Avoiding Blow-Ups

Everyone loves a big winner. The problem is: most don't focus enough on the odds of winning big.  

In baseball, a batter who swings from his heels and knocks it out of the park is considered a hero. In football, a 50 yard Hail-Mary pass that ends in a touchdown is called miraculous.  In basketball, a wild three-point shot that wins the game is considered stellar. But, what are the odds of those outcomes? Sport statisticians know the numbers, and most complain about the show-boats who pull such stunts. Why? Because they know that the odds are terrible, and that it doesn't consistently win games.

Why do people dwell on big wins? Because huge victories are vivid--everyone can imagine themselves as the star. And, big wins seem much easier than hard work over many years.  Who wants to slog away in obscurity for years hitting singles? Most people don't--they want home-runs!

When it comes to investing, this attitude is extremely unproductive. Instead of trying to get steady returns over time, investors eagerly gamble their hard-earned savings hoping they can score a big win. 

With investing, as with many other things, this just doesn't work. If you don't beleive me, examine the record of Warren Buffett, or almost any other billionaire. You won't find that they "invested" in a lottery ticket or bought Apple stock.  

Most investors, unfortunately, seem to think that swinging from their heels is how you win, and they invest accordingly. Their results illustrate the failure of such an approach.

As contrast, look at Buffett's two rules of investing:

• Rule #1: don't lose money
• Rule #2: never forget rule #1

Anything in there about making a big gamble and aiming for a big score? Nope.

Why the boring approach of avoiding losses? Because it works. Show-boating doesn't win in sports, buying lottery tickets doesn't lead to happiness, and investing in "winners" that are "certain" to go up a lot doesn't generate enviable investment results.

Why not pick winners? Because that's what tons of other people are trying to do, and companies perceived as winners have stock prices that reflect investors' generally high opinion. The high competition in picking winners makes it a losers game.

There's not a lot of competition, however, in picking companies that are considered losers. Not surprisingly, this means the odds of good outcomes from investing in supposed "losers" are much better. There is a risk, of course, of investing in the unloved: they may turn out to really be losers.  

And that is why Buffett and so many other value investors focus on avoiding blow-ups. If you buy something that tanks, it will pull you down more than your winners will pull you up. If you can do everything in your power to avoid such blow-ups, your returns will be good--perhaps very good.

How can you minimize the risk of blow-ups? I've found there are two keys:

1. Avoid blow-up situations
2. Don't pay too much for a company

Blow-up situations can be due to financial problems. If a company finances its operations with too much debt, it can go bankrupt and its stock can get wiped out. If a company needs funding and it can't get it--even temporarily--lenders may end up owning the company and you'll own a worthless stock. This means avoid companies that may have leverage or liquidity problems.

Blow-ups situations also occur for business reasons. Most buggy whip makers were toast as soon as Ford's cars were a success.  Technological obsolescence can kill a business seemingly overnight. A major change in end markets, like people getting their information from the Internet instead of newspapers, can kill a business, too. Supply can dry up. Regulations can alter the landscape forever. Competition can steam-roll weak players. Business risk is the hardest to assess, but one of the most frequent causes of blow-ups. You have to do a lot of research to assess this risk.

Management is another cause of blow-ups. They can do it with fraud, like Enron or Worldcom; or they can do it with incompetence, like Kodak; or they can do it with bad capital allocation, like Tyco. Management risk may seem harder to judge than business risk, but I find it's much easier to detect. Evasive management is one thing to look for. Another is inconsistency in measuring their own performance: one quarter it's sales, then next its market share, the next its customer satisfaction.

Doing everything you can to avoid blow-ups is crucial, but not enough. Sometimes, unpredictable things happen: hurricanes hit, earthquakes occur, sound businesses turn out to be unsound because of new technology that no one saw coming.  If you invest assuming you know everything, you'll get burned. Acknowledge, from the get-go, that you're not omniscient, and pay a low price for your investments.

Paying a low price protects you in two ways. First, if a company turns out to be a blow up, you'll do less damage if you paid a low price. Second, you'll earn much better returns on the companies that don't blow up--because you paid a lower price--and that will allow your winners to make up for your infrequent and low-loss losers.

Investing success comes from putting the odds in your favor, and using the right approach. Don't try to swing for the fences. Instead, avoid picking losers and don't pay too high a 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.

What's in a name?

Quick quiz. Would you prefer to work with a: 1) financial planner, 2) investment planner, 3) money manager, or 4) wealth manager?

If you feel like I just asked if you like: 1) pizza, 2) pizza, 3) pizza or 4) pizza, you are not alone. The financial intermediaries who claim to be these things can't keep it straight, so no one should expect clients to, either.

