The China Premise

In analyzing financial markets and the economy, almost everyone holds a premise that's the proverbial elephant in the room: what will happen with China.

For those who believe global growth will have severe problems, their premise is that China is most likely an accident waiting to happen.  Those who believe the opposite, that global growth will take off again, almost certainly hold the view that China is a growth machine that will pull the whole world forward.


If someone holds a view on commodities, currencies, stocks, bonds or gold, I can almost guarantee that behind their view is a premise about what will happen in China.


That premise may be explicit.  Jim Rogers, a noted commodity investor who once worked for George Soros, is a China bull and makes no bones about it.  He moved his family to Singapore and is having his daughter learn Mandarin Chinese because he thinks she won't be able to succeed without it.


Jim Chanos, the famous and successful short seller, is on record saying China is a bubble that will soon pop.  He's putting his money where is mouth is, too.


Some hold their premise implicitly.  I've heard many agriculture and base metal investors insist that prices can only go up.  They may not lay out the case explicitly, but if you ask them you'll find they see endless growth and demand from China.


Others are certain that debt deflation (the unwinding of bad loans) will keep the global economy in the tank for a decade or more.  Once again, they may not come right out and say it, but if you ask them, you'll almost certainly find that they assume China can't keep growing fast enough to overcome bad debt.


The most intellectually honest will admit they don't know what will happen.  After all, it's up to the Chinese.  I agree with the bears that China's command and control economy will end badly (the history on this subject doesn't leave much room for doubt)--IF it stays on its current path.  But, that's a big IF.  


I also agree with the bulls that China has a lot of runway simply playing catch-up with developed markets, and IF they foster free market reforms (rule of law, representative government, property rights, flexible labor markets, private allocation of capital, etc.), then they can be a huge growth story for a VERY long time.  Once again: big IF.


Perhaps the best path is not to guess.  


If you could invest and do well regardless of whether China tanks or soars, wouldn't that seem the best path?  Granted, if you knew how the story would end, you would make more money betting boldly in that direction.  But, is anyone really certain they know what will happen and--more importantly for investors--when?


What happens in China will impact world markets.  In the short run, this spells opportunity whether boom or bust.  I think making a guess on this over the next few years is a fool's errand.  It's better, instead, to prepare for either outcome because getting the timing right is impossible (or lucky).


Making explicit one's China premise is important to understanding one's view of world markets and the economy.  More important than one's premise, however, is whether its based on sound reasoning or gut feel and conjecture.


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.

QE3, Operation Twist and Balderdash

"What's in a name?  That which we call a rose
By any other name would smell as sweet."

--Juliet, from Romeo and Juliet, William Shakespeare

Balderdash - A senseless jumble of words; nonsense, trash (spoken or written)

-- Oxford English Dictionary 

The Federal Reserve is likely to take action today to "boost the economy."  This is yet another attempt in a long line of failed efforts that not only won't work, but will almost certainly make problems worse.

Whether they call it QE3 (quantitative easing, part III) or Operation Twist (named for the 1960's dance and first tried during the Kennedy administration) or Glimdragbig (a word I just made up), it will feature the Fed toying with interest rates (most likely by creating money) in an attempt to get the economy "moving."

The Fed may call it something other than what it is, but it will still smell.  They may use elaborate jargon (nonsense) to mask its true nature, but that won't change the facts.

The Fed's underlying premise is that free markets work...until they don't.  Has the Fed ever correctly forecast when markets will stop working?  Of course not.  In fact, they are almost always too ebullient when they should be cautious, and overly worried when they should be upbeat. 

But, despite these consistent failures, they still pass judgment on markets and they supposedly know when markets have stopped working, and therefore when they should intervene to "get things going." 

As Dr. Phil likes to say, "how's that working for you?"

In case you haven't noticed, economic growth is anemic at below 2%, and unemployment is high at over 9%.  And, this is after countless fiscal and monetary (and regulatory) interventions over the last 3 years.

Why aren't interventions working?  Because the first part of the Fed's premise is right: markets do work.  If you let people freely choose and act, and prevent them from initiating force against each other, they will--over time--rationally allocate capital and other resources to productive ends, thus resulting in real growth and higher employment. 

What the Fed has been doing is preventing this mechanism from working.  Interest rates are at the heart of any modern economy.  It's the time value of money, and therefore drives economic choices at the most fundamental level.  If you screw with those rates, people will mis-allocate capital and the economy will stagnate or shrink.

Sound familiar?  If you need more empirical support, please see Japan over the last 20 years and America during the 1930's as examples of interventions galore resulting in anemic growth, stagnation, or shrinkage (or the Soviet Union, or China under Mao, or North Korea, or Cuba, East Germany, Venezuela, you get the picture!).

Stock, bond, and commodity markets are likely to respond favorably to any Fed intervention--just like they always do (after all, everyone loves a party when someone else is paying).  The dollar is likely to sink (except perhaps relative to Europe, which is even more of a basket case than America) and gold is likely to rally.

That doesn't mean the economy will grow, nor does it mean unemployment will shrink.  Once again, interventions are leading to greater and greater mis-allocations of capital and thus will cause slower growth than would otherwise occur. 

There is good news in all this, and that's that much of the American economy is relatively free.  In such places, people are innovating, adapting, employing and growing.  As long as the bone-heads bureaucrats don't intervene too much, such productive people will eventually create enough growth to overcome the negative effects of repeated intervention.

It may take time, though, so patience will be necessary.  In the meantime, lets all hope the interventionists will stop distorting markets so they can do their thing.  At that point, we'll have an upward spiral to be truly optimistic 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.

"Going to the sidelines"

Most investors have a recurring fantasy they can dodge market volatility. 

When markets start to tank or look scary, such folks want to "go to the sidelines," which means parking their money in cash or safe bonds, "until the skies clear."

When you ask them how they know when to go to the sidelines and when to come back, they frequently tell you they just FEEL it.

To that, I have one thing to say--BALONEY!

Feelings tell you nothing about markets, all they tell you is your emotional state.  Those who use their feelings to guide their investment decisions get nowhere.

Many of these people went to cash in the fall of 2008 or the spring of 2009.  In cash, they have earned maybe 2% returns if they were lucky.  If they had invested whole-heatedly at those times, they'd be sitting on 50% gains or more.  Those feelings don't look too smart in hindsight.

Market prices tank when people get scared.  That's when the bargains appear--when people aren't selling for economic reasons but because of their emotional state. 

The same thing can be said on the upside.  If people feel euphoric--like in early 2000 or late 2007--then it might be time to get more conservative.

Your emotions tell you just the opposite of what to do, so don't listen to them.

My best investments were made when I was scared.  I normally feel sick to my stomach when I purchase investments with the best upside.  My emotions are terrible guides, and so are yours.

When markets get scary or euphoric, it's time to look at the data.  What kind of returns will I get given current prices and normalized earnings.  When I get nervous, I look at the data.  When I'm feeling optimistic, I look at the data.  I always look at the data, not my emotions.

For those who think they can go to the sidelines until the skies clear, I wish you the best of luck--you'll need it! 

If you want to make a bundle on your investments, invest aggressively when you feel scared and get conservative when you're euphoric.

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.

