Heads you win
16 June 2010
Sean Russo
HEAD ’em up, head ’em up, come in spinner, they cry, as the punters bet on heads or tails. Two-Up’s history in Australia dates back to the goldfields in the late 1800s and it was the spread of the discovery of gold that propelled the game across the country. It was very much a working class game which is why it found its way into the trenches in World War One and from there into the hearts of a generation of Australians and into the very fabric of our nation’s story.
Why two coins and not one is not clear but it would seem it was to extend the game; to build the suspense. A single coin toss is very quick, a simple 50:50 bet over in 10 seconds or less. Introducing two coins reduces the chance of a pair of heads to 1-in-4 and the same for a pair of tails. It is the 1-in-2 chance of getting one head and one tail, “odding it” that draws the game out and can extend the time to a payable outcome quite considerably.
While much of the financial media talks about risk and risk aversion as the key themes in international markets the more I read and listen the more I believe the two dominant themes are where to next – high inflation or deflation? (Inflation has become the default.)
At the core of things in the high inflation/hyperinflation camp is the fear of politicians wanting to be re-elected at any cost and that which is accordingly required to keep the voters happy; such that every politician of every colour must eventually come to fall in behind the battle cry, “inflate or die”. (This phrase has been used by many years by Richard Russell of The Dow Theory Letters.) The rabble work no harder but wages rise, house prices rise, they feel happy, more wealthy and they vote for the guy in charge, or the one that offers even more of the same. One doesn’t have to look far at the moment to see what happens when the rabble are told they must earn less, work harder and retire later. So print (sorry, quantitatively ease) they will, say the inflation camp; nothing is more certain.
The deflation camp point to Japan’s lost decades as evidence of what can happen when despite the amount politicians borrow, spend or print the public pulls its head in and seeks to spend less than they earn, either to save or to retire debt taken on in booms past. Remember the 100-year mortgage the Japanese introduced in 1988-89 to deal with their boom time property prices (their version on low-doc/ no-doc loans so that no buyer couldn’t find a way to buy)? Well at last count they still have 78 or 79 years of payments to make on properties down 66% in value. That’s got to be a bit of a dampener on broader consumption however low the mortgage rates are. Pushing on string was how Keynes described it I believe.
Read the papers, the investment banks' and brokers' research, search the net and you will see these two opposing themes argued with passion, with articulate arguments and no end of corroborating historical evidence or analogues. The inflationists seem to get a better hearing in the popular press because as destructive as high inflation/hyperinflation is, the thought of stagnant wages, falling share and house prices doesn’t sell papers or encourage people to trade or invest. Scratch below the surface and the deflationists abound (and many of them do live in caves or the internet equivalent).
Both camps are committed and convinced and despite the complexity of all the inputs required to be considered it seems, rather perplexingly, that they think the result will resolve itself in a manner as simple as a coin toss. If only life, the universe and everything were that simple.
If inflation/deflation is a coin toss I would like to suggest it’s a game of Two-Up and as such the greatest certainty is uncertainty. Two times in four we will be none the wiser, or, what we will keep seeing is a little bit of inflation in some places and a little bit of deflation in others without a definitive result.
In the trenches of Gallipoli the game of Two-Up was clean, 50:50. At modern casinos when the Spinner “odds it” five times in a row the house collects all bets, rather like the way the zero in roulette gives the house its edge. Think of it as the brokerage, commissions and spreads in financial markets.
Being too committed to one camp or another, either in your personal finances or in the way you manage a company (or a country for that matter), can lead to lots of little losses and lots of transaction costs that can all add up to significant losses long before the outcome is clear. And, of course, that assumes we must have an outcome in a timeframe acceptable to most of us. Researching Two-Up there was mention it was sometimes played with three coins. Based on my own attention span I am sure my relatives would have lost interest and started to bet on two flies walking up a wall in the time it might have taken to get a “three coins the same” result, so it’s not surprising it didn’t catch on. But my point is in this big game we are all exposed to throw in the BRICs, the PIGs, the hedge funds, the central bankers, the interconnectedness of the world today and the permutations and combinations are simply too much for most of us to understand the odds of success or failure.
What to do? If you don’t understand the odds of a game of chance don’t play or at least don’t play with more than you can afford to lose. Remember every toss is a discrete event. In a reasonable timeframe betting (or doubling up) against a strong run of heads is applying science to a lottery, it’s an even money bet every time. That said in a life time it’s not unreasonable to expect the outcomes will be even.
As this game has evolved mining companies have become geared side bets to the main inflation/deflation coin toss game. The big money can’t get a taker for the other side of their bet so they are looking to lay money wherever they can. It seems that many mining CEOs believe they have no choice but to accept the outcome of this big game but it’s not true because they can buy option cover, and they can forward sell modest amounts. In truth I think many of them are addicted to the game and have convinced themselves the outcome is clear and it will be favourable.
The aforementioned Richard Russell likes to say, “In a bear market he who loses the least wins”. I think the same is true in very volatile markets. We are all invested in this global game to some extent. Even if we are sitting in a house we own outright with nothing but cash in the bank or dollars under the mattress we have risk. What lies ahead may very well be a war of attrition and therefore risk management strategy must consider that there is significant advantage in being one of the last men standing. To simply survive longer may be to win handsomely.
In recent years we have seen “inflation sympathetic” copper and nickel companies do incredibly well and then almost overnight fall by the wayside or become shadow’s of their former selves on severe and sudden price setbacks, only to see those markets recover for others to enjoy. It seemed impossible to contemplate after years of the same spinner and nothing but heads that those markets could come up tails but they did.
Right now the spinner in the coin toss that is the gold market is running hot. Some would have you believe in that particular game the coins are double-headed; it doesn’t matter what happens gold will go up. Momentum in markets means a lot but sometime sentiment means even more and can often be a contrary indicator because the game ends when there’s no one willing to bet tails.
Despite what “they” (the beneficiaries of the game – the house) would have you believe, that you must play every toss, and insurance (put options) is too expensive, you don’t and it is not. Look at your operating margin, think about what it could shrink to if the spinner just “odds it” a few times, or heaven forbid he “tails out”, then look at what percentage of that current operating margin need be spent to ensure a profit in all future circumstances, even a short but furious burst of tails such as we saw in the oil coin toss game just after “Peak Oil” book sales topped out. The math is not as bad as “they” would have you believe. And remember, draw confidence from the fact that the guys pricing them have no more idea then we do where or how this is going to play out but they suffer from using a tool that assumes markets are efficient and we are all rational (no really)!
Sometimes options are very expensive, sometimes they are very cheap. Many times even when they are expensive I would ask, expensive compared to what? Just remember this, the people who go around telling other people options are too expensive come from two distinct camps; those who want you to keep playing or those who only ever seek a price when every mug is racing to secure protection and never when the spinner is white hot.
For those who think they understand where, how and when this two-up game will end there are politicians and public servants to save you and fairies at the bottom of the garden. For the rest of us there are options. As I said, expensive compared to what?