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Friday, December 31, 2010

Market strategist = diaper

One of my favorite Wall Street jokes: How is a market strategist like a diaper? They both need frequent changing and for the same reason.

So, why are market strategists full of...um...stuff?  Because timing the market is a waste of time. 

Each year prognosticators try to guess where the stock market will go over the next year, and almost every year they are off by a mile.  This is more likely to be the case in 2011 because almost every market strategist is bullish.  The only thing worth less than a market strategist's prediction is a group of market strategist's predictions--especially when they all agree.

Why are market predictions so inaccurate?  Because the things that most impact market returns over a given year are also almost impossible to predict: 
  • Will North Korea lob nukes at South Korea? 
  • Will Israel attack Iran's nuclear facilities? 
  • Will bond markets abandon Japanese, European and U.S. bonds en masse driving up interest rates? 
  • Will the European Union fall apart? 
  • Will the world economy continue to recover at its current pace? 
  • Will China engineer a smooth or crash landing in an attempt to slow inflation and real estate speculation? 
  • Will U.S. unemployment dive from 10% to 5%?
  • Will drug companies discover a cure for cancer?
  • Will accurate prediction cease being an oxymoron?
None of these thing is strictly predictable, but if any of them occur (except that last), they'd have a huge impact on markets.  You'd have better luck trying to predict earthquakes and hurricanes (things entirely deterministic and yet experts almost never get annual predictions right).

So, why do people crave such predictions?  Because we'd all like a sure thing.  Wouldn't it be great to have next year's newspaper and know exactly what stock prices would be a year from now?  We'd all love it, and the entertainment factory that is called news sells tons of advertising each year knowing we'd all love those answers.

But, those answers are worth what we pay for them--nothing. 

Instead of reading the horoscope in hopes that we'll be lucky today, we should get to the daily grind of making things happen for ourselves. 

That's what I'm going to do: resist the temptation to read or make predictions, and instead do research on good investments at cheap prices.  There's a new year's resolution that works.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Thursday, December 23, 2010

Prudence: pitiful performance persists in 2010

Markets move in mysterious cycles that no one can predict with accuracy.  For several years value beats growth, or large companies beat small, and then the trend reverses.  Markets are one of the most mean reverting data series known to man, so you always know such trends will reverse, but never precisely when.

2010 was a particularly frustrating year to wait for trends to reverse, especially for those who were prudent. 

2009 was an understandably great year for junky versus prudent investments.  Junk had tanked in 2008 and prudence had dropped little, setting up a spectacular rise for junk in 2009 versus a mundane rise for prudence.  Once the government vowed to support any company large and imprudent enough to be in severe trouble, junk's star was destined to be born.  It was in 2009. 

However, junk's stardom seldom lasts because investors become understandably nervous as junk's star gets too high.  I naively expected investors to become nervous in 2010, but was in hindsight much too early.  A quick look at the data (from Bespoke) highlights my naivete.

Companies considered junk by the rating agencies rose 19% in 2010.  Double-A and above rated companies returned a mere 6%.  2010 rewarded this form of imprudence with 3.2x the return.

The most expensive tenth of stocks, as measured by price to earnings ratios, returned 23% in 2010, versus 8% for the cheapest tenth of stocks.  Once again, 2.9x the return for jumping into junk instead of piling into prudence.

Buying the top tenth of stocks most sold short (where short sellers expect to profit from price declines) returned 26% versus the 17% performance earned from the bottom tenth with the least short sellers.  It was a mere 53% better to bet on this particular form of imprudence.

Investing in cyclical companies, those most impacted by economic cycles and thus hardest to predict, returned 25% against 11% for the non-cyclicals that perform regardless of cycles--2.3x better to hope instead of plan.

Finally, small companies (small ships are more easily toppled by storms than large ones) beat large 24% to 11% in 2010, giving those who bet the trend was their friend a 2.2x edge over those who expected trend reversal.

My naivete was on prominent display in 2010, but I'm not bitter.  I find solace in the certainty that markets mean revert.  Plus, I've been given the opportunity to buy prudence at even lower prices. 

Will 2011 be my year of redemption.  I don't know for certain, but in the choice between junk and prudence, I can't say I'm even remotely tempted to follow the junky crowd of 2010.

Thank you for reading my blog, and may you have the Merriest of Christmases.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, December 17, 2010

Two areas of concern for markets...

When everyone is bullish about the economy and markets (including yours truly), it's time to look at page 16 news. 

Page 16 news is important, but doesn't seem important enough--yet--to make it to the front page of the newspaper.  By the time a piece of news hits the front page, it's already priced into markets.  One should look at page 16 news to know what hasn't been priced into markets (hat tip to Donald Coxe).

What important news is on page 16 and should be on page 1?  1) Long term bond prices have been dropping hard and 2) oil prices are steadily rising to high levels.

Despite the Fed's efforts to drive short and intermediate term interest rates lower, long term rates have been rising (yields rise when bond prices fall).  This is important because long rates reflect the market's assessment of inflation, and because long rates impact meaningful borrowing rates, like mortgages.

The yield on 10 year Treasury bonds have gone from 2.4% to 3.5% over the last 4 months.  That's a roughly 9% decline in the price of a 10 year bond.  During this same time, the stock market has rallied almost 20%.  As I've said in this space before, bond and stock prices should not be moving in opposite directions over the long run.

(Geek's note: stock prices reflect cash flows discounted over time.  I'm willing to pay $0.91 for $1 of earnings a year from now if I want a 10% return.  That 10% desired return is the discount rate and the $1 I get a year from now is the cash flow.)

Stock prices should reflect long term bond yields.  All things being equal, when long term bond yields rise from 2.4% to 3.5%, this higher discount rate should drive down the price of stocks by over 30%!  Now, as you may have guessed, all things are never equal.

Some believe stock prices are rising and bond prices are tanking because investors are more optimistic about the economy.  I disagree with this position.  Long bond yields rise because of inflation, and inflation is bad for stocks.  Bonds and stocks tanked in the 1970's as inflation fears rose, and rallied strongly in the 1980's and 1990's as inflation fears shrank to nothingness. 

Bond prices do rise and stocks tank when deflation is the fear, as has been the case during the last decade.  But, bond prices tanking and stocks flying because investors are optimistic about the economy?  I can't think of any historical examples to support that.

Keep in mind, too, that long bond yields also impact mortgage rates.  If long bond yields are going up, so are 30 year mortgage rates.  How exactly is giving an already disastrous housing market an additional headwind of higher priced mortgages supposed to be good for stocks and the economy?  I can't think of a good reason.

The spike in bond yields may be a temporary phenomenon, and that is my guess about what's happening.  If bond yields come back down below 3%, that would seem to give the all-clear signal for stocks (at least, for a while).

The other page 16 news is oil prices hovering around $90 a barrel.  The last time this happened, in late 2007 and early 2008, the U.S. economy was entering recession. 

Higher oil prices lead people to consume less.  It tends to act as a natural governor on the economy--when energy prices spike, it tends to slow the economy.  Oil prices impact heating costs, travel costs, grocery costs, pretty much everything.  And, if you have to pay more for those things, you don't have money left over to buy that new electronic gadget you've had your eye on.

