pharmaceuticals, focusing on the development of medicines.

Liang Fang owns and operates 10 drug stores throughout Beijing, China that sell Western and traditional Chinese medications, lease medical treatment facilities to licensed physicians, and generate revenues from the leasing of retail space to third party vendors and the leasing of advertising locations at its retail stores.

Stock Activity
Last Price 0.28
52 Week High 1.30
52 Week Low 0.16
Volume 500
Average Daily Volume (13wk) 35,860
50 Day Moving Average 0.31
200 Day Moving Average 0.66
Volatility (beta) NA

Institutional Ownership 1.40%

Last 12 Months 5 Year Growth
Sales 67.0 Mil NA
Income 11.5 Mil NA
Dividend Rate 0.00 NA
Dividend Yield 0.00% NA

More financials
Fundamental Data
Debt/Equity Ratio 0.22
Gross Margin 38.47%
Net Profit Margin 17.17%
Total Shares Outstanding 42.4 Mil
Market Capitalization 11.88 Mil
Earnings/Share 0.24

ltus

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Here is an article written by Charles Davi I simply do not agree with all of his arguments. However that being said, he has numerous excellent articles on his site derivativedribble on the blogroll.

Insurable Interests
When you purchase fire insurance on your own home, you are said to have an insurable interest. That is, you have an interest in something and you’d like to insure it against a certain risk. In the case of fire insurance, the insurable interest is your house and the risk is fire burning your house down. Through an insurance policy, and in exchange for a fee, you can effectively transfer, to some 3rd party, financial exposure to the risk that your insurable interest (house) will burn down.

When you purchase protection on a bond through a credit default swap, you may or may not own the underlying bond. As such, you may or may not have something analogous to an insurable interest. David Merkel over at The Aleph Blog brought this issue to my attention in a comment on one of my many rants about credit default swaps. Although you should read his article in its entirety, his argument goes like this: just like you wouldn’t want someone you don’t know taking out a life insurance policy on you (because that would give them an incentive to contribute to your death), corporation ABC doesn’t want swap dealers selling protection on their bonds to those who don’t own them (since these buyers would profit from ABC’s failure). Technically, ABC wouldn’t want protection being sold to those that have a negative economic interest in ABC’s debt.

Courting Disaster
We might find it objectionable that one person takes out an insurance policy on the life of another. This is understandable. After all, we don’t want to incentivize murder. But we already incentivize creating illness. Doctors, hospitals, and pharmaceutical companies all have incentives to create illnesses that only they can cure, thus diverting money from other economic endeavors their way. More importantly, even if you don’t accept the “it’s no big deal” argument, insurance contracts have a feature that prevents the creation of incentives to destroy life and property: they are voluntary, just like derivatives.

In order for you to purchase a policy on my life, someone has to sell it to you. And like most businesses, insurance businesses are not engaged in an altruistic endeavour. So, when you come knocking on their door asking them to issue a $100 million policy on my life, they will be suspicious, and rightfully so. They will probably realize that given the fact that you are not me, $100 million is probably enough money to provide you with an incentive to have me end up under a bus. And of course, they will not issue the policy. But not because they care whether or not I end up under a bus. Rather, they will not issue the policy because it’s a terrible business decision. They know that it doesn’t cost much to kill someone, and therefore, as a general idea, issuing life insurance policies to those who have no interest in the preservation of the insured life is a bad business decision. The same applies to policies on cars, houses, etc that the policy holder doesn’t own. As is evident, the concept of an insurable interest is simply a reflection of common sense business decisions.

You Sunk My Battleship
So why do swap dealers sell protection on ABC’s bonds to people that don’t own them? Isn’t that the same as selling a policy on my life to you? Aren’t they worried that the protection buyer will go out and destroy ABC? Clearly, they are not. If you read this blog often, you know that swap dealers net their exposure. So, is that why they’re not worried? No, it is not. Even though the swap dealer’s exposure is neutral, if the dealer sold protection to one party, the dealer bought protection from another. While the network of transactions can go on for a while, it must be the case that if one party is a net buyer of protection, another is a net seller. So, somewhere along the network, someone is exposed as a net buyer and another is exposed as a net seller.