In a recent study by Cerulli Associates, Inc., 1,500 financial intermediaries were found to mis-identify themselves as something they weren't, frequently exaggerating the services they offer.

According to the study, 59% of financial intermediaries identified themselves as financial planners--certified to work with clients in building comprehensive plans that include insurance and estate planning. Cerulli's study, however, found that only 30% of those 59% actually fit that description.

22% of financial intermediaries called themselves investment planners, who focus on asset management, retirement and college savings plans. 56% of the survey's respondents actually fit that description, which makes it sound like a lot of investment planners try to pull themselves off as financial planners.

11% described themselves as wealth managers, who do comprehensive planning for wealthier clients, but only 6% actually fit the description. Once again, it sounds like an inflated title is used in hopes of generating business.

It turns out that money managers, who manage and build investment portfolios (that's what I am), were the only group that accurately described what they do. Apparently, they knew what they were and weren't afraid to describe themselves as such.

I must admit, I've run into this confusion a lot with clients, prospective clients, and even friends and family. Someone asks what I do, and I describe that I manage money for people.  Then, they say, "So, you're a financial planner," or "So, you're a stock broker." I don't blame them for the confusion, but I do blame my industry.

There are a lot of honest people in the financial services business, but it doesn't seem like a large majority. Specifically, a culture exists that focuses on commission-based sales, and convincing people to purchase "products." An old industry adage is that insurance products aren't bought, they're sold. Looking at how most financial intermediaries are compensated, you'll see that the adage is all too true.

I'm highlighting this not just to pat myself and other money managers on the back (whoopee, I'm on Team Honest!), but to illustrate how the financial services industry seems to thrive while confusing clients.  

A helpful term to look for is fiduciary.  A fiduciary "must act for the benefit of their clients and place their clients' interests before their own" (CFA Standards of Practice Handbook).  

When you go to a Ford dealership, you don't expect a commission-based salesperson to recommend a Toyota, but when you are talking to a doctor, lawyer or another professional, you should expect them to treat you fairly.

When dealing with a professional, you are placing yourself in a position of trust with someone who is an expert in a field where you aren't.  It would be unfair, and frequently illegal, if the professional used that position of trust to benefit themselves at your expense.  That is why so many legitimate professional organizations require members to adhere to a code of ethics (and will boot you if you don't!).

When a so-called financial planner earns a 5% commission (yes, on the gross amount of the dollars you invest) because you invest in the mutual fund they recommend, that's not adhering to a fiduciary standard.  When an insurance agent earns a 10% commission selling you a whole life insurance policy or variable annuity, it should be clear their supposed advice is tainted by a big conflict of interest.

The best way to protect yourself, whether you're dealing with someone who claims to be fiduciary or not, is to ask how they are compensated.  That should make it clear whether they are serving themselves first, or you.

What's in a name?  It turns out, a lot.  

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.

Caveman brain and variable cycles

Almost everyone claims to be a long term investor, but few truly are.

A person's real attitude toward investing only becomes obvious with time.  One person initiates an investment approach and sticks to it for 20 years, while another switches after it doesn't "work" over three.  The result is almost always good performance for the person who sticks to one approach, and terrible results for the person who changes course every three years.

In my opinion, the cause of this short-term-orientation is twofold.  

First, human psychology really does a number on us.  Our caveman brain evolved to handle different problems.  You don't need more than three years of data to decide whether you should run from a hungry lion or a pack of wolves.  But, hunter-gatherers and farmers need to think longer-range to survive.  Unusually bad winters and poor rainy seasons don't happen every year, but when they do, you'd better have enough food and clothing stored, or you won't survive.  On an evolutionary time-scale, this thinking is pretty new to us.  As a result, we make lots of mistakes when our caveman emotions take over from our long-range, reasoning mind.

I'm as prone to this difficulty as everyone else, much to my distaste.  My biggest investing mistakes are seldom a refusal to sell something bad, but impatiently selling something too soon.  I, too, have suffered from short-term-orientation with investments that weren't "working," only to see them take off shortly after selling.  

I sold Berkshire Hathaway in November 2009 (having held it for 3 1/2 years) shortly after Buffett bought the Burlington Northern Santa Fe railroad.  Buffett was clearly signaling that his company would never grow like it had in the past.  The stock then jumped 21% in four months.  I was right about underlying growth, but wrong to have sold at a low price to fundamentals.

I sold UnitedHealth in November 2010 (3 1/2 year holding, also) after company management had repeatedly described how new health care legislation could rapidly change their business model.  The stock proceeded to climb 44% in the eight months after I sold.  Once again, I was right on the fundamentals of the business, but wrong on the decision to sell when price to fundamentals were still too low.