Kindling the jobs fire

One of the most interesting skills I learned going through Air Force survival training was how to build a fire.  It comes in handy on camping trips, with fireplaces, and in post-apocalyptic scenarios that only a worrier like me could dream up.

You need three things to build a fire: fuel, heat and oxygen.  In the right proportions, you generate warmth and light; but, in the wrong proportions, you'll get neither.  Too much fuel and you'll smother the fire.  Too little and it will die out.  Too much heat and you'll burn right through your fuel.  Too little and you'll have no fire at all.  Too much oxygen and you'll blow the fire out.  Too little and the fire can't grow.

Building a fire is more art than science.  Having built quite a few over the last 22 years, I've learned how delicate the process can be.  It seems simple in the best conditions--just throw some paper and wood together and light it.  In the worst conditions, however--when the fuel is wet, the wind is blowing hard and it's bitterly cold--a fire can be very difficult to build and keep going.

I couldn't help but think of building a fire when reading recent articles about how to get the U.S. jobs machine pumping.  Jobs growth, which is really just a derivative of economic growth, is like fire: it requires the right ingredients in the right proportions.  The wrong ingredients in the wrong proportions will snuff it out before it can even get going. 

In the best conditions--with a well-skilled workforce, property rights, labor flexibility, and readily available capital--jobs growth will seem to occur magically.  In the worst conditions, however--a workforce trained for jobs the market doesn't need, lots of rules and regulations preventing property protection and labor flexibility, and a dearth of capital--and job growth can be difficult to impossible to build and keep going.

It seems like the real job creators of the world--financiers, businesses, entrepreneurs--have been joined by policy makers trying to "help" get the fire going.  The policy makers may mean well, but they're simply preventing the right ingredients from coming together in the right proportions.  Their incessant meddling is snuffing the fire out time and again.

Job growth requires economic growth.  Economic growth will not occur by taking money from Bobby and giving it to Billy.  Nor will it occur by printing money.  Real growth occurs when capital is available, property rights are protected, labor can seek its own terms, and job skills match market demand.  No magic is necessary, and jobs will grow and flourish in such conditions.

But, any attempt to meddle with ingredients or proportions, especially in bad economic conditions like we're in, and you'll see unemployment continue to stagnate or climb.  If you want real--instead of illusory--job growth, its time to get policy makers out of the way.

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.

Bonds and Gold

David Malpass hit the nail on the head with his editorial Beyond the Gold and Bond Bubbles in the Wall Street Journal today: bonds and gold have done well because people fear both deflation and inflation.

I've been surprised to see both gold and bonds do so well over the last decade.  After all, deflation and inflation are opposites: when one performs well the other usually doesn't.  This makes bonds and gold both doing well a bit of a paradox. 

But in today's mixed message environment, it makes sense from a certain perspective.  Investors are running scared.  They seek safety in some form--any form. 

They correctly see that bad debt (lending which can't be repaid) leads to deflation, so they want to own bonds as protection.  Just look at Japan over the last 20 years: bonds performed much better than stocks.  Or, look at America during the Great Depression: bonds did much better than stocks.

But, investors also fear inflation, which is caused by too much currency growth relative to goods and services.  Witness Weimar Germany in the 1920's or the United States during the 1970's.  In both cases gold protected wealth better than stocks or bonds.

The problem with this reasoning is that it works...until it doesn't.  Let's look at what Paul Harvey called "the rest of the story." 

Bonds were a lousy investment from the bottom of the Great Depression until the 1970's.  Bonds will likely be a very poor investment in Japan over the coming 20 years.

Gold was a great investment in Weimar Germany...until hyperinflation ended.  Then it tanked.  Same with 1970's inflation here in the U.S.: gold was great...until it declined 6% a year for 20 years.

Investing to catch the waves of inflation and deflation require excellent market timing.  It only pays to ride the wave as long as you know exactly when to get off.  Getting the timing wrong--even by a little--will lead to poor results.  But, in case you don't know, no one is good at consistently timing the market (despite all the time, effort and brainpower devoted to it). 

Warren Buffet doesn't time the market.  Neither did Peter Lynch.  Look at the Forbes 400 some time and scout out the market timers--you won't find a single one.  Trying to time the market doesn't lead to permanent wealth--it leads either to temporary or decreasing wealth.

Which is why most investors shouldn't focus on bonds and gold.  If you can time the market perfectly--and good luck on that--you can ride bond/deflation or gold/inflation.  If you are a mere mortal, then don't try juggling nitroglycerin. 

If you want to build permanent wealth, you should do what Warren Buffett and a herd of other smart investors do--buy productive assets at cheap prices, which is when everyone hates them.  Productive assets are things that generate cash.  Gold doesn't.  Bonds do, but the cash they generate isn't protected against inflation (except for TIPS, but they have their own problems).  You have to own productive assets to really be protected against both inflation and deflation.

Examples include real estate, stocks, businesses, rental equipment, employment, education, etc.  These are assets you put money into and get back over time.  They can adjust to both inflation and deflation. 

Does that mean they do well in all markets?  NO!  Investing is not about what does well over a week, month, quarter, year, or even 5 years.  You invest for the long term, not for a short term kick-back--that's speculation!

But, producing assets work like a charm during both inflation and deflation.  Look at the record of stocks, real estate, owning a business, rental equipment, education, or any employment during periods of inflation and deflation.  They do poorly initially, but work very well over time.  That's because they can adjust to inflation and deflation, whereas bonds and gold cannot (gold will maintain, but not grow, value over the full cycle).

Investors flooding into bonds and gold are likely to look brilliant for a while...until they get slaughtered.  The cycle on bonds and gold tend to turn very quickly.  It will only be obvious in hindsight that the tide has turned--and by then it will be too late.

Investors patient enough to invest in producing assets at cheap prices will do well--over the long run--regardless of whether we experience inflation or deflation.  That's how I'm betting.

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.

Surmountable mortgage mess

I've been watching the housing and mortgage markets with great interest for years.

When working for my former employer (2002-2005), I watched (but didn't follow) as he doubled- and tripled-down on investments associated with the housing market.  As his employee, I worked hard, struggling to understand the individual investments, but never fully got my arms around them.  I knew enough to be very cautious, but that was all. 

Now, after watching the boom and bust over the last decade, I believe I have a much better understanding of how the housing, mortgage and financial markets work (or don't work) together.  I've watched, researched, studied, invested and blogged on the subject over the last six years (my blogs from the spring, summer and fall of 2007 are particularly revealing of my concerns). 

So, it was with great interest that I read an article in the Wall Street Journal today, The Mortgage Hangover.  I highly recommend it to anyone who sincerely wants to understand the boom and bust of the housing and mortgage markets over the last decade (and not just looking for evidence to confirm one's conclusions beforehand).  The article is not perfect, but it does a great job of highlighting many of the important details.

Specifically, it describes how the mortgage market was distorted over the last decade in the Bronx.  You may think that Bronx real estate has nothing to do with Florida, Nevada, California or Colorado real estate, but it does.  In fact, I believe it represents a microcosm of all U.S. real estate.

The problem started with well-meaning politicians who wanted everyone to have a home.  That problem was exploited by real estate and finance workers who were heavily incentivized to take things to the brink (which was the inevitable result of bad policy).  When those problems led to collapse, the same well-meaning politicians tried to prevent the resultant suffering.  Once again, those efforts are creating new problems instead of solutions.

