Saturday, June 16, 2012

The ultimate contrarian sell signal for China?

It's a sign of the ultimate height of hubris and I have been watching for this for some time, but the Skyscraper Index is flashing a sell signal on China. Here is an explanation of the concept from Wikipedia:
The Skyscraper Index is a concept put forward in January 1999 by Andrew Lawrence, research director at Dresdner Kleinwort Wasserstein, which showed that the world's tallest buildings have risen on the eve of economic downturns. Business cycles and skyscraper construction correlate in such a way that investment in skyscrapers peaks when cyclical growth is exhausted and the economy is ready for recession. Mark Thornton's Skyscraper Index Model successfully sent a signal of the Late-2000s financial crisis at the beginning of August 2007.
Now comes the news that China plans to build the world's tallest building in just three months! It's a contrarian signal that indicates that an economy is topping out.

The Skyscraper Index is admittedly an imperfect indicator, largely because there are so few data points and the results could be attributable to data fitting. Nevertheless, the ideas are highly intuitive, as Wikipedia explains:
The intuitively simple concept, publicized by business press in 1999, has been cross-checked within the framework of the Austrian Business Cycle Theory, itself borrowing on Richard Cantillon's eighteenth-century theories. Mark Thornton (2005) listed three Cantillon effects that make skyscraper index valid. First, a decline in interest rates at the onset of a boom drives land prices. Second, a decline in interest rates allows increase in average size of a firm, creating demand for larger office spaces. Third, low interest rates provide investment to construction technologies that enable developers to break earlier records. All three factors peak at the end of growth period
Interestingly, the market peak and financial crisis that follow seems to occur sometime between the planning of the building and its completion. Consider, for example, the Empire State Building, which began in January 1930 - after the stock market crash. The Petronas Towers in Malaysia was completed in 1998, a year after the onset of the Asian Crisis. Here is more about the Skyscraper Index from Barclays (via The Big Picture).

To be sure, a peak indicated by the Skyscraper Index doesn't mean that the lights have permanently gone out on the country which constructed the world's tallest building. The United States went on to continue its growth and assume the mantle of global leadership after the Great Depression. The Malaysian economy of today, or the economy of Asia, can't exactly be characterized today as a black hole either.

For today's investor, I remain of the belief that, in terms of the effect on markets, China is at center stage and Europe is the sideshow (see Focus on China, not Europe). This latest signal from the Skyscraper Index confirms that view. If Europe were to stabilize itself but China lands hard, what happens in Greece or Spain won't matter very much.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


FGH said...

There deinitely is something to this theory. It also seems to apply to fast growing retail firms that have opened a new "flagship" store in Manhattan. Maybe a sort of "climax top".

keithpiccirillo said...

Fawlty Towers Dept:
Latest study "Skyscraper Height and the Business Cycle: International Time Series Evidence" by A recent study by Barr, Mizrach and Mundra (2011), at SSRN has a different take:
Both GDP and building height are co-integrated, i.e., they move together over time as well as vector autoregression analysis which allows allow the authors to see if skyscraper height can predict changes in gross domestic product (GDP)(i.e., if height predict recessions).
The authors find that height cannot, in fact, be used to predict changes in GDP.
However, GDP can be used to predict changes in height.
In other words, the study finds that "extreme height is driven by rapid economic growth, but that height can not be used as an indicator of recessions."
Maybe this time, The Year of The Dragon is not yet putting the economic dragon (horse) before the cart.

Cam Hui, CFA said...

Keith -

I am aware of that study. I am not surprised that a regression analysis of building height against GDP growth indicates that building height is not an indicator of recession.

You are not looking at GDP growth and building height, but what happens when building height is excessive. The signal only occurs at the tail and not in the middle of the distribution, much like an overbought/oversold model. If you look at the middle of the distribution, as you do with a regression, you won't find the relationship you are looking for. You need to look at what happens when you get into the tail of the distribution.

Hope that's clear.

keithpiccirillo said...

Then how much more reliable are those who attempt to measure tail risk? I think this is called tail spin. Models like Black-Scholes can go only so far:

"This puts VAR in a quandary. On the one hand, you cannot observe the tails of the VAR curve by studying extreme events, because extreme events are rare by definition. On the other you cannot deduce very much about the frequency of rare extreme events from the shape of the curve in the middle. Mathematically, the two are almost decoupled."

From The Economist/Plato's Cave:

Even Nassim Taleb has failed by taing on the folly of prediction, maybe he went out of his sphere of expertise. I have a hard enough time just understanding Kahneman, and to a lesser extent Freakonomics and Stiglitz and Gladwell.
Thanks for the redirection. :)

Cam Hui, CFA said...

Let me re-phrase my answer a different way:

The referenced study asks, "How correlated is an indicator with subsequent GDP output?" Example: Trend following models.

What I am saying is, "If the indicator is in a certain zone, say the top 5% or 10% of a range of readings, is GDP output likely to mean revert?" Example: Overbought/oversold models.

Both study approaches are valid, but can yield very different results.