My purpose in giving these examples is not to highlight what a moron I am (I've actually gotten many more right than wrong--no really!), but to illustrate that even someone aware of the psychological traps of investing can still fall into them.  The solution is better process, which is fertilized with a thorough, rational analysis of past mistakes.

The second reason I think short-term-orientation sets in has to do with the fundamental nature of investing and business cycles, which are wildly variable in amplitude and duration.  Just as you can't decide the quality of farmland without considering weather cycles, so you can't decide what's going on with an investment without considering investing and business cycles--and that makes analyses more difficult.  

Investing cycles are caused by the boom and bust mentality of investors.  One year investors eagerly pay 20x earnings for an investment, and another year they won't pay 5x.  This boom-bust cycle is caused by the psychology of investors as a herd.  They go from euphoria to terror and back again over time, and no one can predict how long the cycle takes or when it will reach its zenith or nadir.

Business cycles, which are less psychological than investing cycles, are caused by a variety of things (including government policy, fads and fashions, competitive dynamics, just to name a few).  Like investing cycles, business cycles follow unpredictable paths that can distort the information investors need to make good decisions.  A rational analysis of long-term sales and margins over the full cycle is required, as is an in-depth analysis of industry and company dynamics.  Is a downward cycle permanent, or temporary?  Has a paradigm shift occurred that makes the business model defunct?  Only time will tell.

Investors generally have a hard time handling investing and business cycles.  Its easy to panic and "throw in the towel" when the future is unknown, but it rarely generates good investment returns.  People would love to know if their investment approach is working by seeing results right away, but the world is too complicated to say one, three or even five years of data are enough.  It depends, and each cycle is different than the last.  It's more constructive to look at long data samples, but few have the patience or desire for such work.

Given that, what's the solution?  

First, you'll only stick to an approach over the long run if you really--deep down--know it works.  If you've looked at the long term data, you'll know that value investing crushes growth investing over the long term.  If you spend enough time picking the right approach (or the right manager), it's possible to ride through periods of under-performance that can last as long as a decade.  If not, you'll panic and abandon ship at just the wrong time.

Second, you'll have to do battle with your psychology.  You will feel emotions when your investments tank.  You will want to throw in the towel when something isn't working for several years.  Be ready to fight your emotions with reason, data, analysis, or whatever else helps you.  I've found temporary distraction works, as does exercise, deep breathing, meditation, reading.  Do what you must to hold emotion at bay and focus on the facts.  Only then will you stick to your approach.

Our caveman brain and variable cycles make sticking to an investment approach very difficult, but not impossible.  The rewards, however, are truly extraordinary and well worth the time, effort and intermittent anxiety.  

Find the right approach, and stick to it!

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.

Big bad banks?

Just a quick note: the U.S. Federal Reserve made $78.9 billion in 2011, second only to its 2010 record haul of $81.7 billion.

Feeling curious, I decided to look up how much money the U.S. big four banks made in their peak years.  Combining their best, Bank of America (2006), Citigroup (2006), JPMorgan (2007) and Wells Fargo (2010) had combined peak earnings of only $70.1 billion (full disclosure: my clients and I own shares of Wells Fargo).

In other words, the banks that are supposedly the cause of all our earthly problems didn't together, looking at their peak earning years(!), match what the Federal Reserve made by itself in either of the last two years.

The bozos of Occupy Wall Street and everyone else who believes all our problems are due to the greedy, too powerful big banks need a reality check.

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.

Five year snap-back

Each quarter, Barron's publishes how mutual funds performed by sector.  Sectors in this case refers to how mutual funds are categorized, like funds invested in large, mid-size or small companies, growth or value, bonds, international, gold, real estate, science and technology, etc.

I find this information interesting not because I think quarterly or annual performance is meaningful--it's not.  You have to look at much longer periods, like five or ten years, to get meaningful information, and Barron's publishes that as well.

And, here's where things get interesting.  If a particular sector has done well over the last five years, does that mean it is likely to continue to do so going forward?  Not at all.  In fact, a good case can be made that the sectors that do best over the last five years are seldom if ever the one's that do best over the following five years.

And, that's what I look for in Barron's tables.  I look for the sectors that have done best and worst over the last five years because the best will likely become worst and the worst will likely become best.

The analysis isn't quite that simple, of course (nothing worthwhile in life is that easy), but some interesting data points can be gathered that might prove useful in guessing about the future.

For instance, the best performing sector over the last five years was precious metals (8.09% annualized).  That's not at all surprising given that gold and silver have been on a tear over the last decade.  Will it be best going forward?  I doubt it.  I'd guess precious metals will continue to do well for a few more years and then tank.  Good luck trying to jump off the elevator before it plummets.

What else has done well?  If you guessed U.S. Treasuries, good for you.  They were the second best performing sector out of 103 sectors(!) with an annualized five year return of 6.99%.  If you think that one will be the best performing over the next five or ten years, please don't operate heavy machinery.