The good news is that the mortgage and housing problems can be fixed.  It requires that housing and mortgage markets be allowed to reach clearing prices (where free buyers and sellers agree to exchange without any distorting incentives from politicians).  When that happens, housing and mortgage markets can begin growth afresh. 

I'm not saying the process will be pretty, but it will happen.  The destination will be the same no matter how well-meaning those who disagree.  The only question, now, is how quickly or slowly we get there.  Policy can impact the duration of the pain, not its intensity.

The bad news is that politicians and voters are unlikely to take the fast approach.  This is unfortunate, because U.S. economic and employment growth are unlikely to recover until the housing market recovers.  The longer we put off clearing prices in the housing and mortgage markets, the longer until employment and our economy truly improves. 

Mortgage and housing markets need not wallow in freakish misery.  Recovery, both for those markets and the U.S. economy, could start soon.  But, with continued meddling in housing and mortgages, recovery will take much longer and be much less robust.  It's time to face the inevitable, hold our noses, and take our medicine.

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.

NOT just pieces of paper

Successful investing, like everything in life, requires the right approach.  Such an approach isn't just a to-do list, but a way of thinking.  The wrong way of thinking leads one to easily stray from the correct path, whereas the right way leads one to successfully stay on track.

Weight loss programs are a great example.  If your weight loss plan is a crash diet with no thought for what happens after, you're very likely to fail long term.  If your approach is to implement a permanent lifestyle change that includes diet and exercise, then you can and likely will succeed.  The thinking behind the approach is vital to success.

Nowhere is right thinking more lost than on investors.  Instead of thinking of stocks as partial ownership in businesses, they think of stocks as mere pieces of paper trading in a highly abstract "casino" somewhere in New York.  And that's why most generate lousy results.

Santa Cutie, there's one thing I really do need, the deed; To a platinum mine - J. Javits and P. Springer, Santa Baby, originally sung by Ertha Kitt

A stock certificate is partial ownership in a business.  You don't own a piece of paper, but the underlying business.  Ertha Kitt is not excited about a piece of paper called a deed, or even what some other person is willing to pay for that deed on any given day, but for the platinum in the mine and what it's worth in the real world.

Let me give an example to make this even more concrete.  If you have $20,000, and find four other friends with $20,000, you can buy a $100,000 house together.  If that house rents for $1,000 per month, then you'll generate $12,000 a year of revenue.  If you have $2,000 of costs each year for real estate taxes, upkeep and management, then the house has net income of $10,000 per year.  That's a 10% yield for each partial owner ($10,000 net income/$100,000 investment = 10%; $2,000/$20,000 = 10% for each of the five owners).

The deed to the home, or the partial deed specifying that you own 1/5 of the home, is a piece of paper.  But, what you actually own is 1/5 of the home and 1/5 of the income.

Now, suppose some bone-head comes along and offers $50,000 for the home you paid $100,000.  You and the other 4 owners are free to send him packing.  His offer is no sweat off your brow, because you have partial ownership in a stream of income--specifically: $2,000 for the $20,000 investment you made. 

The offer of $50,000 is no obligation for you.  You need not lose sleep at night or panic that such an offer is made.  You can check to make sure the home is still rented, count your annual cash intake, double check the expenses, and go about your merry way thinking very little about Mr. Bone-head.

This is the same attitude investors should have. 

Instead of freaking out when the deed to their partial ownership drops 50%, they should check to make sure the business isn't going under and can still generate profits long term, but then go about their merry way.  There's no need to panic if your partial ownership is generating 10% on original investment.  There's no need to lose sleep when you own a business with profits and assets.  But, it's very easy to lose sleep when you think you own of a piece of paper in some vault in New York and people are offering 50% less than what you paid.

Right thinking here is crucial.  If you know nothing about the profits of the enterprise, you're likely to panic.  If you think of the deed as a piece of paper or symbol on a computer screen, you'll probably panic.  If you think about the underlying business, you can remain calm.  In fact, you may even realize that a 50% drop means your 10% yield has become a 20% yield to the Mr. Bone-heads of the world and buy more partial ownership from them.

Most people lose their shirts investing because they panic and sell when Mr. Bone-head offers 50% off their original investment.  Sometimes businesses really do go under, but it's much more rare than market panics.  On extremely rare occasions, countries and stock markets completely collapse and people lose everything.  The vast majority of the time, though, investors get lousy returns because they buy after things go up and then panic and sell when things go down.  They buy and sell like that because they are focused on stock symbols instead of businesses.

Stocks are not mere pieces of paper, but ownership in businesses.  Thinking of them as such can lead to success.  Thinking of them as blips on a screen is doomed to failure.

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.

Market rollover has little to do with U.S. fiscal problems

One of the most important rules of statistics is that correlation is not causation.  What this means is that just because two things happen one after the other (or around the same time) does not necessarily mean one caused the other.  If I cough and then thunder roars, that doesn't mean my cough caused the thunder.  A causal connection must be established before one can be connected to the other.  Statisticians, not surprisingly, have a name for mistakenly labeling correlation as causation: spurious correlation.

The stock market's recent drop has lead many commentators to assume that recent action (or, more properly, inaction) by the U.S. government in dealing with its precarious fiscal situation caused the stock market to fall.  That's not necessarily so.  Just because the two things happened around the same time doesn't mean one caused the other.

In fact, the stock market most recently peaked late last April, and has been in the process of rolling over ever since.  More tellingly, U.S. Treasury bonds have rallied strongly since our government failed to deal with its debt problems.  If market participants were scared about U.S. government debt, they'd be selling U.S. Treasuries and buying commodities and foreign assets.  On the contrary, commodities (except gold) have been falling and foreign assets have been tanking, and U.S. debt has been rising strongly.

No, the real reason for recent market drops is slowing global growth.  ECRI (the Economic Cycle Research Institute, www.businesscycle.com) started discussing a global slowdown early last May.  Do you think, perhaps, market leaders and ECRI saw the same data in late April when markets peaked and started rolling over?

Indeed, recent economic data has been confirming that global growth is slowing.  Most interestingly, growth has been slowing markedly in China--which has been by far the biggest engine for global growth over the last 3 years.  At the same time, inflation numbers coming out of emerging markets, especially China, have been frustratingly high.

I don't think markets are reacting particularly strongly to government inaction with respect to U.S. debt.  I think they are reacting to slowing global growth, and that more closely explains why bonds would be up and stocks and commodities would be down. 

The unique exception here is gold.  Gold is rallying strongly, probably because gold market participants expect the governments of the world to react to slowing global growth with more stimulus (spending borrowed money and printing currency).  Either bond markets or gold markets are wrong, although I can't say I know which. 

What I do know is that tanking markets are a big opportunity.  Contrary to popular belief, it's better to buy investments when they get cheaper, not when they get more expensive.  With that in mind, I'm hoping that markets tank and serve us up some super-bargain pricing!

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.

Debt binge reversal

Over the last 3 years, I've seen many explanations for our on-going economic malaise.