Just as long bond yields declining would give the all-clear signal for stocks, so would be declining oil prices (below $80 a barrel). 

But, as long as long bond yields spike and oil prices keep rising, bad news is brewing for the stock market and economy. 

I don't have any illusions that I can predict such events, but I will be watching with great interest to see what happens.  If long bond yields and oil prices hit the front page, it'll be too late to do anything but cry in your beer.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, December 10, 2010

The Fed wants MORE (?!) inflation

I know, everyone is taking pot-shots at the Federal Reserve (the YouTube video is hilarious!).  I, however, feel especially privileged to do so not because I read a lot of finance, investing and economics, but because I've always been critical of the Fed.

The Fed was originally created in 1913 after the financial panic of 1907 to prevent banking crises.  Bankers and the government had decided that banking crises could be prevented with a lender of last resort, and many judged that a government agency would be better for this purpose than the ad hoc committee of New York bankers, led by J.P. Morgan, who had previously and successfully dealt with banking crises in the past.  The original goal of the Fed was to be this lender of last resort.

Fast forward to the present, and the Fed's mandate is to maintain price stability and full employment (never mind that the Fed has a lot of control over the former and none over the latter).  As you may have quickly surmised, this has nothing to do with its original mandate.

The people at the Fed long ago decided that deflation (declining prices) was the bane of human existence after the experience of the Great Depression and watching Japan's last 20 years.  They seem to have forgotten, however, that both of those experiences were due to bad loans and not an inadequate supply of money. 

With this background, those at the Fed would much rather experience inflation than deflation.  In their infinite wisdom, they are now working hard to create inflation to fight off the boogie-man of deflation  They want to increase inflation to boost employment (never mind that inflation won't boost employment). 

But, to normal people, declining prices seem like a good thing.  In fact, during a deep recession and recovery with 10% unemployment, most people think declining prices might be a very good thing.

That's because most people haven't been lobotomized by a PhD in economics to believe that declining prices (deflation) or stable prices (gold standard) are a bad thing. 

Most people, too, understand that printing money to create inflation won't create prosperity, but will lead to extremely negative economic consequences (Zimbabwe or Weimar Germany, anyone?). 

Why don't the people at the Fed possess such common sense?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, December 03, 2010

The wall of worry

It should be obvious by now--I'm not much of a short-term market prognosticator.

I can predict 5-10 year returns with a fair bit of accuracy, but I'm terrible over the next day or year.  Fortunately for me, the long run is what matters.

If you've read my blog posts over the last 6 to 9 months, you know I've been overly pessimistic about both the economy and the stock market.  Whereas I saw trouble brewing in Europe, China, and Japan, and poor U.S. employment and growth, things didn't turn out that bad.  In fact, things are looking decidedly more upbeat of late.

Which brings me back to my title: "the wall of worry."  It's an old Wall Street saying that a bull market climbs a wall of worry.  If everyone is optimistic, big market gains are unlikely because everyone who will buy has bought.  In contrast, when some or many are pessimistic, the market has room to run if and/or when the fundamentals prove the doubters wrong.

I was a doubter, and the market climbed the wall of worry--right over my head, in fact.

But, that was yesterday, and to generate good returns over time we must focus on the future.  Is there currently a wall of worry for the market to climb over?

I think there is.  First, there are still plenty of doubters.  Several very intelligent market mavens with excellent long term records continue to forecast storm clouds ahead.  Perhaps it will be their turn to be stepped over. 

Second, look at the news and you'll see Korea on the brink of war, China trying to slow down its economy, Europe's peripheral countries in fiscal shambles, rising unemployment in the U.S., etc.  Bad news is frequently the wall of worry markets must climb. 

There are plenty of worries and worriers to clamber over, still. 

That doesn't mean the market will necessarily rise, or stay flat, or climb (did I miss any possibilities?).  What it does mean is the market could continue climbing, and part of what can and may fuel that rise is the many concerns and few doubters out there. 

The short term may look okay, but the long term isn't quite so sunny.  By my estimates, the S&P 500 is likely to return 4.1% annually from its present 1220 price over the next 5 years.  That projected 22.25% cumulative rise may be a steady 4.1% a year, but it's much more likely to be more volatile.  For instance, the market could rise 20%, then tank 50%, then rise 103.75%.  Any way you slice it, though, 4.1% isn't a huge annual return, and trying to time the market to sell at the top and buy at the bottom is a fool's errand.

The short run (next year?) doesn't look too bad (though my poor short run prediction record should now be scaring you). 

After that, the check will come due.  I don't know when or how that will happen, but I'm preparing by buying investments that I think can solidly beat that 4.1% annualized return, regardless of how bumpy the path may be.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, November 19, 2010

The week that was...

Most weeks, I choose one topic on which to spout my thoughts and opinions.  But, this week, there were just too many interesting things to ponder, so here are 8 brief points of interest.

1)  Earnings season is over and the results were better than expected.  Revenues didn't dazzle, meaning that end demand is slow, but cost cuts more than made up the difference.  This just goes to show that companies and the stock market can do well even in a slow economy.

2)  Economic numbers continue to improve.  Unemployment claims improved, railroad loadings are up, leading economic indicators surprised on the upside as did the Philly Fed's survey.  The economy is improving ever so slowly, but it is improving.

3)  There's been a lot of speculation that the Fed's quantitative easing program is merely an attempt to puff up the stock market to get rich people to spend, thus improving the overall economy.  Andy Kessler and Don Coxe made convincing arguments that the Fed is really worried about real estate and the financial institutions that depend on real estate values, and thus quantitative easying may be an attempt to support bank balance sheets.  Why did the economy roll over in 2008?  Oh, that's right, real estate values tanked and financial institutions froze up.

4)  The mortgage documentation mess promises to have much more lasting impacts than most realize.  This issue goes to the heart of real estate titles and ownership, and the dinosaurs are going toe to toe to find out who will eat losses.  If the banks end up losing this fight, like they should, then we could be right back into a 2008 crisis again.  See 3) above.

5)  Ireland will likely take a bailout from the European Union (EU).  If you think this means Ireland is in a weak position, think again.  When you owe the bank $10,000, it's your problem; when you owe it $10 billion, it's the bank's problem.  The EU is more worried about Greece, Portugal, Spain and Italy than Ireland, so they are hoping to draw a line in the sand at Ireland (after Greece).  Ireland has the stronger hand in this game.  Oh, and by the way, why is another bailout in Europe good news for markets?

6)  China is working hard to slow down their economy, mostly by slowing bank lending, because food inflation is making the natives restless.  China may succeed more than world markets anticipate.  Initially, markets will probably take that hard.  But, over time, this will lower the prices of input commodities, thus improving developing economies.  This may be a case where slowing for them is good news for us.

7)  Many state and local governments in the U.S. look like Portugal, Ireland, Italy, Greece and Spain in terms of fiscal health.  When these issues hit the front page, likely next year or the year after, it will rattle markets and lead to huge bailouts by the federal government.  This will be good in the long run (because budgets are out of touch with reality), but I don't think many people, especially investors, are paying attention to the short term impacts.