The absolute worst sector was short bias funds with a -16.61% annualized return.  It's almost impossible to make money, long term, by going short all the time.  If the world falls apart, short bias funds will perform best over the next five years.  But, then again, you have to wonder whether property rights will be enforced or if the dollars you withdraw will be worth anything.

The Japanese stock market was the next worst sector, with a -13.27% return.  I'd guess that Japan is a very good candidate for a turn-around, but they culturally seem to scorn shareholders so I personally hesitate.  Unlike short-bias funds, I think this one has a good chance of looking brilliant in five or ten years.

The third worst was financial services (-11.09% annualized).  The crash and recovery from 2008 to 2009 makes that unsurprising, and a very likely candidate to out-perform over the next five years.  Like Japan, it has the clear ability to turn around, and everyone hates it, so it's a great contrarian bet.

After looking at the best and worst stand-outs, I look at small versus large and value versus growth.  Anyone who has studied finance knows that, over the long run, small beats large and value beats growth.  The support and records behind that, both theoretically and empirically, are so strong and long that there is very little reason to believe it will change going forward.

However, the long term record also shows that small doesn't--each and every year--beat large, and value doesn't always beat growth.  In fact, long periods of time go by where just the opposite happens.  Such periods are usually followed by a snap-back to historic averages--and profit-making opportunities.

The last five years are very interesting along this dimension, because growth has crushed value and small has beaten large by a much larger margin than is historically usual.  This leads me to believe (and has for several frustrating years now) that value will greatly out-perform growth over the next five years and large will greatly out-perform small.

I'll admit that I don't invest with this approach as my starting point: I don't examine the Barron's tables and then go do research accordingly.  Quite the opposite, the Barron's tables simply verify what I've been seeing in my bottom-up (security by security) research--that precious metals and U.S. Treasuries look very expensive, and that Japan and financials look very cheap.  It also confirms my experience that large companies seem to have much better return prospects than small, and that value looks much better than growth.

Barron's report of five year performance isn't a magic crystal ball, but it does provide some interesting information.  I think we're likely to see a five year snap-back, and my fundamental research confirms that assessment.

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.

A bird in the hand is worth two in the bush

Generally, investors are an optimistic lot. They tend to expect next year will be better than the last one. They tend to over-estimate their abilities. They tend to mistake luck for skill.

Investors are people, after all, and people tend to be over-confident. For proof, simply look at the success of lotteries. The odds are terrible, but the potential payout is huge, so people generally love to play.  

If you ask a lottery player what chance others have of winning, and what chance they themselves have of winning, you'll almost always get two different answers. "I am special," they seem to say, "and I will prevail over the odds."

As far as evolution goes, this is a great attitude to have. Pessimists make lousy leaders, are chronically unhappy, and don't tend to do what is necessary to succeed. Optimists, in contrast, tend to be better leaders, happier, and more confident in doing what they need to succeed.

When it comes to investing, though, the evolutionary program doesn't work very well.  

Investing is basically a contest with other people--not a contest with nature. The goal is not just to pick winners, but to pick winners before other people do. Seeing that Apple has succeeded doesn't do you any good, you have to have seen it before others and acted on that conviction to benefit.

This is why optimists tend to make lousy investors. They invest boldly because they are so sure of themselves. Unfortunately, they are not alone, and investment prices reflect the over-confidence of so many optimists investing boldly.

Optimists assume that high growth will continue. They assume they know more than others. They assume the distant future will look like the recent past. Unfortunately for them, it seldom does.

This attitude isn't just reflected in the actions of individuals, but in their investment advisers, too. People tend to choose optimistic advisers. They want someone who confidently and boldly predicts good things will happen. They don't really want a straight-shooter, they want a leader who they believe will take them to new heights. 

This compounds the problem, because even pessimists tend to prefer optimists as advisers. That leaves even fewer pessimists doing the actual investing, thus causing prices to over-reflect the optimistic attitude.

So, why do pessimists make better investors? Because, unlike optimists, pessimists tend to under-estimate their abilities, they tend to think things will get worse, they tend to mistake skill for luck. Instead of investing in "high potential growth," they tend to invest in actual performance.

A bird in the hand is worth two in the bush. The performance that has actually occurred is worth more than the potential that hasn't. High growth always slows over time, and low or negative growth almost always improves more than expected.

The pessimist invests in the bird in the hand instead of hoping for two in the bush. It rarely turns out there are two in the bush, and even when there are, they are almost impossible to catch.

The pessimist tends to generate better investment results because he isn't over-confident.  He doesn't invest in potential, but in the actual. Being unsure of his ability to predict the future, he doesn't try. The pessimist ends up selecting investments that optimists hate, and thus pays a very low price for it. 