One of the worst--and most popular--is the greed of bankers.  This is wonderful stuff for those who believe in Marx's class struggle, but it fails when confronted with the facts.  What?  Did bankers suddenly become greedy in 2006?  I don't think so!  No, they were greedy all along and were simply reaping increasing rewards from a poorly designed system until the balloon popped.  They may have ridden the wave with aplomb, but they didn't create it.

Is it the fault of the rich?  This is another popular target for Marxists.  People love to blame whoever emerges unscathed from a tight spot.  These blamers are the same folks who held the Jews responsible for the Black Death.  According to such rocket scientists, anyone who doesn't perish must be the cause.  They pay little attention to cause and effect, like the fact that Jewish hygiene prevented them from getting the plague as much.  Such accusers just love to blame, blame, blame.  No, the rich didn't cause the crisis.  They may have been smart enough to go into the crisis prepared, or may have ridden the wave with skill like the bankers, but they weren't the cause.

Perhaps the fault lies with immigration, some say.  Yes, in the greatest country on earth, absolutely filled to the gills with immigrants, some morons think immigration is to blame.  If we hadn't opened up our borders to Mexicans and Islamic terrorists--they seem to say--we'd all be in the Garden of Eden right now.  People who get someplace first always seem to say stuff like this, but it never holds up to the facts.  If immigration were to blame, this country would have been stillborn in 1600.  On the contrary, one element likely to help solve our problem, as is the case in Japan and Europe, is more, not less, immigration.

Okay Mr. Smarty Pants, if it wasn't bankers, the rich or immigrants, what was it?  I may take a lot of flak for saying this, but the fault, dear readers, lies not in our stars, but in ourselves.  The wave we rode from boom to bust was debt.  It wasn't just individuals, or private companies, or local, state and federal governments, it was all three.  We did this to ourselves with too much debt. 

Instead of saving to buy stuff, we borrowed to spend today.  We did it collectively.  A democracy only requires 51% of the vote, but we had a stronger majority than that.  Only a very small minority--minute really--said you can't spend what you don't have without consequences.  Voters spoke, and politicians listened.  Then, we spent and promised money we didn't have.  We borrowed from those who had saved.  Now, we're in deep doo-doo (sorry for the highly technical use of economic jargon).

When you're digging yourself a hole, the first step to getting out is to stop digging.  But, to do that, you need to recognize that you're digging a hole and stop digging.  Pointing fingers at other people will not solve the problem.  It has to start with a recognition of each of our role in the problem. 

We decided to promise benefits we couldn't possibly pay for.  We decided to borrow money to pay for goodies today--whether vacations, or gadgets, or homes, or whatever--instead of saving up to pay with cash.  We decided to spend all the money we made and then some, and now that a rainy day has come along, we're dreadfully unprepared. 

We did this to ourselves--our wonderful democracy shot itself in the foot! 

Now, we need to cut spending and save more, but no one wants to look in the mirror and admit that fact.  Even now, we don't want to give up our promises or reduce our spending.  Even with the mathematical facts staring us in the face, we still want to have our cake and it it, too. 

We won't get to.  And, putting off that day of reckoning just makes getting out of the hole harder and harder as each day goes by.  It's time to stop blaming someone else, and recognize we did this to ourselves.  Only then will our debt binge be reversed and our future prosperity assured.

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.

Cash matters, not accounting "profits"

Most investors are happily oblivious of accounting rules.  I envy them.

Accounting rules are supposed to standardize how companies report their financial condition.  Instead, the rules tend to muddy the waters.

Few realize that accounting rules are set by an accounting body called the Financial Accounting Standards Board (FASB).  Although this body is supposed to be independent, when majority rule or special interests don't like its rules, the Congress or Executive branch pressure it to toe the line.  This is seldom in the interests of individuals or shareholders.

Accounting rules don't stop shareholders from digging through the data and seeing things clearly.  In fact, I'd say such an effort is one of the keys that allows dedicated investors to get better returns than most. 

You see, what matters is not the accounting number a company reports, but how much money a business actually makes.  What matters is cash: how much cash did the company make after all expenses. 

Earnings per share and net income--the accounting fictions companies report--are not the same as cash.  Accounting fictions are based on assumptions that can distort or even mislead.  Cash doesn't mislead.  It's what's left in the the bank account at the end of the day.

Most investors ignore cash because it takes effort to calculate and understand.  The accountants don't make it easy to find.  But, it's there for those who look.

A business spends cash to buy inventory, pay workers, build factories.  After it sells its end product, it receives cash from buyers.  Subtract cash received from cash spent, and you have cash earned. 

What matters it not accounting profits--which can't pay dividends, repay debt, buy back stock, expand the business--but cash.

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.

Savings, not consumption, grows the economy

It's hard to believe, but in a country where thrift was once a virtue, it's become a vice in the view of many.

The blame lies clearly with economists and politicians who try to reverse cause and effect.  Their attempt fails when confronting the facts.

Imagine yourself on an island in the Pacific Ocean without any outside contact.  Do you think you could grow your standard of living by eating more, or by storing food?

The answer is obvious.  You can't consume what you haven't produced.  You can't live in the shelter you haven't built, you can't eat the fish you haven't caught, and you can't escape on the boat you haven't constructed.

To have the time to build the shelter and boat, you'd have to put enough fish aside so you could build instead of fishing.  You can't both build and go fishing, and without fish you'd starve.  To grow your standard of living, you have to forgo consumption by eating less, which then becomes savings.  The savings then allows you to build shelter and a boat.  Savings is what leads to growth, not consumption.

And, so it is in the world economy.  To get to the point where we have shelter, transportation, clothes, etc., we need to first save up enough food to have the time and resources to devote to building the other things we need.

Here's another example.  Assume you want to open a store that sells clothes.  To rent the store, purchase inventory and pay employees, you need money.  You can't use the sales revenue you haven't gotten yet.  You need to use someone else's savings.  Once those savings are used to rent the store, buy the inventory and pay employees, you can pay back the person you borrowed from.  But, you can't borrow what's been consumed--it must be saved first.  The lender has to save instead of consuming in order for the store, the jobs or the clothes to ever exist.

Once again, so it is with the world economy.  To create growth, hire new employees, etc., you need savings first.  Savings that are invested create growth.  Consumption can't do it.

If you spend more than you produce, your standard of living will go down.  That's just a fact.  You can't spend your way to prosperity.  You have to save first.  But, to save, you need to spend less than you make.

Sometimes, savings doesn't produce growth.  As illustration, suppose you put enough fish aside to build some shelter, but a storm comes along and blows it away.  Now, you have to save enough fish up, again, so you have enough to get by as you rebuild a new shelter.  Consumption won't fix the problem, only more saving. 

Using my second example from above, suppose the clothes store fails--suppose buyers are not interested enough in the clothes to pay as much as the rent, employees and inventory cost?  Then you won't have enough to pay back the person you borrowed from.  To build back to the point the lender started from, more savings will be required--which means the lender will have to consume less and save more.

Once again, so it is with the world or national economy.  Bad loans are solved by more saving, not consumption.  Destruction by mother nature requires more saving, not more spending. 

More spending than production leads to lower standards of living.  The solution, once again, is savings, not consumption.

Don't be fooled by those who say the U.S., or China, or Europe, or Japan, or anyone else can create prosperity or growth by borrowing to consume.  Growth comes from savings, not consumption.  And borrowing to consume requires even more savings to get back to break even.