8)  Long term bond yields spiked over the last couple of weeks.  An almost 5% decline in the 10 year U.S. Treasury bond over a couple of weeks should be a wake up call for investors who think bonds are risk free.  It should also give pause to equity investors who should know that stocks should go down when long term bond yields spike.  But, why worry about that, the market is rallying!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, November 12, 2010

Pension pain

You've got to be a bit of a geek to love investing.  One reason is the math--there's lots of it.  Another reason is that you should enjoy digging through obscure footnotes to financial statements.  Most people would rather get a root canal than read such arcana.

I, however, am a big fan. 

An area that will soon get big attention is pension accounting.  You must dig into footnotes to see this information, and it's not a pretty picture.

When organizations, whether governments or companies, report their financial situation, they must disclose how much they owe employees through pensions.  Like all accounting information, this is based on assumptions.  One key assumption--that's way off base--is return on assets.

An organization that owes money to employee pensions must estimate how much they need to pay out and how much return they'll get on assets to make those payments.  If they assume lower future payments or high returns on assets, then their pension liability magically shrinks!  And you thought Santa was good...

Not surprisingly, most companies and public pensions are making flattering assumptions to make their financial statements look better.

As a simple example, most companies I research (with pensions) assume they'll get 8% returns on assets.  That may not sound ambitious to you, but it is.  Bonds will probably provide 4% returns from here and stocks will return around 6%.  Assume a pension has a standard 60% equity/40% bond allocation, and you get a whopping 5.2% return. 

So, most companies and governments are under-reporting pension liabilities by around 33%.  This will be difficult for many companies, but they will get by (although shareholders will be less sanguine).  Public pensions, however, will be a nightmare.

Another fact unknown to most is that governments have a different set of accounting rules than companies.  Whereas companies have strict rules about accounting for and allocating assets to pensions, government bodies are much more lax (pay as you go, easier assumptions).

I was reminded of this recently when talking to a lobbyist who works for our local power company.  I asked him if the utility would be bought by a company or taken private, and he said he didn't think anyone would buy it because they would have to account for pensions differently, and that would wipe out the value of the utility company.  Wow!

Now, picture that occurring all across America.  Most public pensions are grossly under-reporting pension liabilities, and they are in trouble even before reporting that huge liability accurately!

This will make big news at some point, probably within the next 2 to 3 years.  The cause will be interest rates rising (thus decimating bond values) or a big decline in equity prices (hitting pension assets from the other side). 

Mark my words: pensions will cause real pain to shareholders and major pain to state and local governments (which means taxpayers). 

Just when you thought it was safe to go back in the water...

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, November 05, 2010

QE2 launched to much fanfare

This was no buy the rumor, sell the news week.  This week, it was buy the rumor, buy the news...whatever you do, just buy, buy, BUY!

The Federal Reserve will create dollars out of thin air and use them to buy debt issued by our Treasury Department, and this was good news to markets.  Everything, except the U.S. dollar, rallied. 

Happy days are here again.  A chicken in every pot, a car in every garage, prosperity for all.  Print away, dear Fed!

Okay, I'm just bitter because I thought  more than 3 people might see election outcomes, quantitative easing part 2, and 9.6% unemployment as less than good news.  I was wrong.

But, the little voice of reason in my head is screaming in protest, "How can printing money with no backing create prosperity?!  I know, for a fact, it can't!!!" 

A lower dollar means a little extra business for a couple of U.S. exporters.  But, the U.S. imports vastly more than it exports, so it means higher costs for the majority of us. 

If you don't believe me, look at commodity prices--they're up 19% since August.  The rocketing price of cotton is jacking up clothing costs.  Oil at over $86 a barrel will translate into high gasoline and heating oil prices.  Copper closing in on $4 means higher prices for electronics.  Et cetera, et cetera, et cetera.

Soon, this will translate into higher costs and lower profits for U.S. companies.  It will also mean higher prices for all U.S. consumers.

Quantitative easing will not create jobs in the U.S. or increase lending to U.S. businesses (although both of those things are occurring completely separate from and despite federal action).  The Fed's printed dollars are going to find their way into emerging markets, commodities and government bonds.  In the short run, it means "party on, Wayne"; in the long run, it means more inflation.

Oh, by the way, the last 2 times the Fed tried to create prosperity with the printing press (and the economy was not on the brink of financial collapse) ended in the dot-com crash and the housing crash. 

While the party is going, it will seem great, just like the NASDAQ and housing bubbles back in 1999 and 2006.  But, when it ends, and few will see it coming or be prepared, it's going to hurt like no hangover we've ever experienced.

In the meantime, the markets will rally and the prudent will look foolish.  And, yes, I'm looking like a fool.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, October 29, 2010


There's a lot of news coming out next week, both mid-term elections and the Federal Reserve meeting to announce the much-anticipated launch of QE2 (quantitative easing, round 2). 

The key question for markets is: how much of the news is already factored into prices?

This points to one of the most difficult concepts for investors to grasp--prices do not reflect current or past information, but investor expectations.

Many investors are surprised when good news comes out--"company earnings grew 50%"--only to see a stock's price tank.  Why?  Because market price already reflected greater than 50% growth. 

Or, they're surprised to see bad news--"the economy shrank by 2%"--lead to a jump in the stock market.  Why?  Prices reflected a more than 2% economic decline. 

Prices, whether for bonds, stocks, commodities or currencies, reflect investor expectations.  Prices move up when actual news is better than expectations and down when it's worse than expectations.

Which raises the question in my title: will news next week exceed, fulfill or disappoint expectations?  If fulfilled, prices won't move much; if exceeded, prices will jump; if disappointing, prices are likely to fall.

Right now, investors clearly expect the Federal Reserve to announce a quantitative easing package that is favorable to bonds, stocks and commodities and bad for the dollar.  Will that announcement fulfill, exceed or disappoint?  Markets seem too optimistic to me, but as the old Wall Street saying goes: "don't fight the Fed."  On the other hand, is the Federal Reserve printing dollars really a cause for stocks and bonds to appreciate?  Something to think about.

Investors currently expect Republicans to take back the House of Representatives and make gains, if not restore a majority, in the Senate.  Do market prices already reflect that expectation, or will they be disappointed?  For that matter, are market participants correctly reflecting what will actually happen if their expectations are fulfilled?  Will Republicans cutting spending be good or bad for stock prices in the short run?  Something to ponder.

The S&P 500 is selling for around $1180 right now, reflecting an expectation of 14% per share earnings growth over the next year.  With the economy likely to grow at around 2% and profit margins at cyclical highs, is overly optimistic earnings growth expected?  What will happen to stock prices if those expectations go unfulfilled?

In the long run, investing success is all about paying the right price for an asset.  In the short run (which is what Wall Street does with less than 6 month holding periods), investing success is all about guessing investor expectations.  For those focused on the long run, next week is a non-issue.  For those focused on the short run, next week will be a nail-biter.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, October 22, 2010

Buy the rumor, sell the news

An old saying on Wall Street is "buy the rumor, sell the news."  It means that markets tend to react to rumors by bidding up prices and then selling (pushing prices back down) when the news actually hits.

