Housing Prices, Uranium and the Black Swan

The median Melbourne house price fell by $20,000 in the three months between July and September. That's a six percent drop from $340,000 to $320,000. As far as we can tell, this is proof that house prices do not always and forever go up.

The fall wipes out all of the gains of the last twelve months. It also raises the issue of whether the next interest rate move by the Reserve Bank of Australia will be a rate cut rather than a rate rise. On paper it looks like a simple prospect. With national GDP growing barely over 2% and house prices slowing down, inflation looks whipped!

Not so fast! With Queensland and Western Australia booming, Australia is starting to look like Europe, at least in monetary terms. Different states with different growth rates would, normally, have different interest rates. To contain inflation in Western Australia and Queensland, you might raise interest rates. Or, left to its own devices, the price of money would go up on its own.

In slower-growing states like New South Wales and Victoria, lower rates would ease the burden on indebted home owners and might ignite a boom in business investment, the very same kind that's driven growth in productive capacity in the resource economy.

This is all Friday afternoon speculation anyway. The country has one interest rate policy. It's not going to change any time soon. And average debt levels are so high to begin with that even incremental changes in rates are going to punish those who have too much gearing. Merry Christmas!

Walter Diversified Services (ASX: WDS) debuted on the ASX yesterday. The mining services provider was welcomed into the world at an IPO price of $1.50. Enthusiasm during yesterday's trading drove it up nearly 20%, before the stock closed at $1.66, up 11 percent for the day.

The company provides services for the underground coal mining industry. It also provides pipeline construction and maintenance services for the water, gas, and oil industries. As we wrote in the December issue of Outstanding Investments, mining service companies are on the receiving end of billions of dollars in capacity expansion spending by larger oil, gas, water, and resource firms. The fact that WDS joins Sedgman Ltd (ASX: SDM) and the stock we tipped in December's Outstanding Investments is proof that institutional investors are keen on the mining services story and that 2007 could be a great year for these stocks.

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Do you think the Daily Reckoning is too long? You wouldn't be alone. In our defense, we'll say that it is free and that you don't have to read it if you don't want. But there is a reason why we take time to explore the kinds of financial events other analyst consider statistically unlikely. It's a simple reason. Though financial calamities are hard to predict, the consequences of being caught unprepared for one are catastrophic. It pays to think about them.

Nassim Taleb makes this point beautifully in his book "Fooled by Randomness." He writes about Black Swans, which, in every other place in the world except Australia, are so rare that for a time, some scientists didn't think they existed at all. A "black swan" is also a tag for a financial event so rare that it's statistically improbable. But that doesn't mean you shouldn't prepare for it.

You could even put it in cricket terms. In the Brisbane Test of the Ashes series between Australia and England, Shane Warne bowled 43 overs in England's two Innings. He gave up 149 runs and captured 4 wickets. Then, in just 32 overs in one day in Adelaide, Warne conceded only 49 runs while taking four wickets, and crushing England's hopes of taking that little tiny trophy home with them.

Hundreds of balls are bowled in cricket. Comparatively few wickets are taking as a percentage of the total action. But it's the wickets that matter most. England surely knew this. Perhaps they were just unprepared for what seemed unlikely, namely, getting cut down like daisy's by Shane Warne.

You see, as Taleb points out especially in your financial decisions, it's best not to confuse the frequency of an event with the magnitude of its consequences. Just because something happens rarely, or infrequently, doesn't mean you can afford to ignore it. Insurance-against hurricanes, fires, floods, and theft-is designed to protect you from low-probability, high-magnitude acts of god, nature, or malevolent strangers.

Is there any kind insurance like that in the financial markets? Sometimes a risk is a risk. There is no hedging it. If you ask a beautiful woman to dance, she will either say yes or no. The only way to eliminate the risk of embarrassment is to sit out the dance altogether, which means forgoing the company of beautiful women on the dance floor. In investment markets, being in cash is the equivalent of not dancing. And frankly, we don't mind cooling our heels at times of high-risk, like now.

But the better solution is to own an asset that has unique "dance style." We are talking about gold, of course, which is a show-off inasmuch as it doesn't move at all on the dance floor by itself. It just sits there looking golden, while everything else moves around it. So where will gold prices-currently at $631-go from here?

"Gold's current identity crisis," writes John Hathaway at Tocqueville Asset Management, "will be resolved when it breaks to new highs against a basket of commodities...Gold's price behaviour relative to other commodities is inherently unpredictable precisely because of its monetary nature."

Hathaway was explaining that the mainstream medias clumsy attempt to equate gold with crude oil prices misses the point of gold's fundamental role as money. Traders treat gold like just another commodity too. That explains why the gold price dropped along with the oil price.

What Hathaway is suggesting-and what we agree with-is that there is a latent and large source of investment demand for gold because it is NOT a paper currency. The creation of the gold ETF's (the first one of which traded right here in Australia) introduced gold as a viable, hard asset alternative to paper currencies and bonds.

Granted, professional fund managers driven by the need to invest huge sums of cash and beat benchmark indices are not going to load up on gold bullion, which has no yield and employs no leverage. But even if a small fraction of institutional liquidity moves into the gold bullion and ETF market, the price of the underlying metal will soar to meet the demand.

The only real question is why more fund managers don't see gold's value as, in Hathaway's words, "an escape from depreciating currencies." We suspect it's because many of this generations fund managers have never seen the world's reserve currency (the U.S. dollar), light up like a hydrogen-filled Zeppelin in the New Jersey sky.

The collapse of the U.S. dollar is just the kind of low-probability, high-magnitude event that respectable financial analysts can't take seriously in public. But in private, they'd be well-advised to prepare. And if they don't, we don't really care. Gold will do just fine without them. We're counting on it.

It turns out our great nuclear debate may be a bunch of hot air. Uranium must be enriched to become nuclear fuel. And the world is currently short of enrichment facilities. Earlier this week, the Wall Street Journal reported that, "Enrichment facilities, which turn uranium into fuel for nuclear power plants, have already pledged their services because of growing interest in nuclear fuel by other countries...Thomas L. Neff, a senior researcher at the Massachusetts Institute of Technology, says the supply issue means, 'it will take heroic efforts to fuel the expected growth in nuclear power by 2015. Under the most positive assumptions you just might get there. But they may not pan out."

Finally, we've been publishing the Daily Reckoning in Australia for just over a year now. We thank you for your patience and time and attention and humour and intelligence. Sometimes, we think, it would be easier if we simply had a super computer like Mike in Robert Heinlein's "The Moon is a Harsh Mistress."

Mike, who later became self-aware thanks to his large number of associational neural nets, was able to compute probabilities for nearly any event based on a huge number of variable inputs. He could even pick ponies. Plus, he was such a nice thinking-machine that his first male friend, Manuel Garcia O'Kelly, gave Mike the honorific of "Fair Dinkum Thinkum"

There is not a computer alive that has cracked the code of the markets, though. At least not yet. In fact, there are very few men or women who manage to do it well, or for very long. Your best bet is to stick to basic principles and things you can know with your own tow hands, two eyes, two ears, and two halves of your brain. And even then...

One last note...please join us if you can next week for our very informal and festive "Doomer's Ball" at Café Presse, 97 Brighton Road, Elwood, 3184 from 6:30 PM to 8:30 PM. It will be a small, intimate, conspiratorial gathering, with a special mystery guest and lots of good finger food. See you there!

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