What happens going forward? The optimist ends up paying a high price and finds out the future isn't quite as good as he confidently predicted. The pessimist ends up paying a low price and finds out the future isn't quite as bad as he worried. The optimist's investment tanks on disappointment; the pessimist's investment rallies when things turn out less bad than most predicted.

This process is so counter-intuitive that few follow it. Who brags they invested in a near-dead company? Who loves to brag that they invested in Apple? It's human nature, right?  

To get better results, though, you need to be a bit more skeptical. You need to worry that potential growth will falter, to question your confidence, or to find someone more paranoid than you to do the worrying for you.

It may sound counter-intuitive, but it works. When it comes to investing, hope is foul language. 

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.

All eyes on China

Most investors are focused on Europe, but they should be focused on China instead, because what happens in China is likely to have a greater impact than what happens anywhere else.

There are many candidates for focus next year.  The one that makes all the headlines is, of course, Europe. Its economy, as a whole, is still the largest in the world, after all. If that economy collapsed, or the European Union came apart, or the currency union changed dramatically, then it would, without doubt, impact the global economy. But, a lot of what's happening in Europe is already discounted in market prices. News on the front page is rarely a big mover of markets because markets anticipate change more than react to it. And, although Europe's economy is large, it doesn't contribute much to global growth. There's a small chance that Europe is the big mover of markets next year, but I doubt it will be.

Japan is a dark horse that may have a big impact on the global economy next year. Its economy is still #4 behind Europe, the U.S. and China, but hasn't grown in 22 years. The issue from Japan isn't earthquakes or tsunamis, but debt. Japan is the most indebted country in the world if you compare its overall debt to the size of its economy. The amazing thing is that they pay the lowest interest rates in the world on that debt. The reason rates are so low is that the Japanese are so willing (and compelled) to buy Japanese government debt. When retirees start to outnumber savers, though, Japan will have to start raising debt at much higher interest rates. If markets start to anticipate that inevitable transition next year, Japan could be the big mover of markets. I doubt it will be, though, because I don't think that crisis will come to a head for another couple of years.

The Middle East is, as always, another dark horse that could greatly impact global markets. Although the Arab Spring is making the headlines, the greater concern involves ancient rivalries between Arabs and Persians, and between Iran and Israel. If Iran succeeds in creating unrest between Shia and Sunni on the Arabian Peninsula, or if Israel becomes increasingly worried about and takes action regarding Iran's nuclear program, then oil prices will rocket and the global economy will tank. Like Japan's issues, these are unlikely to come to a head next year. But, unlike Japan's issues, the Middle East is unlikely to face an inevitable conclusion in the short to intermediate term.

The good old U.S. of A. is another place to focus next year. It's an election year, so many both inside and outside North America will be curious to see how our political field changes and how that could impact the global economy. The U.S. economy is huge, but is growing so slowly that it has less impact on the global economy than it did five or ten years ago. In my opinion, our political transition is unlikely to change things much, so I doubt it'll have a big impact on markets. Not only is Congress unlikely to tackle our debt issues during an election year, but the Fed is also running low on monetary ammunition.

China, I think, is the most likely candidate to move markets next year. It is both the world's 3rd largest economy and the fastest growing. It is also the biggest supplier of goods to Europe and the U.S., the 1st and 2nd largest economies. It has a huge impact on emerging market growth, too, because so many emerging economies supply China with the raw materials and other inputs that fuel their manufacturing powerhouse. In 2013, China is going to go through a major political change (every 5 years, there's a major changing of the guard) that's likely to be anticipated by markets in 2012. At the same time, China is trying to tamp down high inflation and an overly-exuberant real estate market. Add all these factors together with a bunch of global investors over-focused on Europe, and you have a high probability that China is the one moving markets next year.

I'm not alone in doing this, but I'm watching with great interest what happens to oil and copper prices and on the Shanghai Stock Exchange. Oil futures (which are high, but not outrageously so) seem to be reflecting concerns in the Middle East more than growth in China or emerging markets. Copper has fallen over 20% since last spring, but has not yet declined to global recessionary levels. Shanghai, like copper, has been falling since spring, and is down at levels last seen in the spring of 2009, when U.S. markets were hitting bottom.  

I don't really know what will happen in markets next year, but I'm watching China with greater interest than Europe. If China tanks, the world economy will follow; if China thrives, markets are likely to do much better than expected. 

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.

"Where's the market going next year?"

Some people love to ask questions they don't really want an answer to.

When people find out I'm a professional investor, they frequently ask where I think the market is going next year (especially in December). Having no ability to read minds, I assume their question is sincere and I launch into a description of what I do and don't know. About one-eighth of the way into my overly thorough explanation (I tend to talk too much), I can see their eyes glaze over as they imagine themselves someplace more pleasant...