Unless you've never read my blog before, you know that I don't tend to pay much attention so this short-term, trader-oriented approach.  However, I am sometimes so completely baffled by the way markets react to news and rumors that I can't help but remember the old saying.

Since late August, the stock market has rallied strongly, as have commodities and gold.  Over the same period, the dollar has tanked.  Since spring, the bond market has rallied strongly, too.  What's going on?

In my opinion, bonds have rallied strongly because economic numbers have been weak.  Unemployment remains high, GDP growth has slowed, the ECRI weekly leading index has tanked (but is recovering), and new unemployment claims have stayed stubbornly over 450,000.  I think bond holders are forecasting a sustained slowdown or recession and continued deflation.  This should not be good news for stocks, commodities and gold, and should be good for the dollar.  So, why is the opposite happening?

In short, the answer is that Federal Reserve board members, since late August, have been strongly hinting that the economy is so weak it may need another round of "quantitative easing."  For those of you blissfully ignorant of what the heck quantitative easing is, it's economic jargon for central bankers printing money (without physical backing).  In this case, they will print dollars, creating money from nothing, and use those dollars to purchase government bonds on the open market.

Why is that good for every market except the dollar?  Good question.  It's good for bonds, because the government will buy bonds in large amounts.  It's good for stocks because this will supposedly goose the economy.  It's good for commodities and gold but bad for the dollar because it means inflation.  If you're confused now, good for you.

Let me summarize: the U.S. economy is doing so badly that the Federal Reserve is going to try to intentionally create inflation.  Somehow that's good for stocks, bonds, commodities and gold, but not the dollar?  That can't be so.  Inflation may be good for commodities and gold and bad for the dollar, but it's definitely not good for stocks and bonds.  Something's amiss.

Which brings me back to: buy the rumor, sell the news.  The Fed has not officially announced its second round (the first was in 2008) of quantitative easing (colorfully dubbed QE2 by market watchers).  That is most likely to occur in early November.

I think that markets are buying the rumor of QE2 and may very well sell the news come early November.  Markets may be particularly unhappy if the news of QE2 doesn't meet its grand expectations. 

In the long run, bad economic news can't be good for stocks and commodities.  If the Fed does manage to create inflation with QE2 (which is not a given), it won't be good for bonds, stocks or the dollar. 

How can bad news about the economy be good news for markets?  In the long run, it can't be.

My ability to time the market is somewhere around zero, so take what I have to say with a big grain of salt.  I'm not buying this rumor, nor selling the news, but caution is highly recommended.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, October 08, 2010

Mixed up markets

When most people think of "the market," they think of the stock market.  But, there are other markets that are equally or more important to pay attention to.

For example, bond and currency markets are bigger than stock markets.  Commodity markets are important, too, but most people ignore them.

Why are other markets important, you may ask?  Because they frequently bring warnings of contradictory premises held by different participants in each specific market.

In a normal state of affairs, currencies and gold should move in opposite directions.  That's what's happening right now, especially with gold flying high and the U.S. dollar crashing.  All good there.

Normally, commodities move opposite the dollar.  Commodities have been soaring and the U.S. dollar is tanking, so everything looks as it should there, too.

Next, we come to bonds.  Bonds and commodities normally move opposite each other, and here we run into our first contradiction.  Commodities are soaring and bonds are climbing, too.  The first indicates inflation and fast economic growth and the second indicates deflation and slow or declining economic growth.  Both markets can't be right.

Furthermore, commodities and stocks usually move opposite each other, which is just another way of saying bonds and stocks tend to move together.  Climbing commodities indicates inflation and high interest rates (lower bond prices) which both tend to be bad for stocks.

Don't get me wrong, I'm not saying these relationships exist at all times and all places.  But, when I see markets seeming to indicate different opinions, I take notice.  It means markets are mixed up and one will turn out to be right and the other wrong.

Things are pretty mixed up right now.  The dollar is sinking, commodities are climbing, as are stocks and bonds. 

The dollar is sinking because the Fed is going to print money to try to further revive our flagging U.S. economy.  That means a lower U.S. dollar, higher inflation, and rising commodities and gold.  So far, so good.

But, a lower dollar, higher inflation and rising commodities is inconsistent with high bond and stock prices.  High inflation is bad for bonds and stocks.  That contradiction must be resolved.

To further muddy the waters, rising bond prices usually correspond with higher stock prices, but not super high bond prices.  Super high bond prices means very low bond yields, which tends to indicate low growth, deflation and economic stagnation.  And, that's usually NOT a recipe for higher stock prices.  As illustration, Japan's bond prices have gone up for 20 years while its stock market has lost 75% of its value. 

Bonds are indicating slow or negative growth and stocks are rallying, and that doesn't make sense.  Bond markets are right more often that stock markets, so the on-going stock rally might be in danger. 

High gold and commodity prices and a falling U.S. dollar should mean lower bond prices and high bond yields (a.k.a. inflation).  Once again, this contradiction must be resolved.

Over time, all markets will sync back up again.  Either bonds and stocks will tank and the dollar will continue to fall; or, commodities and gold will tank, the dollar will rally, and stocks and bonds will continue to rise.  It may take time, but markets will re-achieve consistentency.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, October 01, 2010

Competitive Devaluation

The issue I fear most from an economic, political and geo-political standpoint is the huge debt overhang of the largest developed economies of the world: U.S., Europe, U.K. and Japan.

Solving this nightmare is not just an issue for the developed world, either, because it also greatly impacts the developing world (especially Brazil, Russia, China and India).

In order for the developed economies to pay off their debt, they must either grow their way out of debt or print money to inflate away the debt they owe. 

Growth would be the best and most honorable way to solve the problem, but growth in developed economies is inhibited by high debt loads (which lead to slower growth) and huge social programs (Medicare, Medicaid, Social Security and their equivalents in the other developed economies).

I'm sorry to admit it, but democracies have never successfully voted away social programs, and I don't think they will this time, either.

That leaves inflation.

But, inflation is a nasty solution to debt problems. 

From an economic standpoint inflation is tough to put back in the bottle once you let it out.  If you think the Federal Reserve or any other central bank has a dial they can turn to 3%, 5%, or any other specific level of inflation, I'm sorry to let you know that smurfs aren't real, either.

Inflation crimps a whole economy as everyone--from employees to employers, from government bureaucrats to private companies--becomes bogged down in trying to figure out wages, salaries, costs, prices, tax rates, etc.  No high inflation economy runs smoothly and efficiently.

The political and geo-political stage started to ripple this week as the U.S. Congress is trying to pressure China into revaluing their currency and Brazil's Finance Minister remarked that an "international currency war" is taking place as governments manipulate their currencies to improve their export effectiveness.  Japan recently announced they will be active in currency markets to prevent the price of the yen from rising too much and becoming uncompetitive in global markets.  These trends will result in the beggar thy neighbor problem I highlighted in a previous blog.