So aren’t the net sellers worried that the net buyers will go out and destroy ABC? Clearly, they are not. The only practical way to gain the ability to run a company into the ground is to gain control of it. And the only practical way to gain control of it is to purchase a large stake in it. This is an enormous barrier. A would be financial assassin would have to purchase a large enough stake to gain control and at the same time purchase more than that amount in protection through credit default swaps, and do so without raising any eyebrows. If this sounds ridiculous it’s because it is. But even if you think it’s a viable strategy, ABC should be well aware that there are those in the world who would benefit from the destruction of their company. This is not unique to protection buyers, but applies also to competitors who would love to take ABC over and liquidate their assets and take over their distribution network; or plain vanilla short sellers; or environmentalist billionaires who despise ABC’s tire burning business. In short, ABC should realize that there are those who are out to get them, whatever their motive or method, and plan accordingly.

Hands Off My Ether
The fact that others are willing to sell protection on ABC to those who don’t own ABC bonds suggests that any insurable interest that ABC has is economically meaningless. For if it weren’t the case, as in the life policy examples, no one would sell protection. But they do. So, it follows that protection sellers don’t buy the arguments about the opportunities for murderous arbitrage. So what is ABC left with? An ethereal and economically meaningless right to stop other people from referencing them in private contracts. This is akin to saying “you can’t talk about me.” That is, they are left with the right to stop others from trespassing on their credit event. And that’s just strange.
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It is really this argument and conclusion that I disagree with;

So aren’t the net sellers worried that the net buyers will go out and destroy ABC? Clearly, they are not. The only practical way to gain the ability to run a company into the ground is to gain control of it. And the only practical way to gain control of it is to purchase a large stake in it. This is an enormous barrier. A would be financial assassin would have to purchase a large enough stake to gain control and at the same time purchase more than that amount in protection through credit default swaps, and do so without raising any eyebrows.

With recent market history, we can see that in a bear market, just the suspicion of hidden bad news can decimate a common stock price. More ominously, in a Bank, the hint, suggestion, or nasty rumour of an insolvency can trigger a Bank run.

Due to the nature of “Reserve requirements” Banks operate on a sliver of capital that can in times of stress and dislocation in financial markets evaporate very quickly. How quickly?

By making some simplifying assumptions it is relatively easy to make a back-of-the-envelope estimate of how long a Bank could survive in the event of a bank run. Therefore, using the following assumptions: all withdrawals on day 1, and continuing each day until exhausted.

*all demand deposits are withdrawn
*1/30 of all 1 month deposits
*1/90 of all 3 month deposits

Where a large proportion of a banks deposits are retail, this will in all likelihood overstate the speed of withdrawals, due to the effective term of deposits exceeding their legal term.

On the asset side, all securities can be assumed to be sold immediately, at market, with no markdowns [unlikely in reality, as we have seen] an estimate made of vault cash, and deposits with other banks.

The net result provides a figure of about 10 days for the most conservative banks [US] and, for the less conservative 5 days or less. Thus we see the collapse of Bear Stearns, Lehmans, as about par for the course, once the confidence of depositors [customers] has been lost.

We had the situation of “Short Selling” being banned by the SEC, appeals to Congress on how rumours propogated by short sellers were bringing down the company etc. Banning short sellers was most definitely the wrong response, however it does illustrate the “rumour” in action.

If this sounds ridiculous it’s because it is. But even if you think it’s a viable strategy, ABC should be well aware that there are those in the world who would benefit from the destruction of their company. This is not unique to protection buyers, but applies also to competitors who would love to take ABC over and liquidate their assets and take over their distribution network; or plain vanilla short sellers; or environmentalist billionaires who despise ABC’s tire burning business. In short, ABC should realize that there are those who are out to get them, whatever their motive or method, and plan accordingly.

Businesses should plan accordingly, but haven’t, thus, as in every credit cycle, we lose the poorly managed business, due to whatever reasons. The advent of CDS has added simply a further variable to the mix. Surely though, a CEO paid in the tens or hundreds of millions of dollars to manage, can and should do his homework. Obviously not.

In summary then, CDS contracts were intended as a form of insurance contract, and I have blogged to this effect concerning CDS previously. Unfortunately, they [CDS] have been adopted as instruments of speculation, due in no small part to the enormous leverage offered. Their very opaqueness also lends to them additional speculative benefits, as positions cannot always easily be traced to owners who may simply be “talking their book.”

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There seems to be yet another discussion brewing of interest over on the iBC site. This particular one concerns “Value Investing.” The supporter of value investing is rather outnumbered by the traders. There are however some interesting points, which I am going to steal. The discussion has focused on LTUS a pharmaceutical company operating in China.

