The 80/20 Principle

By: Henry To | Fri, Apr 22, 2005
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Hopefully, this week is not getting too exciting for my readers just yet. True, both Intel and Yahoo blew out their first quarter earnings forecasts on Tuesday evening, and for the first time in many days, it looked like that the market will at least have a decent rally yesterday (Wednesday). It was not to be - the market opened up in the morning and pretty much grinded down the entire day. The VIX shot up over 13% to 16.92 and the one-day NYSE ARMS Index closed at 1.97 - the highest reading since early February. Hopefully, my subscribers have heeded our "A Turn in the Tide commentary over the weekend and did not go long yesterday morning. The Bank Index has once again broken its support level at 95. Watch this: The intraday low of the Bank Index was 94.48 last Friday. If or once we break this low, then I think there will be some fireworks up ahead. Finally, the fact that the market was unable to rally (in fact, it actually did a 180-degree reversal) despite the oversold condition of the market and despite the good earnings reports from Intel and Yahoo is very ominous!

Latest reading from the Investors Intelligence Survey: The percentage of bulls now stands at 48.4% while the percentage of bears stands at 26.9%. The resultant bulls-bears% differential in the Investors Intelligence Survey is 21.5% - an increase from a reading of 17.2% last week. What should we make of this? Sure, the stock market is still oversold in the short-term, but in the grand scheme of things, a lot of the sectors are just starting to break down. From a contrarian standpoint, an increase in the bulls-bears% differential in the Investors Intelligence Survey at this stage of the game is cause for concern. FWIW, I do not think that this reading has bottomed yet. We will find out in the coming weeks. (Note: The S&P 500 futures is up 8 points while I am finishing up this commentary - let's see what the market can do today.)

Okay, so the inflation (as measured by the CPI) in the UK may not be as bad as it is over here, but the Bank of England is clearly worried about it. According to the Guardian, inflation in the UK just hit a seven-year high. I will quote:

The Office for National Statistics (ONS) said the consumer prices index (CPI) had risen to 1.9% in March from 1.6% in February, driven by stronger price increases for transport, food, furniture and clothing. The figures for last month were much stronger than City analysts had expected, and the sharp upward move towards the Bank's 2% target is likely to heighten concerns that it could raise interest rates - which currently stand at 4.75% - over the coming months.

"This is a nasty surprise for the Bank of England that significantly increases the chances of an interest rate hike in May," Howard Archer, the chief UK economist for the consultancy Global Insight, said. "While much of the increase was due to higher energy and seasonal food prices, there was evidence that retailers were starting to push through stronger prices in other sectors."

Mr Archer also noted the presence of other sources of inflationary pressure, including higher oil prices and a tighter labour market. "Consequently, we expect the Bank to raise interest rates by 25 basis points next month," he added.

There is now no doubt in my mind that the various Central Banks around the world is cutting back on liquidity. With yesterday's CPI report, the Federal Reserve is going to follow through with its Fed Funds rate increases. After the next FOMC meeting on May 3rd, the Fed Funds rate will be at 3%. Unless the stock market experiences a 10% correction and stay there in the next few months, my guess is that the Fed Funds rate will be at or over 4% by the end of this year.

Yesterday's news about the Chinese economy growing at a higher-than-expected 9.5% in the first quarter also fueled the likelihood of another interest rate hike by the People's Bank of China. Moreover, the Taiwanese Central Bank is also looking to raise rates for the rest of this year.

Ironically, all this liquidity generated by the Central Banks around the world since 2001 may come back to haunt us further down the road. From late 2002 to 2004, the surest best have been the reflation trades - and as a result, every asset class around the world is now overvalued. Let me play devil's advocate and ask my readers this question: What happens if some or most of these asset classes start to fall in value or deflate? The combined weight of the fall in so many asset classes will be severe and unprecedented. Combined with deflationary pressures being generated by the exporting of goods and services from China and India, it is not obvious to me that all the printing of currency around the world will do any good. For people who are quants or in academia: While it is usually obvious what the duration of a bond is (that is, a change in a bond's value given a change in interest rates), it is not at all obvious what the duration is for, say, the S&P 500, real estate, or commodities. These relationships have changed over time and will continue to. A classic example is Japan. 15 years ago, who would've thought that Japan would still be mired in its own deflationary/liquidity trap after an unprecedented period of low interest rates all across the curve?