This competitive devaluation process is a race to the bottom and has an ugly history.  In the past it's led to world war and economic collapse.  I wish I could say these were idle fears, but they are not.

The U.S. economy currently has low inflation, and that looks set to last until the private market works down its bad debt problem (which I think will happen over the next 3 - 5 years).  Some believe the U.S. economy will experience the low inflation, deflation and low interest rates of Japan over the last 20 years.  In that environment, cash and bonds will do very well.

Never say never, but I doubt we'll experience what Japan did.  In that case, inflation is the more likely threat, and that's not a good scenario for owning a lot of bonds or cash.

The competitive devaluation that's occurring does not need to continue, so my fears may be unjustified.  Even if they are justified, the end-game is unlikely to play out soon, but over the next decade.  Hope is not a strategy, so I'm hoping for the best while preparing for the worst.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, September 24, 2010

Stock picking is dead; long live stock picking!

As human beings, we have a tendency to look backward instead of forward. 

Psychologists have illustrated this tendency with experiments demonstrating hindsight bias and recency bias.  Nowhere does this seem more evident than with respect to economics and, particularly, the stock market.

As support, see the Wall Street Journal's article today: 'Macro' Forces in Market Confound Stock Pickers

The article's point is that stock pickers, with a few exceptions, have not shined brightly in their performance over the last couple of years as macro-economic "forces" have over-whelmed stock picking ability.

Fair point, but only if we drive best by looking through the rear-view mirror instead of the windshield.

It's true, gold, U.S. Treasuries and cash did best over the last two years.  It's true, too, that bonds and cash have beat stocks, as a whole, over the last 12 years. 

But, that's history, not the future.  As Warren Buffett put it, if the past were the best guide to the future investments, librarians would be the billionaires.  They are not.

I couldn't help but chuckle at the title of the article, too.  Confound.  CONFOUND!  The word means overthrow, defeat, ruin according to my Oxford English Dictionary. 

Not a reference to short term under-performance; not a temporary set-back that may reverse; not in contradiction to all financial history; but, confound! 

Isn't this from the same popular press that said Warren Buffett was washed up in 1999 because he didn't "get" the Internet?  Aren't these the same folks that fawned over the housing boom and how home prices could never go down?  Check, and check.

And, now, they've pronounced stock picking is ineffective, done, washed up.  To me, that sounds like an excellent reason to bet that stock picking is about to come back in a major way.

Remember, the popular press called for the Death of Equities in 1979, just 3 years before the greatest, 20-year bull market in history. 

It may not happen tomorrow, or even the day after, but a headline like that leads me to believe that stock picking is about to experience a renaissance.

Stock picking is dead.  Long live stock picking!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, September 17, 2010

Manic-Depressive Mr. Market

Benjamin Graham, Warren Buffett's mentor, had a wonderful parable for thinking about the stock market.  He called it the parable of Mr. Market:
"Imagine that in some private business you own a small share that cost you $1,000.  One of your partners, named Mr. Market, is very obliging indeed.  Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.  Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them.  Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly."
"You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.  But the rest of the time you will be wiser to form your own ideas of the value of your holdings..." (Graham, The Intelligent Investor, 1973)
The market has been particularly manic-depressive lately, and this has reminded me of the parable of Mr. Market.

One day, the market seems to foresee another recession on the horizon--the market sinks as investor sentiment tanks.  Another day, the market foresees an economic boom on the horizon--the market leaps and investor sentiment soars.

Is the data really that self-contradictory, or is the market just that short-sighted.  I believe the latter.

Much economic data, like unemployment claims, housing market numbers and income growth, indicate an economic slowdown.  Not a recession, mind you, just a slowdown.

Other economic data, like railroad traffic, commodity prices and industrial capacity utilization, indicate an economic expansion.  Not a boom, per se, but an expansion.

Mr. Market, in his manic-depressive way, takes these data points as signs of a collapse or boom.  As a result, market commentators have referred to the stock market's reaction as risk-on/risk-off.  It's either one or the other, and nothing in between.

What is the reality?  Not too surprisingly, given the data and my build-up, something in between.  The slowdown could turn into a recession, but hasn't, yet.  The expansion could turn into a boom, but it isn't at present.

Mr. Market should be more sober-minded and focus on the long term instead of the short term.  There is neither reason to dive for cover nor party like its 1999 (can you tell I'm about to turn 40?).

Given the data and a long term view, it is best to be cautiously optimistic.  The market is mildly over-valued, but nothing like it was in 2000 or 2007.  In fact, long term returns look promising, especially when compared to bonds or speculations like gold. 

Mr. Market needs to take a chill-pill, relax and take a deep breath.  Lucky for sober-minded investors, he probably won't, and this will provide ample opportunities to exploit Mr. Market's manic-depressive tendencies.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Thursday, September 09, 2010

Price paid = returns reaped

Investing has to be one of the worst fields for excess noise.

Currently, most people are focused on the short term versus the long term, inflation versus deflation, macro-economy versus micro-economy, developed versus emerging markets, bonds versus stocks, fiscal versus monetary policy, stimulus versus cost-cutting, etc. 

The list goes on and on. 

But, almost all of that is noise.  As far as your investing and financial future are concerned, what matters is the price you pay today.

In the short or long run, whatever you invest in will be at some price in the future and will have yielded some interim cash payments.  If you pay too much for it now, you'll get a poor return.  If you pay a cheap price, you'll reap a good return.  That's it.

All the factors I highlighted above may influence that outcome, but it's mostly noise, because what you pay for an investment now will determine your return in the future much more than the rest.

This is a simple concept to grasp, but hard to execute.  It's easy to get distracted by the noise.  I get distracted every day by it--sometime several times a day!

Let's take the stock market as an example.  With the S&P 500 at around $1110, you'll get a 6%-like return over the next 5 years.  If you paid the $1023 it was selling for in early July, you could expect at 8%-like return over 5 years.  If you paid the $1217 it traded at in late April, you could expect a 4%-like return over 5 years.

The price you pay now determines your return later.

Emerging markets are growing faster than developed markets.  But, emerging market prices reflect that fact, so the price you pay now determines your return.

Apple is growing like a weed.  But, Apple's price reflects that growth, so the price you pay now will determine your future return.

If you pay too much now, you won't get your desired return.  If you pay a cheap price now, you're return will be satisfactory.

Ignore the noise.  Ignore the crowd.  Focus on price paid relative to value received.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, September 03, 2010

Is Deflation Really That Bad?

People in the financial world don't have nightmares about werewolves or falling off a cliff, they wake up in a cold sweat crying out one bone-chilling word: "Deflation!"

Ordinary (or should I say normal?) people don't suffer from this affliction.  In fact, I'd dare say most people don't even think of the word deflation, much less dream about it.

However, to those in the financial world, whether investors, economists, accountants, or central bankers, the word deflation conjures up visions of the Great Depression and Japan's Lost Decade (it's been 2 decades, actually, but it's always referred to as 1 for some reason).

Is deflation really that bad?  It all depends on what you mean by the term.  For some odd reason, the term refers to two very different things.