Josh Says:

Currently, TAST is a paper win and LTUS is a loss. I believe LTUS will be green soon.

I continue to look for better values. If I had found them, I would have sold TAST already.

If my investments rally to +33%, I will consider removing the capital.

In value investment, catastrophe chances appear to be the major consideration (rather than win probability). If I can read the fundamentals correctly, then I win when I buy them. However, if TAST loses its line of credit (recently reaffirmed), or LTUS turns out to be adding weird fillers to their pharmaceuticals, my fundamentals mean nothing. As far as I can tell, my risk remains low.

VIX to 30 is not a prediction. I meant it as shorthand for a consolidation period that ropes in longs.

November 29th, 2008 at 12:00:20 am

Josh Says:

The stock market can be wildly inaccurate. That is the basis of value investing. Continuing to mention stock price and volume does not change the company’s abilities. If you told me you have reason to believe LTUS is falsifying data, or that they cannot meet growth estimates, I would listen.

When I talk about risk, I refer to what the company is doing, not the stock.

I do not need LTUS to do anything in this rally. As I said, a consolidation period will give me feedback on my choices. Right now, there is only volatility.

I mention 33% because I could sell 3/4th, turn it into a zero risk investment, then move on to pick another.

I enjoy this site. I read it every day. It rarely contains advice for long term investors. You continue to give me advice for trading the market. I continue to say I am not trading.

November 29th, 2008 at 12:44:04 am

This is the meat of the argument from the value investor, Josh. The traders, weigh in with the following criticisms;

WeeklyTA Says:

1) You have some shit that’s $0.28 that traded 500 shares today. And you say your risk is low? Please. Don’t even call this a “value” stock. It’s a dumped penny stock.

2) You mentioned “below 30″ on the VIX. That’s not a consolidation point. That is a total breakdown, including a break below the 200-day MA.

3) “Even if my two picks turn out” is another gambling statement. Traders aren’t supposed to even be thinking that sort of nonsense.

4) “I believe LTUS will be green again”. Now you are ‘hoping’ and possibly praying later on. Save that for church.

5) You’re willing to remove capital only when you get a “33%” return. Another part of the gambling psyche. Where did the “33%” figure even come from?

6) If you’re a brand new investor/trader, and you’re buying stuff like #1 starting out, then you deserve to lose every penny.

Don’t bullshit me bro. Stop justifying shit and just listen to what people with experience are telling you.

November 29th, 2008 at 12:32:53 am

WeeklyTA Says:

You’re not listening. You should be asking a lot of questions, not blabbering all these stupid statements. I guess it all depends on your definition of investing. Trust me, you’re gonna be trading those penny bitches. You might not yet know it yourself. This is a trader’s market, don’t forget that. Ask a lot of questions and get some wisdom instead of trying to pitch some textbook shit.

November 29th, 2008 at 2:19:17 am

Yogi & Boo Boo Says:

Josh – Listen carefully to what WeeklyTA is saying. YOU’RE NOT LISTENING!

Just because you can post here does not mean you must. Please don’t take this the wrong way. Go get an education, then come back and and argue with Danny and WeeklyTA. These two gentlemen are in their analytical prime. They’ve presented cogent arguments in defense of their positions.

Statements like the following:
“It rarely contains advice for long term investors. You continue to give me advice for trading the market. I continue to say I am not trading.”

show a complete lack of understanding of trading/investing and insult a site that enables experienced and serious traders to exchange trading ideas and insights.

In the spirit of full disclosure, I happen to be positioned for a much longer duration bear market rally (both in time and price). So I have the “other side of the trade” of Danny, WeeklyTA, WoodShedder, and DevilDog.

I trade long term, so please don’t say there is nothing here for persons of the long term persuasion. EVERY long term position starts out as a very short term one. EVERY long term sale is executed EXACTLY in exactly the same manner as a short term sale.

BTW, what are you doing playing around with garbagio like LTUS? You will learn NOTHING from trading JUNK. Use an ETF, or if you want to trade individual stocks, on fundies, analyze the Dow 30 stocks. There are enough low priced stocks to satisfy your need for junk and action, as well as real values and balance sheets for an investor to take down positions.

November 29th, 2008 at 9:40:30 am

Woodshedder Says:

Josh, you’re missing something very important.