Having gone through this routine hundreds of times over the last ten years, I've learned that most people don't really want an answer. I don't know if they are making polite conversation, or if they want me to express a certainty no human possesses, but I get the impression they'd really like to hear me say, "up, Up, UP!!!," or "sell everything and buy gold!" But, I have the dual problem of being brutally honest (just ask my wife) and overly verbose, so they end up quite disappointed.

If you really don't want to know what I think, or if you desire precise descriptions about the future, then please feel free to let the mental fog drift in, and imagine yourself on a sunny beach with an adult beverage of your choice...  

If, however, you'd like my opinion, please read on.

Sorry, but I really don't know if the market will go up or down next year (for a longer term assessment, see below). No one else does, either, so this isn't a matter of professional negligence on my part, but the nature of the beast. There are no short-cuts to building wealth any more than to getting an education, losing weight for good, pursuing a worth-while career, or building fulfilling relationships.  

Stock market returns include three parts: 1) dividends, 2) earnings growth, and 3) crowd psychology.  Dividends and earnings growth tend to be relatively stable and are easy to predict over the intermediate to long term (3+ years). Crowd psychology, however, isn't at all predictable and tends to completely overwhelm the impact of dividends and earnings over the short run.  

Anyone who says they can predict crowd psychology a year in advance belongs in a circus side-show, or on Wall Street as a strategist (the latter pays much better than the former, just in case you're weighing the options). And that's why no one, not even brilliant people with decades of experience and multiple degrees from esteemed institutions, can tell you where the market is going next year.

Sorry to disappoint you, but it can't be done.  

If, however, you'd like to know what kinds of returns to expect from the stock market over the long run, then I do have something to say. For, crowd psychology tends to dampen out over time, thus regressing to the mean.  Because this tends to occur over several years, it is possible to make reasonably accurate assessments of long term returns.

On that score, I'm likely to disappoint you, too. I think the S&P 500 will return around 3.5% to 6.5% over the next 5 years.  That includes dividends, earnings growth (including inflation), and a regression in crowd psychology back to the mean (I include 6 year projections each quarter in my client letters, which can be accessed here).

How can I expect such modest returns even though the market has gone nowhere for 11 years? It all comes back to crowd psychology. People tend to go from greed to fear and back again over long periods. There are long cycles of 15 to 20 years with several smaller 3 to 7 year cycles along the way.  

For example, in 2000, people were euphoric. Then their hopes were dashed into 2003, but not completely. They became greedy again in 2007, but not as much as they were in 2000.  Those happy feelings were shredded again into 2009, and this time people became even more depressed than in 2003, but not completely despondent.

Before we get to a long term market bottom, we're very likely to get to the completely despondent point. That could result in a flat market for the next 5-10 years, or a cataclysmic crash and then gigantic boom over the same time period. I don't know because of that predictability-of-short-term-crowd-psychology thing. Historically, it's more likely to be bust then boom, but who knows?

What I do know is that down cycles like the one we're experiencing end, and are followed by up cycles. Everyone would like to know the timing of such events, because you could make a fortune timing it perfectly, but no one does.  

I will offer a warning that it won't be fun when the down cycle ends. For starters, the news on the front page will look terrible. No one will want to invest in securities.  Stocks will sell at very low prices relative to historic dividends and earnings. Articles will appear saying that stock investing is dead. At that point in time, when you'll want to run screaming from the room, is when a new bull cycle will begin.  

That's also why I'm not trying to time the cycle. I'm almost fully invested and plan to remain that way. Why?

First, its impossible to pick the exact bottom, so anyone trying to do so is likely to miss it and think it's still in the future. By the time they realize it's in the past (which can only be demonstrated with hindsight), they'll have missed a huge part of the up-side.

Second, remaining invested will allow me to generate slightly better returns than the market through the down-cycle. This may sound like a foolish endeavor (like catching a falling knife), but beating the market by even 3% a year over the down-cycle means I'll start the up-cycle with 65% more money than I otherwise would. That's a much nicer place to be than guessing about about market bottoms when the world is in total panic (remember 2003 or 2009, when people truly thought there was no bottom in sight?).  

I do have a view on the market, but it's not for the next year, and it's dour for years, then very profitable after. The problem is: most people don't want to hear that.  

That's okay, I need someone to buy from and sell to over the cycle.  

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.

Ducking thunder

It's hard not to feel a bit shell-shocked by current events. Each piece of bad news makes a person want to duck and cover until the storm passes. Although I understand this feeling and can sympathize with it, I don't think it's constructive.