One refers to the end of a credit expansion that ends in debt defaults, bank failures, and tremendous and long-lasting economic collapses.  That's the nightmare one.

The other thing deflation refers to is when money supply doesn't keep up with economic growth.  In my opinion, this one isn't bad at all. 

Can you imagine what life would look like if the cost of goods went down by 3% a year instead of up 3% a year?  Would you really have nightmares if the cost of computers, cars, TV's, food, clothing, etc. went down each year?  I don't think so--everyone loves a sale!

And yet, this is why people get so confused, because deflation refers to two entirely different things.  Can you imagine going to the grocery store and seeing hamburgers labeled "Rat Poison"?  You know hamburgers aren't poisonous, but the label would definitely throw you off.  The same is true with the word "deflation."  It refers to something yummy like a hamburger, and at the same time something terrible like rat poison.  No wonder people fear deflation.

Historically, deflation (the good kind) got a bad name in late 1800's United States.  After the Civil War, the U.S. experienced years of declining prices as the government worked to get its finances back in order and U.S. currency back on the gold standard.

It was great as long as you hadn't borrowed lots of money.  This was a boom time for railroads and manufacturing industry like Carnegie Steel.  If you owned stock in James J. Hill's railroad, the Great Northern, you received 8% dividends that bought more and more stuff each year, plus you benefited from the railroad's growth! 

The cost of things were going down because the U.S. economy was becoming more productive.  It was great unless you owed debt.  Debtholders hate deflation because it means they must pay back loans with dollars worth more each year.

This was especially painful for marginally profitable farmers.  Industrialization had made farming more productive, which meant marginal farmers couldn't break even.  They borrowed to try to keep up with productive farmers, but this just created new problems.  You can't pay back loans or farm profitably if the value of the corn you produce is going down faster than the debt you owe. 

So it is with every technological advance.  I'm sure caveman Ug was put out of the hunting business by caveman Thug who invented a new, more effective spear.  Such is the way of the world.

This industrial/technological/economic shift led to the populist movement and William Jennings Bryant's "cross of gold."  But, none of that helped the poor farmers who needed to find economical work.  Eventually, they went to work in factories and a new boom occurred.

But, the legacy of deflation as a bad thing lived on.  The very vocal minority of unprofitable farmers (and especially their political demagogues) made enough of a ruckus that deflation has a bad name to this day.

Next time you wake up in a cold sweat dreading deflation (not very likely, huh?), just reflect on which type you dreamed about--the hamburger, or the rat poison?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, August 27, 2010

Pushing on a string?

If you've ever water-skied, you know you must keep slack out of the line to stay on your feet.  If the line loosens, you have little time to take out the slack or you'll be swimming.

The Federal Reserve, too, must keep the line tight.  Otherwise, it finds itself pushing on a string.  And, as any water skier knows, pushing on the string is of little use.

Why is the Fed pushing on a string?  Because it--like a boy with a hammer--has only one tool at it's disposal: creating money out of thin air.

When the economy slackens, the Fed reduces interest rates (by printing or threatening to print money).  This is supposed to encourage borrowers to borrow, thus increasing economic activity.  As long as borrowers think they will get higher returns on the money they borrow than the interest rate they owe, they'll borrow. 

But, a problem occurs if borrowers either can't or don't think they can get good enough returns on the money they borrow.  When that happens, the Fed can lower rates and print money all they want and the economy won't improve.  That's when the Fed finds itself pushing on a string.

There are serious questions about the U.S. economy being at this point.  Very smart people are concerned the Fed can't get the economy going again, and they have powerful historic examples like the Great Depression and Japan to support their thesis.

During the Great Depression, the U.S. experienced a huge drop in economic activity, high and sustained unemployment, and significant deflation. Shrinking money supply was one of the things blamed, and so most economists have taken that as the solution to a similarly deflationary scenario like now.

Japan has been in a 20 year on-again/off-again recession.  Over this time, its stock market is down 75% and its economy hasn't grown.  Its central bank, like the Federal Reserve, has tried lowering interest rates and quantitative easing (a euphemism for printing money).  These solutions have kept unemployment from spiking, but have done nothing to improve economic growth and have left the Japanese government with a huge load of debt.

I think these two examples are important in understanding our present situation, but most analysts and commentators miss the point.  I do think the Fed is pushing on a string, but not for the reason that most suggest.

Borrowers will only borrow if they think they can get good returns on capital.  Such lending will only be effective if positive returns on capital are earned.  For the economy to grow and standards of living to improve, you need positive returns on capital. 

The issue is not employment, nor printing money, nor interest rates, nor fiscal stimulus.  The issue is positive returns on capital.  Without that, there is no growth, only decline.

The U.S. government tried all sorts of things during the Great Depression to improve employment and get the economy going (both Hoover and Roosevelt).  The result: the worst economic decade in U.S. history.  The U.S. economy finally started growing again during World War II.  Was that because killing people and destroying property is growth?  NO!!!  It's because the government boondoggles finally ended and individuals were able to get positive returns on capital.

Japan will not improve until positive returns on capital becomes its focus.  As long as employment and consumer demand are the focus, Japan will not grow.  Only when the Japanese economy refocuses on generating positive returns on capital will it grow again.

The same is true here in the U.S.  Printing money, lowering interest rates, giving loans to negative return on capital projects, and creating boondoggle employment will not create growth. 

The Fed is pushing on a string, but that's because it doesn't understand where growth comes from.  It doesn't come from creating money or lending, it comes from positive returns on capital, and there's nothing the Fed can do to bring that about. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, August 20, 2010


My daughter, like her mama and daddy, is a tad bit independent. 

Being terribly independent myself, I have little problem with that.  But, it can be a bit difficult at times, especially as a parent trying to get a three-year-old to brush her teeth or get dressed in the morning.

One of her teachers, Ms. Karen, was very delicate in communicating this predilection to us.  She used the sandwich approach, saying that Vivian was 1) self-directed, 2) independent to the point of being difficult, and 3) more likely to be a leader than a follower.  Mama and daddy were quite proud despite the obvious and nerve-fraying meat of the sandwich.

Like most parents, we tend to amuse ourselves with our child's tendencies.  So, to prove Vivian's independence to others, we simply ask her if she is a contrarian.  Naturally, she proudly states that she is NOT a contrarian (missing the irony of the statement).  Mama and daddy are quite amused, even if at her expense.

The investing world, too, is filled with it's own Vivians--contrarian to a fault.  They don't see themselves that way, of course.  In fact, they credit their contrarian approach for their investing success.

Don't get me wrong, I think a contrarian approach makes a lot of sense, but not as a principle to action.  It makes sense to look at what everyone else is selling; the contrarian trash pile is an excellent place to look for bargains.  But, everything thrown away is not of value, and doing the opposite of everyone is not by itself the best approach to picking investments.

I was reminded of this when I saw how many big, smart, and vastly more-successful-than-me investors had invested in British Petroleum (BP) during the second quarter.

Did they invest in BP simply because everyone was selling?  This makes some sense because it's obvious that many sellers were irrational, simply selling to get it off their books no matter at what price.  As a trading strategy, I suppose I follow that reasoning.