The fundies of LTUS do not really matter. It does not matter if it is trading at a discount to what you have determined is its true value.

The fact of the matter is that nobody wants LTUS. 500 shares traded on Friday.

The danger of your assumption is that you, and only you, have this ability to determine what is value and what isn’t.

Man, it isn’t that hard. It is not like you are privy to some information that no one else has. You have the same thing everyone else has. And do you really think that you are the only one on the planet who has noticed that LTUS may be a value?

The problem is that it appears that you are the only one on the planet who think LTUS is a value. Only 500 shares traded, when it is at or near 52wk low. Obviously, no one else shares your assessment.

So again, it doesn’t matter if it is a value or not, as there does not seem to be anyone else who is willing to bid up this “value” stock.

My advice to you is the same as it was last week. Start with a stock like X, or AA, or any of the stocks that have been knocked 80-90% off their highs. They will have participation from institutional investors, who are likely using the same metrics as you to determine value. Then, your work will be rewarded when the stock gets bid back up, instead of your $$ languishing in a name no one knows or cares about.

November 29th, 2008 at 11:23:22 am
Woodshedder Says:

I should add that investing is a multi-faceted game. One facet of the game is participation. You need to add a minimum volume filter to the stocks before you treat them to your analysis.

November 29th, 2008 at 11:25:31 am
Woodshedder Says:

Josh, one more thing. Also, I hope you continue to post here as I think these discussions are probably helpful for a broad group of folks.

You wrote:
“When I talk about risk, I refer to what the company is doing, not the stock.”

Josh, the stock price is the proxy for risk. How else is risk quantified in a given company, if not for the price of the stock?

November 29th, 2008 at 12:02:40 pm

I haven’t seen any analysis for LTUS from Josh, so really can’t comment on any analytical style that he may have employed within his valuation.

What I will do however is run the numbers on LTUS myself to get an idea of the valuation that I would place on this common stock.

I think we can simply dismiss the Yogi & Boo character and his comments quickly. Simply his understanding of a fundamental analysis is extremely shallow, thus we can discount his assessment. We can also dismiss “Weekly TA” as an empty drum beater. Thus we are left with “Woodshedder”

The fundies of LTUS do not really matter. It does not matter if it is trading at a discount to what you have determined is its true value.

Really? Why is that?

The fact of the matter is that nobody wants LTUS. 500 shares traded on Friday.

Really? Here are some holders;
Holder Name Shs Held $ Market Value %Out Fully Diluted Shs Rpt Date
Liu (Zhong Yi) 11,346,853 11,914,196 26.7 11,346,853 04-24-08
Song (Zhenghong) 6,772,483 7,111,107 16.0 6,772,483 04-24-08
Genesis Technology Group, Inc. 3,250,000 3,412,500 7.7 3,250,000 04-24-08
Tan (Shaohua) 3,170,304 6,578,381 7.5 3,170,304 03-25-07
China West, L.L.C. 2,589,358 2,175,061 6.1 2,589,358 01-08-08

The danger of your assumption is that you, and only you, have this ability to determine what is value and what isn’t.

This argument seemingly is thrown at every fundamental analyst at some point. That it almost invariably originates from non-fundamental analysts might provide a clue as to the usefulness of the argument.

Man, it isn’t that hard. It is not like you are privy to some information that no one else has. You have the same thing everyone else has. And do you really think that you are the only one on the planet who has noticed that LTUS may be a value?

The information however is not, and is never clear cut. The truth is almost always hidden under layers of accounting chicanery, both good and bad.

The problem is that it appears that you are the only one on the planet who think LTUS is a value. Only 500 shares traded, when it is at or near 52wk low. Obviously, no one else shares your assessment.

I think the 5% ownership disclosure has dispensed with that chestnut. I shall also have a look at this stock, who knows, maybe the number might rise to two.

My advice to you is the same as it was last week. Start with a stock like X, or AA, or any of the stocks that have been knocked 80-90% off their highs. They will have participation from institutional investors, who are likely using the same metrics as you to determine value. Then, your work will be rewarded when the stock gets bid back up, instead of your $$ languishing in a name no one knows or cares about.

Here I actually agree. The problem that hasn’t been mentioned with small capitalization stocks is that in a recession, it is their ability, through the strength of their Balance Sheet to survive the storm. Larger capitalization stocks, with stronger Balance Sheets tend to survive, this is an intangible value that is important in any analysis.