When you hear a loud clap of thunder, it's hard not to duck. The problem is that by the time you've heard the loud noise, it's much too late to do anything about it (not that ducking would help anyway). The danger is long past and you're just reacting instinctually and uselessly at that point.

The same is true in financial markets. Unless you're a professional trader working at one of the world's financial centers, by the time you hear the bad news it has long ago been reflected in security prices. Whether it was Baron von Rothschild 200 years ago or instantaneous computer trading today, you and I are not going to benefit from trading on the news.

That doesn't mean we can't interpret the news more intelligently and act on it in the fullness of time, but thinking that we can duck and cover at the sound of thunder is total folly.

This reminds me of my experience in pilot training. Not surprisingly, you don't want pilots to panic or freak out when an emergency occurs. Our human instincts don't serve us well in the cockpit, so they train pilots through repetition--in a full-motion simulator--to keep their cool in emergencies and successfully deal with problems.  

We called it "dial-a-death" because the instructor pilot literally had a dial where he chose the emergency you were to handle. The first several times you were given a tough emergency, it was hard not to freak out, but over time you could learn to keep your cool even under the toughest of circumstances. For me, the key was to breath deeply and get very focused on properly diagnosing the problem and then meticulously taking corrective action. If you sat there thinking about the consequences and how worried you were, you were doomed.

I think this analogy is perfect for financial markets, too. We need to be ready for emergencies by preparing ourselves mentally. We need to expect things to go wrong instead of hoping, uselessly, that they won't. We need to know how to act when things go wrong so our instinctual desire to duck is suppressed and we do what we know we need to do. We need to focus on controlling the things we can control instead of wishing we could control the things we can't.

How do we prepare for financial emergencies? Go into the situation with your financial house in order: 

• spend less than you make
• save the difference (pay your future self, first)
• invest your savings wisely (by being prepared for both good and bad market conditions that you know will happen, but not when)
• have enough cash at your disposal to handle life's inconveniences
• get enough insurance
• set up an estate plan  

Also, know what not to do: 

• panicking won't help
• don't assume see can see bad financial conditions coming (don't worry, no one can consistently)
• don't assume that bad times won't come
• don't believe you can "go to the sidelines" until the storm is over
• don't try to time when to get out and get back in (you will almost always do both way too late)
• don't inundate yourself with bad news that makes you want jump out a window (good pilots don't stare at burning engines, they focus instead on putting the fire out)

If you're more opportunistic (and this is clearly not for everyone, just like flying airplanes), be ready to benefit from others' panic. Be ready to sell your safest holdings and buy what the panicky sellers are abandoning recklessly. Financial panics are always the best time to invest, and precisely when your instincts most desire to seek cover.  

Just like pilots can learn to handle terrifying emergencies, you can learn to handle and profit from financial panics. Be prepared, have a plan, take deep breaths, and don't try to duck--it's already too late.  

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.

Why I'm all about value

Investing in glamorous stocks generates lousy returns; investing in out-of-favor, unloved and even hated stocks generates great returns. And, that's why I'm all about value.

The return from investing in stocks can be roughly broken into two parts: 1) how a company does, which is what almost everyone focuses on, and 2) investors' general attitude toward a company.

Most investors, whether individual or professional, focus almost exclusively on #1. They look at growth, sales, profit margins, competitive positioning, return on capital, new products, distribution, marketing, etc. Don't get me wrong, this is vitally important stuff. But, it's only half the picture.

Just as important is investor perception. When a company is loathed, its price reflects that fact. People sell investments they loath. They don't want to talk about such investments at cocktail parties. Most of all, they don't want to try to explain why they've bought something unpopular.  

When a company is loved, its price reflects that fact, too. People buy investments they love. They're excited to talk about such investments at Christmas parties and how they are going to make a fortune. With these investments, people enjoy explaining why they bought it, and how much money they've already made (sometimes including all the relevant facts).

But, loved companies aren't as good investments as those that are loathed. The reason is simple: it's in the math.

Loved companies sell at a high price relative to underlying fundamentals. All those people who love a company buy it, and that drives its price up. Loathed companies sell at low prices to underlying fundamentals. Everyone who hates it sells it, and its price reflects that.

If all that mattered were the fundamentals, then loved companies would almost always out-perform loathed companies. But the math of returns reflects both fundamentals and the price paid for those fundamentals.

Perhaps a theoretical example will better illustrate my point. Say two companies, Loved and Loathed, both make $1 per share in earnings.  

Loved is growing at 15% per year. Because everyone loves Loved, they pay a high price for it: $30 per share, or 30 times earnings (this is not unusual, Apple sells at 15x, Google at 20x, and Amazon at over 100x!).  

Loathed, on the other hand, isn't growing at all. Because everyone loathes Loathed, it sells at a very low price, or 5 times earnings (think Merck after Vioxx, or BP after Mecando).  