If you had followed BP for years, understood its value, and then bought when the price tanked, I can understand that, too.  That shows an appreciation for the nature of the investment, the risks involved, and the price to value relationship.

But, to buy it as a long term investment simply because others are selling makes little sense.  As Warren Buffett put it, if you aren't willing to own an investment for 10 years, why would you want to own it for 10 minutes? 

I didn't buy BP because I thought it was a terrible company before the Horizon rig blew up in the Gulf of Mexico.  It had been carefully cultivating its green image and spouting "beyond petroleum" blather while racking up lousy returns and the worst environmental record in big oil (just for reference, the most profitable company, Exxon, has one of the best). 

Not only did I judge BP poorly, I also thought its long term risks were almost incalculable.  Few thought Three Mile Island would halt one of the cleanest, most efficient energy sources in America, but it did.  Knowing how irrational people were about that, why would I think a huge oil spill in the Gulf would be different?

Contrarians buy what others are selling without necessarily  understanding their purchase.  The strategy works like a charm...until it doesn't.  That's why a lot of contrarians tout their records as proof.  But, investing has a huge element of luck as well as skill, so both short and long records can be deceiving. 

Exhibit 1 is Bill Miller's record at Legg Mason Value.  He beat the market every year for 15 years, then got crushed from 2006 to 2008 (down -56% vs. the market's -23%).  I'm certain he did more research than a pure contrarian, but he also owned Bear Stearns, Countrywide Credit, Fannie Mae and a host of other companies with terrible business models.  After all, he had made a fortune and his reputation buying lousy banks in the early 1990's that were bailed out by the government.  Not surprisingly, he was cursing the government for not bailing out his investments in 2008.

A contrarian approach works as a good starting point, but it's not the whole enchilada.  You need to do a lot more research and be very honest with yourself (if you don't really know, you'd better walk away). 

Excellent long term investment results are as much about not stepping on landmines as buying good investments.  A pure contrarian approach will eventually find landmines and lead to a blow-up.

Now, if I could only convince Vivian that contrarianism isn't its own end...

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, August 13, 2010

Unemployment puzzle

Unemployment in the U.S. has stayed at a stubbornly high 9.5%.  This has puzzled many economists, politicians, commentators and individuals.

In almost all post-WWII recessions, employment has recovered more quickly toward normal levels.  But not this time.  In fact, unemployment hasn't stayed this stubbornly high since the Great Depression.

I think I understand why, and, if I'm right, it means unemployment will stay high for quite some time.  I believe there are two causes: interest rate policy and the unemployment safety net.

When the government sets interest rates, they will of necessity always be above or below where free-market rates would settle in the natural supply and demand for funds.  Just like any government price control, it will always and everywhere lead to either surplus or shortage

When rates are set too high, new investments won't be made where demand would otherwise exist, leading to mis-allocation of capital and an economic slowdown.  When rates are set too low, new investments will be made where demand would otherwise not exist, once again mis-allocating capital, but with a boom and bust cycle ensuing.

Because the majority prefers lower interest rates and we live in a democracy, too low interest rates are most often what we experience.  That leads to an escalating over-investment and crash cycle.

Remember the dot-com boom?  Prior to that episode, the Federal Reserve had dropped interest rates to fight the Asian contagion, Russian default and Long Term Capital Management debacle of 1997-1998.  In 1999, rates were maintained at artificially low levels to deal with the phantom Y2K problem.  The result: a dramatic over-investment in technology, media and telecom that resulted in a tremendous mis-allocation of capital and employees.  To this day, fiber-optic cable that was deployed 10 years ago still hasn't been fully utilized.  To this day, people who were employed in technology, media and telecom during the boom are transitioning into other fields.

To fight the dot-com wipe-out, the Fed again resorted to extra-low rates.  These low rates encouraged people to speculate again, but this time in the housing and credit markets.  The result, again, was a huge mis-allocation of capital.  Many more homes were built than people could afford.  Many more loans were made because home ownership was seen as an inherent good.  Many more cars were built and auto loans were made because rates were so low.  The result was a tremendous mis-allocation of dollars and people to the housing, financial and auto markets than otherwise would have existed.

Now, of course, many of those who had been employed in housing, finance and the auto field are unemployed.  The mis-allocation of capital to those fields has led millions to be trained to do something for which the market had no need. 

And, this is where the unemployment safety net comes in.  When those employed in technology, median and telecom lost their jobs, they had to find new ones.  Because they weren't offered unemployment benefits for 99 months, they went and found new jobs.  Many of those jobs, ironically, were in the housing, finance and automotive fields that were being artificially spurred by too-low interest rates!

I'm not blaming unemployment insurance as a political statement.  I'm pointing to facts.

Rogoff and Reinhart's work (This Time Is Different) shows how employment recovers much more quickly in emerging economies without unemployment benefits.  Whether a recession or banking crisis hits, emerging economies recover employment more quickly. 

Anecdotically, I've heard several stories of people who could get full- or part-time work, but elect not to because they'd be paid less to work than not to work!  It's not a political statement to say that many people prefer to be paid not to work than to work. 

Combine huge mis-allocations of capital due to interest policy with a huge unemployment safety net, and you have a recipe for sustained, high unemployment.  (As another example: see Europe.)

Or, consider the Great Depression.  Interest rates were held artificially low after World War I to allow France and Britain to less onerously pay back war debts.  The result was first a huge real estate boom and bust in the mid 1920's and then the stock market boom and bust in the late 1920's and early 1930's. 

Just like recently, artificially low interest rates led millions into fields that had no fundamental end demand (at that time, most of it was related to farming and banking).  When the inevitable bust came, millions were laid off from those fields and provided unemployment benefits. 

Interest rate policy leads to mis-allocations of capital and large groups being unemployed.  Unemployment safety nets then encourage those unemployed not to look for new work.  It's a recipe for high and sustained unemployment every time.

If I'm right, we'll have high and sustained unemployment until capital is correctly allocated (not likely with--once again--artificially low interest rates) and/or the unemployment safety net is removed, neither of which seem likely in the short or intermediate term. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, August 06, 2010

Beggar thy neighbor

I was surprised this week to read several reports that Europe announced improving production and business confidence, particularly out of Germany.  Several European companies announced better than expected earnings, too. 

After all, weren't financial commentators the world over (including yours truly) prattling on a couple of months ago that Europe was coming apart at the seams?

And then I remembered the phrase "beggar thy neighbor."  It refers to the political policy of devaluing one's currency and/or erecting trade barriers to boost one country's economy at the expense of other economies. 

It's called beggar thy neighbor because it only works as long as your neighboring countries don't react (hence the begging).  If they erect their own trade barriers or devalue their currency, then the game is up and everyone ends up worse off.  Like most boondoggles, it only seems to work as long as you focus on the surface and not the aggregate.

Because I have a sarcastic sense of humor, I couldn't help but be amused by all the Germans who were coldly saying, a few short months ago, that the Club Med countries should be dumped from the euro currency and even the European Union.  Now that the Club Meds have caused the euro to drop, Germany seems to be making out like a bandit. 