Next time you hear someone prattle on about how we need more consumption to get growth "going" (I don't care if they have a Nobel prize in economics--that just means they should know better!), think about an island in the Pacific and that consuming fish doesn't create shelter or boats.

It's time to go back to our country's roots, it's time to tear down the over-worship of consumption and spending and replace it with a reverence for savings and investment. 

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.

Long term optimistic, short term pessimistic

Markets seem to be sitting on the edge of their seats, and for good reason. 

On the positive side, there are tremendous innovations in technology, growing and thriving emerging markets, and the possibility (I didn't say likelihood) of real fiscal reform in developed markets.

On the other hand, there are very big fiscal problems in developed markets, increasingly burdensome regulation that's slowing growth/innovation/employment, threats from bad growth and politics in emerging markets, and the ever-present danger of terrorism and natural disasters.

Markets are waiting to see what choices politicians make, because if they screw up--which is extremely likely--then things will get significantly worse before they get better.  If politicians straighten out the fiscal messes they've made, and reduce ineffective and burdensome regulations, then individuals and entrepreneurs will be free to innovate and grow everyone's prosperity. 

If they don't, then several crises will unfold and we'll likely end up with the same reforms anyway.  Herb Stein once said that if something can't go on forever, it won't. 

The developed countries of the world have built up too much debt and entitlement programs which can't possibly be paid for.  If/when politicians wait too long to deal with those mathematical problems, crises will result that will force change anyway.  We'll get change, it just depends on which route we take.

One route will require much more pain and time and the other will require less difficulty and set us on the road to a big recovery.

Having studied history quite a bit, I think politicians and voters will put off the pain until it's too late, but they can't avoid logical consequences any more than the U.S. Congress can legislate gravity out of existence.

Canada in the mid-1990's faced the music and have been booming ever since.  They saw that economic reality couldn't be avoided and changed course.  They are very much the exception, not the rule.

If the U.S., Europe and Japan face the music, we can all get on with life.  If not, then tough days are ahead.

And, that's why I'm long run optimistic and short term pessimistic.  I don't think our politicians will face the music because voters don't want to, either.  But, like a 3-year-old throwing a fit, that won't change the facts.

If past market cycles are any guide, we'll get down to 10x normalized earnings at some point, which would be 670 on the S&P 500 today, 890 five years from now, or 1200 ten years from now (versus a level of 1320 now, requiring drops of 50%, 33% and 10%, respectively).

It's not inevitable, but it's very likely.  Plan accordingly.

After that, we'll probably have another long boom that will take the market back to euphoric peaks.  That will be a fun ride, and I'm very optimistic it will happen.  But, probably not as soon as I'd like.

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.

In-depth research

I must admit, I love doing research.  I have an innate curiosity about almost everything, so when I get to dig into a company and its industry, I'm in hog heaven.

Recently, I've been digging into the technology field and it's amazing how many nooks and crannies there are to understand. 

Just in computers, you have two major sides: hardware and software.  Both of those can be divided into customer sectors: consumer, small and medium business, public, and enterprise.

Just in the enterprise part, you have storage, servers, mainframe/virtualization/cloud software, networking equipment, database software, operating systems software, middleware, and applications.

Some businesses compete across all categories, like IBM, HP and Oracle.  Others pick niches that allow them to work with competitors in one market and against them in another.

The hardware side also has a long chain of providers.  If you buy a disk drive, the company you buy from probably out-sources assembly and buys parts from others instead of manufacturing itself.  In the case of enterprise storage companies like EMC and NetApp, they are more software than hardware companies!

And then there are services.  Some businesses are pure consulting with no products to sell, others provide services in one particular niche, like storage, and still others do everything from top to bottom, like HP.

Is it better to be a niche company, or cover the whole field?  Which companies have sticky products that are hard to dump, and whose products or services are easy to quit?  How is the landscape changing?

Technology seems to be more rapidly changing now than five years ago, and a lot of that is a culmination of widely available and cheap high speed broadband, both wireline and wireless. 

Will old businesses that were once dominant be toppled, or can they adapt to the new landscape?  Or, will customers be the ones to benefit because stiff competition reduces profitability?

To truly understand all these nuts and bolts, and to be honest enough with yourself to know what you don't know, you need to do a lot of homework.  Sometimes that homework pays off in insights that generate better than average returns.  Sometimes it's just a dead end.

Either way, in-depth research is the best way to go when it comes to investing.  I believe that is one of the reasons it's so hard for part-time investors to generate above average results--they are competing with people who are digging deep in areas and ways that no part-timer can match.

But, it's not enough just to understand the companies, the technologies and the competitive landscape.  You also need to understand the financials and be able to value individual securities. 

In many ways, I think I'm one lucky duck, because I get to do what I love, what interests me, what I'm good at, and what the market needs all at once. 

For me, in-depth research isn't just a means to other ends, it's a very enjoyable end in itself.

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.

Ahhh...the classics

Just as there are classics to be read and re-read in literature, history, philosophy, psychology, etc., there are classics that should be read and re-read in investing.

The most important, in my opinion, is Graham and Dodd's 1934 classic, Security Analysis.  I just finished re-reading it recently, and found many gems to share here:

"A moment's thought will show that there can be no such thing as a scientific prediction of economic events under human control."

Free will makes precise economic predictions a fool's errand.

"There are no dependable ways of making money easily and quickly, either in Wall Street or anywhere else."

That seminar you and 40,000 other participants paid for and sat through will make the speakers a fortune, not you.

"Investment theory should recognize that the merits of an issue reflect themselves in the market price not by any automatic response or mathematical relationship but through the minds and decisions of buyers and sellers"

Take that efficient market clods!

"Perhaps [the intelligent student] would be well advised to devote his attention to the field of undervalued securities--issues, whether bonds or stocks, which are selling well below the levels apparently justified by a careful analysis of the relevant facts."

Value investing...careful analysis of the relevant facts...there it is.

"Analysis connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic."

Principles applied logically!

"The value of analysis diminishes as the element of chance increases."

No, Virginia, everything is not worthy of analysis.

"The analyst must pay respectful attention to the judgment of the market place and to the enterprises which it strongly favors, but he must retain an independent and critical viewpoint.  Nor should he hesitate to condemn the popular and espouse the unpopular when reasons sufficiently weighty and convincing are at hand."

Lemmings need not apply.

"Analyzing a security involves an analysis of the business."

It's shocking how infrequently this is the case.

"In general, the analyst should refrain from elaborate computations or adjustments which are not needed to arrive at the conclusion he is seeking."

Occam's razor for investing!

I could go on (and on and on and on, as my wife can tell you), but you get the idea.

It's amazing how much wisdom can be derived from a book written 77 years ago, and how little can be found in thousands written since....

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.

Vacillating when the outcome is clear

Sometimes, the outcome is obvious, but people wish it were otherwise. 

Whether you look at the fiscal situation in Europe, Japan and the United States, or countless examples in world history, you'll find lots of examples where the proverbial writing is on the wall, but most ignore it. 

It's not that they don't grasp it.  They do.  It's that they don't want to.  Like a three-year-old having a good temper tantrum, they drop to the floor, close their eyes, and kick and scream that reality is what it is. 