I apologize for not providing my usual analysis. The objective of today's commentary is basically to stimulate the brains or my subscribers and readers. Our website is not named/branded MarketThoughts.com just because we thought the name sounded good! Now, let me ask you more questions and provide my conjectures for the day.

I want to discuss the 80/20 Principle in this commentary. Most of my readers should know what the 80/20 Principle is - it is usually a principle that is applied to management theory or production techniques. However, the 80/20 Principle was first observed by the Italian economist Vilfredo Pareto (statistics or actuarial mathematics students should know what the Pareto distribution is) in the late 19th and early 20th century. On studying wealth and income distribution in both England and Italy, he observed that 20% of the population consistently held 80% of society's wealth over time. Over the course of the 20th century, many more economists and researchers studied this principle, and more or less, found the principle to be true in many aspects of everyday life and endeavors, such as:

Okay, you get the idea. To read more about the 80/20 Principle, you can go to the following website.

The 80/20 Principle can also be applied to the stock market. For example, 80% of all the total gains in the major stock market indices can be attributed to 20% of all trading days, and vice-versa. Furthermore, 80% of all stock market volatility can be attributed to 20% of all investment entities - entities that are considered marginal or engage in strategies that are not mainstream (such as using leverage). On an individual basis, 80% of all gains (or losses) can be traced back to 20% of all one's trades. What does that mean? First of all, it means that risk-management techniques and the adoption of them are all the more essential. Secondly, it means that most of your trades will be duds that are either losers or won't go anywhere. Patience is a key, but when the right stock or market opportunity comes along, one will need to seize the opportunity and follow through! Corollary (okay, I am guilty - I studied math when I was in college): 80% of all stock market gains are made by 20% of all investors. The rest get the "scraps and still more are hit with long-term losses.

Let's now talk about the 80/20 Principle in relation to the U.S. economy and world economy. First of all, I wouldn't go as far as to say that 20% of the working population produces 80% of the services or goods in our economy. However, the "top 20% of the working population certainly has the biggest long-term impact - individuals such as Bill Gates, Michael Dell, Richard Branson, Thomas Edison, Andrew Carnegie, and perhaps individuals like yourself - entrepreneurs who are very creative and are willing to take business risks and work on your creative side. Perhaps you won a "teacher of the year award and had made a lasting impact on many kids who were unwilling to learn (it is true that most people don't remember most of their elementary school teachers but only the ones that are real exemplary)? Or maybe you are a social worker who helped saved many lives in your daily activities? Anyway, I could go on and on.

Conversely, it doesn't take much for some individuals to ruin it for the rest of us as well, especially in this day and age. Consider the many spammers who roam the internet and costs billions of dollars in lost productivity each year. The business scandals of the last few years - figures such as Ebbers, Fastow, and Winnick - these guys have all given corporate executives a bad name. The events of September 11th also illustrate this point - all the more important given that it didn't take a whole lot of actual physical manpower in order to carry out such a horrible and huge-impact terrorist (economically as well) act.

Long-time readers should know that I have written many articles with references to the state of globalization today and specifically on the economies of China and to a lesser extent, India as well. In the long-run, I am very optimistic on globalization and I believe individuals who are willing to embrace globalization and use their creative talents to find a world market for their business knowledge and skills will not only earn huge rewards from it, but will also make a lasting impact on many lives and companies in the world economy. Again, this is the 80/20 Principle at work.

I am in the midst of reading "The World is Flat by Thomas Friedman and on page 30 to 31, I found this little "gem (like it or not, this certainly will make a huge impact on you if you didn't know this already) on globalization. I will quote:

Every time I think I have found the last, most obscure job that could be outsourced to Bangalore, I discover a new one. My friend Vivek Kulkarni used to head the government office in Bangalore responsible for attracting high technology global investment. After stepping down from that post in 2003, he started a company called B2K, with a division called Brickwork, which offers busy global executives their own personal assistant in India. Say you are running a company and you have been asked to give a speech and a Powerpoint presentation in two days. Your "remote executive assistant in India, provided by Brickwork, will do all the research for you, create the Powerpoint presentation, and e-mail the whole thing to you overnight so that it is on your desk the day you have to deliver it.