Josh, the stock price is the proxy for risk. How else is risk quantified in a given company, if not for the price of the stock?

Interesting assessment of risk. Incorrect, but interesting. Which carries more risk, paying $5 for every $1 of earnings, or, paying $0.50 for every $1 of earnings?

I’ll be following along sub rosa.

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An update from the continuing debate regarding inflation/deflation definitions. “j” being the original author of the previously quoted piece.

j Says:

Jake:

Credit contraction is not deflation, it’s a adjustment or a repudiation of the previous malinvestments. It is symptomatic of deflation but is not deflation.

Shed:

Commodity prices falling may be a symptom of deflation but it is not deflation.

Fly:

Again you misunderstand symptoms and causes. I really don’t know what you are talking about when you refer to your ” deflation rant”. Your comments didn’t prompt me to write this.

Anonymous:

Velocity is a tautology (as Mises) correctly described it.

Hillbilly:

Credit is NOT money.

Again let me repeat the definition of deflation.

Deflation is a contraction of the money supply bringing on a fall in the general price level in the economy.

Seeing there is no contraction in the money supply- in fact we have its opposite- there is no deflation.

November 28th, 2008 at 7:36 pm
Anonymous Says:

J, why do you insist on excluding “credit” from the definition of deflation? It is not strictly a reduction in money supply (M1 or other) and yet you keep arguing that fact, why?

According to Investorwords.com the definition of Deflation is “a decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy. The opposite of inflation.”

Click to Edit November 29th, 2008 at 12:23 am

The argument has seemingly reached the question of whether “credit” constitutes money?

The answer one would think is obvious. Obviously not. Credit, is the money of the mind. As such, expanding credit is highly inflationary. The destruction, or contraction of credit therefore is disinflationary.

If I am granted credit, in any form, I can increase my “demand” for products and services. If everyone else is also granted “credit in the same amount” then, they can compete for the same “fixed” supply of products and services, thus, the general price level rises for all.

However, should the supply of products and services, increase proportionally to the expansion of credit, then, equilibrium is maintained, and price stability will ensue.

The expansion of credit can progress at many multiples of the potential in expanding production of goods and services. The phenomenal growth of China in GDP terms, stands as stark testimony to the rate of debt [credit] growth in the US & Europe.

Therefore the supply of $7.1 Trillion dollars from the Treasury & Federal Reserve constitutes what exactly? The answer to that question will answer the likely direction that the macro-environment is to take in the future.

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I see that there are at least some out there who share my frustration with the mainstream and professional economists.

Definition of deflation and general idiocy in the population at large.
by j on November 28th, 2008 at 5:16 am

(3 votes, average: 4 out of 5)
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I’m almost at my wits ends reading people’s comments abusing economic terms they don’t understand. Deflation this deflation that. Almost every single comment I see discussing deflation is a suggestion that we’re entering a deflationary period.

Even the idiot professor Roubini is incorrectly using the term.

Why are they saying this?

Because credit markets have had a second hole drilled for an anus, stocks are lower and or the real estate market is down.

The next person who makes such a comment again after reading this will be sent to fucking Gitmo for intellectual terrorism.
What we are currently experiencing is an adjustment; a cleaning up process by the market of previous mal-invesmtents. The adjustment is NOT deflation. Get it. It is pure and simply that: an adjustment process.

The correct definition of deflation is a material contraction in the money supply ( M1 and or broad money) accompanied with a falls in the general price level.

CPI is not an inflation/deflation index and the recent fall in the CPI was NOT deflation.

The next time I catch anyone at this site mentioning deflation in the incorrect way, I will hunt you down and have you publicly hung in the town square. I will then leave the body to be eaten by hungry dogs and cats.
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2 Responses to “Definition of deflation and general idiocy in the population at large.”
Treepart Says:

Zaqwan went looking for his basketball to take to the local court to play hoops. However upon finding his ball, he was disappointed to find that someone had deflationed it and he had no pump to inflation it back up.

“Treepart” it seems you brain has deflated as well

Try taking a smart pill

November 28th, 2008 at 7:14 am
Woodshedder Says:

j, I understand your point. However, it is really one of semantics.

If something has gone down, lowered, etc., it can be said that it has deflated.

Gas prices dropping? They have deflated. Gold prices dropping? Deflation.