And yet, reality doesn't change.  It doesn't care how loud you scream, how much you kick, or how tightly you squeeze your eyes.  At least a three-year-old can make an honest argument that they don't really understand.

I was really struck by this recently in watching The Teaching Company's course, "From Yao to Mao: 5000 Years of Chinese History" taught by professor Kenneth Hammond.  In it, I learned that China's confrontation with the western world in the 19th century was as clear as could be.

First there were the Opium Wars with Britain, then the defeat in the Sino-French War, and then the crushing blow in the first Sino-Japanese War.  In every confrontation of east meets west (for Japan had adopted western ways), east lost--Big Time.

How did China face each of these defeats?  Did they realize they were behind the times and needed to change?  Nope.  Each time, political infighting within China snuffed out any good kind of reform and led to the next defeat. 

The writing was clearly on the wall, and yet the political leaders in China just kept clicking their heels like Dorthy in the Wizard of Oz.  It didn't work.

Can Greece continue paying public employees huge salaries when not enough taxes are collected?  No.  And yet they riot.

Can German banks afford the losses on the Greek debt they hold?  No.  And yet they dither.

Can Japan's economy grow when most of its companies show contempt for shareholder interests?  No, sir.  Can an aging population that doesn't allow much immigration support that aging population by borrowing?  Not really.  But they'd really prefer not to change.

Can Wisconsin, Illinois, New Jersey, New York, San Francisco or California afford its pension promises?  No, and yet they vacillate.

Can the United States pay its current obligations to Social Security and Medicare.  Not at all.  But reform hasn't occurred. 

Like China confronting the west, the outcome is clear.  And yet, they all vacillate.

Wouldn't it be easier to face facts, do some math, and make necessary changes?  Without the slightest doubt.  But, on the other hand, most people don't want to.  I wonder if reality will change for them this time...?

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.

The Virtue of Concentration

If you ask 100 financial planners the most important concept in investing, my guess is 99 of them will say diversification.  I agree with that sentiment for most people, but not for everyone.

Most people, after all, don't lead the world.  Most are happy to be led, to let someone else take the risks.  Most seek first and foremost to stay out of trouble.  It works, but it's not a great way to get ahead.

Diversification is protection against ignorance.  If you don't know what you are doing, diversification allows you to benefit from some of the upside while primarily focusing on protection from the downside. 

If you don't want to take risks, if you don't know what you are doing, if you don't want to stand out, or if you are unsure of yourself, then heavy diversification makes a lot of sense.

If, however, you do want to get ahead, diversification is the wrong way to go.

The facts bear out this contention.  Investors with the best records don't diversify heavily, they stay focused in the areas they truly understand and they concentrate their bets there.

In fact, the firms with the best records tend to hold only 5-10 positions per analyst.  As any financial planner will tell you, that's not diversification.

It makes sense, too, if you think about it.  If an investor works 250 days a year and 10 hour days, he has 2,500 hours a year to work.  If he owns 500 stocks, that's a mere 5 hours a year to understand each stock.  If he owns 100 stocks, that's 25 hour per stock per year. 

How well can an analyst really know a company he studies for 5 to 25 hours a year in a dynamic, rapidly changing economy?  Not very well.

Now, suppose his competition only follows 25 or 10 stocks.  That's 100 or 250 hours a year to follow each business.  Who do you think knows each business better, understands its competition and economics, evaluates management more thoroughly?  The guy who spends 5 to 25 hours per year, or the guy who spends 100 to 250 hours per year?

It's really no contest.

And that's why I'm a concentrated investor and consider it a virtue.  I'm seeking to lead, to get better than average results, to get ahead. 

I know I can't compete with investors who spend 20 to 50 times more hours understanding each business, and I take great comfort knowing most of my competitors are less focused than I am.

Don't get me wrong--concentrated investing is not for everyone.  It's almost guaranteed to be more volatile, look more risky, and suffer the criticisms of financial planners. 

Those who don't want to stand out, take intelligent risks, or be criticized won't enjoy being concentrated.  But, for those who do, the rewards are great.

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.

Economics rap

(If you'd like to skip my set-up to two amusing and excellent economics rap video's, please zip to the bottom for the links)

After graduating from the Air Force Academy in 1992, I went on a knowledge-gathering binge.  I read philosophy, pop science, great quotes and great literature.  I was eager to put my 17 years of learning to work, but I realized I still had much more still to learn.

After graduating from pilot training, I got back to work in my knowledge-gathering project, this time filling huge gaps in my knowledge of history, politics and economics.  In that journey, I found out about the Austrian economists.

In college, I took Economics 101 and 201, which focused on micro-economics--the economics of supply and demand in individual markets--and macro-economics--economics at the aggregate level (national, regional, world). 

Little did I know that an intellectual battle had been fought long ago, and that the Austrian economists had been essentially stricken from the record of academia.  In almost any college in the nation, the focus of macro-economics courses was on Keynes and the Monetarists (Milton Friedman being the most prominent of the latter).

My problem, before reading the Austrians, was that Keynes and the Monetarists didn't seem to very well describe reality as I saw it.  Keynes, a British economist, saw the government having an active roll in the economy, smoothing out the bumps of free markets.  But, my reading of history clearly showed this always ended in tears.  The Monetarists, based especially out of Chicago and MIT, constructed complex mathematical models based on assumptions that were clearly false, so they too seemed off the mark.

When I read the Austrian economists, especially Carl Menger, everything seemed to fall into place.  I felt like a physicist reading Newton for the first time--this was clearly a better description of reality.  So, I was stunned that my college classes never mentioned the Austrians and that they were basically relegated to the back-woods of academia (much like Aristotle during the Dark Ages).

As time went by (I first read the Austrians 16 years ago), I realized the Austrians weren't and wouldn't get a hearing any time soon.  The Austrians, including Hayek and Mises, were considered to be cranks and irrelevant (like those who believe in the gold standard--oh wait, that's becoming fashionable again, too!).

The Austrians showed that economics was best left to individuals freely choosing their own economic destiny.  Interest rates, prices, quantities produced, etc. set by the free market would fluctuate, but this would be infinitely better than bureaucrats setting them more disastrously. 

In particular, they showed that bureaucrats setting interest rates would lead to gross mis-allocation of capital over time, leading to worse booms and busts than occur in free markets.

This discussion may seem academic, but it became clear to me that the Great Depression could be clearly understood in this framework.  The Federal Reserve was created in 1913 to prevent financial panics.  In the mid 1920's, the Fed held interest rates artificially low so France and Britain could pay back their debts from World War I.  This led first to a real estate and then a stock market bubble that crashed (sound familiar?).

The mis-allocation of capital for years before 1929 had caused the Great Depression, not animal spirits (Keynes) or inadequate money supply (the Monetarists).  This seemed a more accurate description of reality than anything else I had read.

Not surprisingly, this meant the Austrians clearly saw the dot-com and housing bubbles building and bursting more recently--because they were focused on the mis-allocation of capital due to the Fed fiddling with interest rates!  Keynes and the monetarists were oblivious and even responsible for the busts! 

Despite all this supporting evidence, I still expected the Austrian economists to remain in the backwoods during my lifetime.  I didn't think they'd get their hearing. 