The main reason is that Germany is mostly an export economy (like China and Japan).  In fact, China overtook Germany only last year as the world's largest exporter.  Germany's economy would grind to a halt if it weren't selling to others.  Not surprisingly, the euro dropping benefited them most.

But, it won't last too long.  Even now, U.S., Japanese and Chinese politicians are most likely forming policies that will lead to our own devalued currencies or new trade barriers that will eliminate the euro advantage.  The effort will succeed in kicking Europe--particularly German--in the shins, but it won't make anyone better off.

In the long run, people adjust to currency changes.  Over time, a burger in Asia, Europe and America will cost about the same in real value.  Buyers and sellers adjust the prices they are willing to pay and receive until things are back to the way they were.  Currency depreciations don't work for long, and trade barriers just reduce everyone's standard of living. 

Beggar thy neighbor doesn't work, unless of course your goal is to get elected in the short run.  It may be the only thing less productive than re-arranging deck chairs on the Titanic.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, July 30, 2010

Ponzi finance, government style!

My wife is beginning to dread it when I talk about the economy (perhaps I'm being over-generous in saying "beginning"...).  This past week, I even dragged my dear sister down into the muck.  Now, poor reader, it's your turn.

Government finances are looking more and more scary to me.  I was reminded of this recently when recalling much of what I read about housing finance in 2003-2005 (yes, I was that early...and no, I didn't make any money betting against it...).

In particular, I remembered the intellectual framework of one Hyman Minsky, a great economist most people have never heard about.  His "Financial Instability Hypothesis" was frequently quoted with respect to subprime home loans.

In general, he said there are three types of lending, one following the other.  As lenders proceed from one financial crisis to the next, they walk farther and farther out on the risk limb until they fall off.  Then, they start all over again.  Silly, isn't it?

The first type of lending he called "hedge finance."  This is lending where the bank expects to be repaid both interest and principal.  Seems infinitely prudent, huh?  It is.  But, when it works well for some time, financiers move out the risk limb.

Next comes what Minsky called "speculative finance."  This is where the lender expects to be paid interest, but not all the principal.  Does that sound imprudent to you?  It may, but it's quite common.  If you've ever paid 20% interest on a loan or credit card, you've participated in speculative finance.  Banks charge that high interest rate because they don't expect you (or someone else offered the same loan) to fully repay the principal.  The high interest rate allows them to still make money even without full principal payment.  This is very profitable business in good times, which leads lenders farther out the limb.

The final phase is called "Ponzi finance."  This is where the lender expects neither full interest nor principal payment.  It only works as long as asset prices are rising, as was the case with the housing market, or as long as a "greater fool" can be found to buy the loan from the lender, also the case with housing.  This is the phase that ends in tears.

Which, brings me back to government debt.  A long time ago, the developed economies of the world went from hedge financing to speculative financing.  They did this when they decided never to repay their debts, but simply to roll them over (which means using a new loan to pay off the old one) each time they come due.

Because governments don't die like people do, they can--in theory--keep rolling their debts over forever.  In practice, every government dies and every single one has defaulted at some point.  If they haven't, yet, it's only a matter of time.  If you don't believe me, see the excellent work of Niall Ferguson, and Carmen Reinhart and Kenneth Rogoff.

Just like home loans progressed from speculative to Ponzi finance, I believe government debt is walking out the same limb, too.  This struck me most profoundly this week because of two data points.

The first was when I read that U.S. mutual fund investors were putting 6 times as much money into bond funds as they were putting into stock funds.  At the same time, any poll you read will tell you that the very same investors openly acknowledge that U.S. debt levels are a major problem and that they are skeptical the debt can be repaid.  If people are investing in debt they think is bad, they are not expecting principal and interest--they are expecting a greater fool to buy their bonds at a higher price!  That, my friends, is Ponzi finance.

The second data point comes from very smart, professional investors who support the deflation premise.  Most such investors openly acknowledge that U.S. debt problems are almost insurmountable, but that they are investing in U.S. debt because they believe deflation will happen and that they can make money as U.S. debt prices rise (in deflationary times, people seek the same safe havens, like U.S. debt, thus driving up the price).  Such investors aren't saying they expect to hold that debt long term--they doubt that interest and principal will be repaid!  They are overtly expecting to offload such "investments" on other dumb investors.  Ponzi finance!

Like the housing market, this is likely to end in tears.  The problem is getting the timing right (as it was with the housing market).  With so many buying government debt they openly acknowledge is dodgy--at best--everyone will be looking for greater fools to sell to at the same time, and the race to the exits is likely to be ugly.

Although my wife hates to hear me say it, it's getting scary out there.  We can still pull back from the precipice, but time is running out.  Our elected officials may suddenly become prudent (not in any democracy I know of).  We may experience a growth boom that saves the day--until the next crisis.  But, at some point over the next 5 to 10 years, we are going to live through the transition from Ponzi finance back to hedge finance, and that's just plain scary. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, July 23, 2010

Short term pain, long term happiness

With my daughter turning three in August, I know we'll soon have a conversation or two about honesty. 

It's a complicated subject, so I expect this conversation to occur off and on over the next...say...75 years (I plan to live to 115).

Most people think honesty is about lying or not lying, and therefore not very complicated.  I disagree.  I think honesty is about facing the facts.  If you frame honesty in such a way, you can live a moral life, and achieve and sustain happiness (which is what I think morality is all about).

You can lie and be moral.  For example, if I'm served liver and Brussels sprout casserole I can tactifully lie by thanking the server.  I'm not denying the fact that I hate liver and Brussels sprouts, but the thanks is polite.  That white lie is not incompatible with honesty.

If the Nazis come to my door and ask where I'm hiding the Jews, I can't say, "first door on the left," and be moral.  Once again, the lie does not deny the facts, it simply acknowledges that I have no moral obligation to be truthful with monsters (actually, being truthful will definitely bring unhappiness).

It's my stand that you have to be honest, to face the facts, in order to be happy.  But, happiness is not equal to instant gratification.  Sometimes, being honest with oneself or others is short term painful.

For example, think about making a mistake on the job and telling your boss.  Your boss is unlikely to be happy, but you have to face the the facts and let your boss know because she has the right to know.  If your boss is any good, she will reward that honesty over time even if she isn't happy with the mistake.

In fact, I would go so far as to say that many (most?) moral things, like honesty, are short term painful in order to reach long term happiness.

I exercise 5 days a week.  I work out hard enough that it's mildly painful.  But, the rewards pay for the effort.

I work hard to find investments.  I spent hours, day, months doing research on each investment idea.  This is rarely a fully pleasant experience.  And yet, I know it will work in the long run.  That's why I do it.

Buying investments that will do better than average almost always includes short term pain.  The reason why it will do better than average is because something is wrong.  Most people will think you're nuts for investing there--that's why it's cheap!

Over the long run, too, buying such short term pain provides long term happiness.

Do you think my three year old will understand why honesty or investing can bring short term pain and long term happiness?  No, me neither. 

But, over time she will, and then she'll be long term happy, too.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.