Really, unless the conversation is particular to the issue of money supply, deflation is an accurate term.

November 28th, 2008 at 10:13 am
Leave a Reply

I do have a couple of problems with the article however. The CPI is a measure of inflation/deflation, not the only measure mind, but certainly one of the measures.

The second problem revolves around the statement regarding a “contraction in the money supply,” constituting the correct definition of “deflation.” While for practical purposes this will suffice, the problem actually runs a little deeper, and concerns the true function of “money.”

Money is a unit of exchange. [hopefully a store of value] It is not however wealth. Wealth, measured in the ability to produce, is the correct measure of inflationary/deflationary forces. The measurement however is usually simplified within the measurement of units of exchange, money + credit.

The comments section however displays the true level of confusion within the terms. First, and most obviously, the definition of “deflation” outside of an economic context has been grafted onto an economic context, this is guaranteed to confuse the issue.

Second, let’s take one of the examples, and reframe it in “purchasing power” terms. If I am a holder of Gold, purchased at $1000/oz at the top of the market, and the price is now $800/oz, the price has fallen.

Is that “deflation?” Let me state a definition of the terms.

Inflation is a fall in purchasing power.
Deflation is an increase in purchasing power.

Thus, Gold has displayed inflation. A decrease in my purchasing power. Had Gold risen in price to $2000/oz, then, Gold would have been deflationary.

However, if we take Gold from a producer of Gold’s perspective, the picture changes somewhat. If I produce gold from a mining operation, then, we must start the calculation from the cost of production standpoint.

Cost of production………………….$250/oz
………………………………………..$1000/oz

Under the two scenarios, we have radically different conclusions. If I produce gold @ $250/oz, then at $800/oz, I have increased my purchasing power, thus, gold could accurately be described as deflationary.

However, if my cost of production is $1000/oz, and gold is selling for the same $800/oz, then gold could be described as inflationary.

However the terms inflation & deflation do not define the isolated case, they define the aggregate of the economy. They are macro-terms, not micro-terms. Thus, even should gold on an individual basis be described under either scenario, it is irrelevant unless all prices, on aggregate indicate a specific condition.

The correct perspective however is to view the inflation/deflation question from the perspective of the producer.

In summary, the application of terms must in my view take into account as many of the variables and facts possible, prior to hanging the label of inflation/deflation. The media, unsurprisingly do not take account, which is not unexpected. What is unexpected is that “Nobel prize” winning economists, professional economists and others who should know better, make the same mistakes.

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John Forman has a post regarding EMH, which ties into the recent discussions with regard to Gaussian distributions.

The question of whether the markets are efficient was broached again by a fellow blogger recently. The idea is that if the markets are efficient, then it’s not really worth attempting to trade them (meaning stock market investors should stick to index funds). This is all based on the Efficient Market Hypothesis (EMH).

There’s a bit of confusion in the public about what market efficiency really means. It does not mean that the price in the market reflects the value of the asset in question (like a company in the case of a stock). It means that current price reflects the array of potential future outcomes. Basically, the theory says that every idea of what could happen in the future is incorporated into the current price.

Actually I disagree. “Efficiency” means exactly that. That the “current market price” reflects the value of the asset.

With regard to the future, the future is unknown and unknowable. Thus, the market follows a “random walk” as new information is released to the market. Here is the catch, a “random walk” relies upon “independant observations.” The market however does not display independant observations, the market displays “dependant observations.”

Here’s my view.

The more actively traded a market is, the more it tends toward efficiency – especially in relatively low volatility and quiet news environments. Those are times when information can be distributed most efficiently and participants are most likely to act rationally. As you get into less actively traded markets, and as you start adding pressure to a market efficiency becomes less and less the case. Information distribution becomes less efficient and participants act increasingly less rationally.

Here we have a number of interesting problems. The first, measuring the “activity” of a market. Are we talking about the “number” of participants, or the volume of shares? Does it even matter which? Is the market consisting of a small handful of huge institutions the same as a market consisting of a huge number of more moderately sized participants?

Volatility and “news events” are linked, that this is causative seems to be implied. There is news every day. In fact the flow of news has expanded exponentially. How to assign causation to “relevant” or “important” news, in other words, separating out the noise.

Rationality and market participants are linked to a decreasing efficiency in distribution of information flow. An interesting hypothesis, however, this hypothesis is not pursued.

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