I must admit, I was short-sighted and wrong.  The Austrian economists are coming back.  As proof, here are two links (Keynes and Hayek round 1, Keynes and Hayek round 2) to rap video's featuring none other than Keynes and Hayek (not the real people--they are both dead--but actors playing economist rappers).

Perhaps the Austrians will get their hearing.  Perhaps people will start demanding economic policies that conform to the facts of reality and human nature.  I must admit, I would be all too happy to be wrong on this.

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.

Gold is money, but that doesn't make it a sound investment

"Gold is money.  Everything else is credit." - John Pierpont Morgan

I must admit, I'm a bit of a gold bug. 

After studying economic and financial history for over 16 years, it's quite clear to me that wealth is not pieces of paper, but economic goods.  And money--as a store of value or medium of exchange--is not pieces of paper, either, but an objective equivalent of wealth freely chosen by economic participants. 

Over thousands of years of human history, economic actors chose first rocks and cattle, then base metals like copper, and finally precious metals like silver and gold as mediums of exchange. 

Governments, starting with Croesus in Greece, started minting coins of precious metal not because they arbitrarily decided what money should be, but because market participants were already using it and they grabbed the market for themselves (not for the first or last time, I might add).

After seizing that market, every government has proceeded to debase money by reducing the amount of precious metal in coins, and every time economic participants have adjusted their actions accordingly, revealing the debasement for what it really is--inflation.

Every time, inflation got out of hand and led to price controls that, as always, caused shortages instead of reducing inflation.  And each and every time, this led to a slowing and contraction in economic growth that eventually led people to demand money backed by specie--metal or metal-backed currency.

Both the Chinese and French boldly tried paper currency only to find it yielded the same disastrous result as metal coin debasement--but faster.  Since the 1930's, U.S. currency has not been redeemable in specie.  Since the early 1970's, U.S. currency has not been backed by specie at all.  Want to guess why the 1970's witnessed a huge spike in inflation?

Look at a dollar bill some time and you'll see written across the top "Federal Reserve Note."  A note, for those of you who don't live on planet economica perpetua (I do!), is a debt instrument--in other words, credit.  As Mr. Morgan put it, gold is money and everything else is credit.

With that overlong introduction, you get an idea of why I believe gold is money.  But, let me be clear, that doesn't necessarily make it a good investment.

I think Warren Buffett put things clearly when asked a question about inflation protected assets at his most recent annual meeting.  He noted that there were three types of assets: 1) assets backed by currency, like dollars, euros, bonds, savings accounts, 2) assets backed by something tangible, like gold, art, antique cars, diamonds, land, and 3) producing assets, like stocks, farm land, rental real estate. 

In an inflationary scenario, you can expect the first type to lose value (perhaps badly), you can expect the second to maintain value, and you can expect the third to grow in value.

I place gold firmly in the second category, which makes sense.  You expect gold to maintain value regardless of inflation, but you don't expect it to grow in value relative to the value of other things.  Gold is money, so it is a store or protector of value, not a grower of value. 

You do, however, expect the third category to continue growing regardless of inflation, because it throws off economic value.  Instead of being debased, like currency denominated assets, or maintaining value, like tangible assets, you would expect producing assets to continue producing. 

A farm continues producing corn, regardless of how corn is priced.  Stocks are priced in terms of earnings, where revenues and costs adjust to changing prices over time.  Rental real estate rates adjust to underlying currency, whether dollars, dinars, or drachma.  You get the idea. 

I know gold is money, but that doesn't make it a great investment.  Gold may preserve value, it may provide insurance against negative outcomes, but gold is not a producing asset.  You may speculate in gold prices, but that's not investing.  For my money, I want growth, not standing still or speculation.

Gold is money, no doubt, but that doesn't make it a sound investment.

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.

Is the trend really your friend?

"Many shall be restored that now are fallen and many shall fall that now are in honor."
- Horace, Ars Poetica.

We humans have a tendency to extrapolate recent trends into the distant future.  This approach doesn't work in the real world. 

Stocks that roared from 1996 to 2000 were expected to keep roaring.  They didn't.

The national housing market that hadn't declined since the 1930's was expected never to decline.  It did.

Extrapolating recent trends into the distant future is foolhardy.  And yet, people do it over and over again.

Once dominant IBM became less so.  The same can be said for Apple and Google today, or even Facebook and LinkedIn.  But, try telling that to the raving supporters of such companies.  You'll be angrily told you don't get it.

China is on the upslope and Japan on the downslope.  These trends, too, are unlikely to continue.  Such is the nature of things. 

Regression to the mean--the tendency of economic series to drift back to average--is a well-founded phenomena.  And yet, people expect present trends to continue forever.  They won't.

Corporate profit margins are at all-time highs.  They won't continue higher for long, or even stay at today's levels.

Commodities have been roaring.  That trend will not go in one direction.

Bond yields have been going down since the early 1980's.  That cannot continue indefinitely.

The U.S. government has never significantly defaulted on its debt.  Just a matter of time.

Small capitalization companies have done exceedingly well over the last 10 years.  The future will not look the same.

Emerging markets have been on a decade-long tear.  Anyone want to bet that will go on forever?

Trend extrapolation is a dangerous way to invest.  And yet, people keep doing it over and over again--and then losing their shirts.

A few trends last long, but they are the exception, not the rule.  Those who bet on a regression to the mean always look stupid in the short run, but then rich in the long run. 

So, why are so many suggesting, once again, that the trend is your friend?

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.

The Foolishness of Forecasting

"Prediction is very difficult, especially about the future" - Niels Bohr, Danish physicist

"...the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future." - Benjamin Graham, value investing "Dean"

Warren Buffett, probably the most successful investor alive, doesn't make earnings forecasts.  He doesn't do what every MBA student is taught: build a model that forecasts future earnings over time.  That doesn't mean the future isn't important to him.  Quite the contrary.  He is obsessed about the future!

But, that doesn't mean he makes forecasts.  Why?  Because forecasting is notoriously difficult.  The records of various forecasters, whether historians, economists, political scientists, financiers, social scientists, and, especially, government bureaucrats, are terrible!

My own record here is exhibit #1.  I like to forecast political and social outcomes, but my forecasting record is as dreadful as everyone else's.

But, isn't successful investing about forecasting the future?  Doesn't one have to know what sector of the economy, which asset class, etc. will do best?  No.

In fact, the records of those who try to do the above are as poor as everyone's.  Those selling such forecasts want you to believe the future can be forecast, but if they were any good at it, they'd be making a fortune doing it instead of selling forecasts. 

I can guarantee you, knowing the future would make you rich.  But, that makes the rather huge assumption that you can do it successfully.  I've never met or read about anyone who can.  Like ESP, tons of people seem to think it's possible, but when submitted to scientific testing, proves lacking.

So what does Warren Buffett do?  He studies the historic record intensely so that he understands a company, its industry, its competition, its competitive advantages and threats, its management, etc., then he pays a cheap price relative to that historic record. 

He doesn't forecast earnings growth explicitly, but he does buy businesses with a record of growth and with all the expectations of future growth behind them.  Its a qualitative rather than quantitative assessment. 