"You can give your personal remote executive assistant their assignment when you are leaving work at the end of the day in New York City, and it will be ready for you the next morning, explained Kulkarni. "Because of the time difference with India, they can work on it while you sleep and have it back in your morning. Kulkarni suggested I hire a remote assistant in India to do all the research for this book. "He or she could also help you keep pace with what you want to read. When you wake up, you will find the completed summary in your in-box. (I told him no one could be better than my longtime assistant, Maya Gorman, who sits ten feet away!)

Having your own personal remote executive assistant costs around $1,500 to $2,000 a month, and given the pool of Indian college grads [(India graduates approximately 89,000 MBAs a year)] from which Brickwork can recruit, the brainpower you can hire dollar-for-dollar is substantial.

Given that Friedman didn't hire a remote executive assistant himself, it is probably too early to assess the impact of such an outsourcing business mode. Of course, there are always cultural (I'm talking about company culture here) differences across the board so every presentation can't be standardized, but given the choice of paying $2,000 a month to hire a bunch of very productive MBAs in India (who would be able to learn your style over time) or hiring and training someone new (who may be getting paid $75,000 a year and who may not be as productive), who would the executive go for? How many times can the local guy get an assignment at the end of the day and return it to his boss the next morning? Also, keep in mind that it also doesn't take much for someone to start a trend. Once a few people have used the service and like it, the demand for this type of service could potentially explode.

In the short-run, however, I have mentioned the possibility that the current "phase of globalization may be over for now, given the calls for trade restrictions in recent weeks amid the huge surge in imports from China in the first few months of this year. If things continue this way, our textile industry will be decimated by the end of this year. I am not going to give my opinion on the textile industry - but let's just say that a great many people and forces will definitely fight this to the end. Quotas and tariffs are a huge possibility, given the potential slowdown of the world economy and the U.S. economy that I discussed over the weekend (which will act as a "double whammy for textile producers and manufacturers).

On the other side of the globe, certain political forces in Europe are now blocking economic reforms and the liberalization of the exchange of services within the European Union. In the latest "Outside the Box article from John Mauldin, Louis-Vincent Gave from Gavekal.com talks about the adverse economic impacts in light of the recent developments - all for political gains. Like I said before, the 80/20 Principle also works the other way. In this scenario, the President of France, Mr. Jacques Chirac can be regarded as an antithesis to an individual like, say, Michael Dell.

I will quote: When told of the 1938 Munich accords that allowed Hitler a free rein into Czechoslovakia, Churchill said: "they sacrificed honour for peace, and they shall have neither".

Witnessing recent events in Brussels, Churchill's statement comes to mind. Two weeks ago, European leaders tore away the Stability and Growth Pact (SGP) and dismantled any hopes of liberalization of European services (the Bolkestein reforms) in the hope of securing a "Yes" votes in the May French referendum on the European constitution. In so doing, Europe's leaders sacrificed necessary economic reforms in the hope of political gains, and they will have neither.

I urge all my readers to read this article in full. I had the opportunity to speak with Louis-Vincent Gave and his father while I was in Hong Kong late last year and they are both very experienced and intelligent when it comes to analyzing the world's stock market and economy.

Moreover, the Bank Credit Analyst, in their April 13th daily commentary, suggests that the amount of Japanese exports to China has been slowing down - even before the recent tensions between the two countries. Coupled with the potential slowdown of the world's leading economies, trade between China and Japan may continue to slow down going forward

Conclusion: The 80/20 Principle is not strictly a management theory - the phenomenon was first "observed and described by Italian economist Vilfredo Pareto - and it can be applied to also aspects of life and endeavors. When it comes to the development and advancement of the world's economy, it really doesn't take much for a few to ruin it for the rest of us. The advancement of society over the last 200 years is more or less attributed to the fact that the "top few has finally overpowered the "bottom few. The development of various institutions, modern government, our education system, and the modern corporation has certainly helped. Again, my conjecture of this commentary is this: Recent events going on around the world and domestically may be predicting at least a slowdown in the "current phase of globalization - the recent surge in Chinese imports to the rest of the world and the reluctance of the Chinese to revalue their currency (the Renminbi) may just be the icing on the cake. There is a lot of potential for political gains here. I will discuss this further in this weekend's commentary.

Signing off,


 

Henry To

Author: Henry To

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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