Most importantly, he doesn't pay for future growth.  The price he pays has a margin of safety, rendering an accurate forecast of the future unnecessary.  If he pays a low enough price today, he'll get an acceptable return no matter what.  If growth continues, and he spends gobs of time focusing on this qualitative aspect, his return will be better--perhaps much better. 

That's it.  No magic flutes, no crystal balls, no whirling dervishes.  Just understand intimately a particular business (and no one understands what makes businesses tick like Buffett), pay a fair price for it, and let the qualitative tailwinds blow you on to wealth.

This is very contrary to what most investors, both professional and individual, do.  Most investors spend the vast majority of their time trying to figure out what the future holds instead of studying the past and present with the same intensity.  They make elaborate models with spreadsheets to forecast all the potential variables to the fourth decimal place.

The result isn't just that they don't understand the important variables of the past, the result is forecasts that are notoriously bad. 

The average Wall Street analyst over-estimates business growth by 50% (businesses they study with great intensity and with unique access to industry insiders). 

The average economist considers himself a hero if he gets the DIRECTION (not magnitude) of economic variables correct, and almost always miss major turning points (they have models of such mathematical complexity that physicists are intimidated by them). 

I could go on, but you get the point.  Forecasting is a dead end.

Contrary to all investing lore and conventional wisdom, this does not suggest broad diversification.  Don't get me wrong, diversification is the right way to ride economic growth at minimum cost.  But, if you want to do better than that, you need to concentrate on the very few things you can understand better than others. 

As you may have guessed, that's an understanding of the past and present, not a brilliant forecast of the future. 

If you study every cell phone company in great detail from quarter to quarter, and understand each of their technological, managerial, competitive, economic aspects, and you realize that one stands head and shoulders above the others, yet is selling at a very reasonable price, you may have a good investment.  If, on the other hand, you recognize that the technological or competitive dynamics are such that you can't figure out who is and will stay on top, then you should move on to an industry where you can.

A tremendous amount of study and intellectual honesty is required to do this, but so few put in the effort that thar's gold in them thar hills.

Don't forecast.  Study intensively the past and present, and pay a low price.

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.

The Fallacy of Too Big To Fail

I've tried to stay away from the Too Big to Fail discussion, but after doing research on the banking sector recently, I decided to put in my two cents.

First off, "too big" assumes some standard.  It assumes that something of a certain size is "good," but when that size becomes "too" much, it becomes "bad."  (What, like too much health, too much peace, too much prosperity, too much happiness, too much virtue?)  By what standard?  For what goal?  By whose judgment?  No data or references are provided by most of those who make this argument, which makes me suspicious right-off.

Lately, this argument has been made with respect to banks.  "XYZ Bancorp is so large that it can take down the whole financial system" seems to be the implicit line of reasoning behind the Too Big to Fail discussion.  Does that mean breaking XYZ into 10 or 100 or 1000 small banks that all fail at once is better simply because they are each small?  Are lots of small failures good and one large failure bad?  Is smallness somehow an implicit good?  No. 

I guarantee that if you break XYZ into lots of pieces that all have the same debt to equity ratios and loan exposures as XYZ as a whole, they will all fail at the same time.  And, you'll end up in an even worse situation than if an integrated XYZ bank had failed.  Too big or small isn't the issue, the real issue is leverage and loan exposure. 

The Too Big to Fail argument assumes that somehow lots of smaller banks will not fail at the same time but one large one will.  Oh, like lots of small banks did so much better than large banks because the housing market can't possibly crash nationally (note: I'm being sarcastic).  Oops, that argument didn't float.

The housing sector crashed nationally and that almost took down our financial sector and the rest of the economy for reasons other than large banks.  The banks were a symptom, not a cause. 

If banks weren't back-stopped by the FDIC and Federal Reserve and driven to hold low equity to capital, they wouldn't have crashed due to too much leverage. 

If home ownership weren't explicitly supported by Congress, the Executive branch, tax policy, FHA, GNMA, Fannie Mae and Freddie Mac (government supported enterprises), etc., then all kinds of mortgage derivative instruments would never have been created and crashed.

If the government hadn't driven the creation of rating agencies and given three of them exclusive control of debt ratings that banks, insurance companies, etc. must use in the purchasing of securities, then risky securities would never have had a huge, captive markets in the first place.

If the Federal Reserve weren't encouraging speculation with interest rates below free market equilibrium, there never would have been massive mis-allocation of capital to the housing sector all at once.

The only thing that seems too big here is government intervention in banking, housing, debt ratings, and interest rates.

Back when banking was more free (it's always had lots of government interference), banks carried 40% equity against 60% in liabilities.  With government back-stopping and lots of regulation, that ratio is now 10% equity to 90% liabilities (it was 7%/93% right before the financial crisis).  Perhaps things were safer when banking was more free.

The history of bank failures in the U.S. has smallness written all over it.  Our regulatory structure has long encouraged lots of small banks.  But, a small bank in Iowa is very likely to crash and depositors to be wiped out when an inevitable bad corn crop occurs.  In contrast, a large bank with loans to corn farmers in Iowa, gold miners in Nevada, cotton growers in Mississippi, steel manufacturers in Indiana, orange growers in Florida, cheese producers in Wisconsin, etc. is unlikely to have all loans default at the same time, thus protecting depositors and borrowers.

Unless, of course, speculation is encouraged on a national level, or large banks are driven to hold 10% equity to 90% in liabilities.  That doesn't happen, though, without national coordination--in other words: without a national regulatory structure that lines up the dominoes to fall at the same time and in the same direction. 

If leverage and loan exposures were the problem, wouldn't greater regulation of those issues fix the problem?  No.  Not all banks are the same, and so no regulatory body can foresee all the potential business mix issues that might come up (only someone omniscient could).  JPMorgan, with international operations, investment banking services, and proprietary trading operations, has very different risk exposures than U.S. Bancorp's community banks.  You can't come up with one-size-fits all prescriptions for either debt ratios or loan exposures.

In addition, any attempt to prevent problems is more likely to create systemic risk, because a bunch of banks marching to the same music are much more likely to fall together than several separate banks marching to their own drummer (each might fall on their own, but not together systemically).  This is the same reason why periodic recessions and small fires that burn the underbrush prevent catastrophic problems.

The road to hell is literally paved with good intentions--which frequently take the form of national (or international) regulation.

I can't help but point out one other blatant inconsistency of the Too Big to Fail argument.  If bigness is inherently bad, then why have a BIG, super-governmental body to oversee, break-up, regulate and control banks or any other sector of the economy?  Wouldn't its bigness be an inherent threat? 

Please keep in mind, too, that no markets in the world are as highly regulated as housing and banking, the epi-center of our latest financial crisis.  Big regulation didn't help there.  In fact, I strongly argue it created the problem. 

When looking at bigness, it's useful to recognize that the regulatory bodies are already much bigger and more powerful than the regulated. The Federal Reserve made $80.9 billion in "profits" last year (by trashing our currency and punishing savers, no less) compared to the two most profitable non-governmental businesses: Nestle's $37 billion and ExxonMobil's $30 billion.  At least Nestle and ExxonMobil produced things people wanted to buy!  I won't even mention the ridiculous spending power of other federal government branches. 

If bigness is the problem, then banks or any other non-governmental businesses are the wrong target for concern.  But, even there, the concern is not size, per se, but what an organization does.

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.