Now, what happens going forward?  

Even supposing Loved can maintain 15% growth for five years, people eventually become less excited about it. They know such high growth can't last forever, and a fad eventually becomes boring to those excited about the newest thing. As the saying goes, ardour cools.  Instead of being willing to pay 30 times earnings, investors are only willing to pay 20 times earnings (still a very generous premium). Over five years, earnings per share will have doubled, but stock price will only go up 33% ($2 earnings per share times 20, $40 on a $30 investment is a 33% return).

Loathed, on the other hand, continues to be a dog. It doesn't grow at all over the following five years. In contrast to Loved, everyone who hates Loathed has already sold it and gets bored with hating it over the following five years. When investors become surprised that Loathed doesn't go out of business, the price starts to recover. Although Loathed earns the same $1 per share it did 5 years earlier, people are eventually willing to pay 10 times earnings for a no-growth business. Over five years, Loathed returns 100% ($1 earnings per share times 10, $10 on a $5 investment is a 100% return).

My example above may seem contrived, but that's how things really work out. There are countless research papers from Fama and French, to James Montier, to David Dreman supporting my contention. Or look at the investment records of Warren Buffett, Walter Schloss, Robert Rodriguez, O. Mason Hawkins and Wally Weitz.  

If you think this is a smooth ride, think again. It's no fun owning Loathed. People will think you're nuts (believe me, I know). Almost no one will want to talk to you about investing--especially at cocktail or Christmas parties. But, it pays very well.  

Making this approach even tougher, investing in value goes out of favor for long periods of time, too. Value grossly under-performed from 1995 to 2000, before dramatically out-performing from 2000-2005. Value has gain been out of favor over the last six years. C'est la vie!

It may look ugly, be unpopular, and under-perform for long periods, but value investing works by capitalizing on investor perception. That's why I'm all about value. 

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.

Hero to toad

Investing is a brutally competitive business.  Unlike being a doctor or plumber, where you fix things in reality, investing is all about how you perform relative to your peers. No one gets an appendectomy, or has their pipes unclogged, and then asks how that fix compares to all other fixes done by all other professionals. If the problem gets fixed, the customer is happy.  

Investing is more like sports in this way. Hardly anyone asks about a football, baseball or basketball players' career stats. Instead, people want to know how athletes stack up to the competition, and more specifically, how many championships have been won.

I was reminded of this recently with the announcement that Bill Miller is retiring from managing Legg Mason's Value mutual fund. You may not have heard of Miller, but he became famous in the early 2000's for beating the S&P 500 year after year. Amazingly, he managed to beat the S&P 500 every calendar year for the 15 years ending in 2005. This made him a deity among many individual and professional investors.  

If Miller had retired in 2005, he would still be touted as the hero he seemed to be. He'd be able to write best-selling books, make a fortune with speaking engagements, and perhaps even milk that hero status for the rest of his life.

Instead, Miller stayed on the job and has gone from hero to toad. Not only did he fail to continue out-performing the S&P 500 every year after 2005, he managed to lose a huge amount of his clients' money (after making a ton for them prior to that). Investors have abandoned him en masse as his fund went from over $20 billion in assets to around $2 billion, now.  

A good question to ask is whether Miller "lost his touch," or if he ever had a touch to begin with. I don't think Miller lost his touch, I think the odds simply caught up with him.  

Looking at Miller's record, you'd see that he didn't out-perform every period, he just happened to out-perform calendar years over 15 years. Change the date to October 31st instead of December 31st, and you would have seen that he didn't out-perform every year. Added to that, he really didn't out-perform the market by that much over those 15 years. His edge was small and has been completely erased.

Look deeper into his process, and you'll see an almost blind contrary approach--buy what others hate and wait. Because the market always recovered nicely between 1990 and 2005, Miller looked like a genius (even though he wasn't). In fact, I believe Miller was one of the most over-rated money managers of the last 20 years.

Does that make Miller the toad he is being treated as now? Not at all. Miller out-performed most (probably 80%) professional and individual investors. He's neither a hero nor a toad, but clearly an above average money manager.

And yet, people's perception of him is based on his retirement date, not his career stats. One feels for Bill Miller like one feels for sports greats that never win the championship. They are always seen as "could-have-beens" instead of the out-performers they are. Such is life.

Many seem to forget the role that luck plays in life, and particularly in sports and investing. Many that seem great, are both good and lucky; and many that seem mediocre are actually much better than perceived.  

Think for a second, about Steve Jobs. Looking at his career in 1985, 1990 or 1995, he seemed like a loser to most. Even in 2000, when he was clearly (in hindsight) on the come-back trail, most (including me) had written him off as a has-been. Then he went on to change the computer, mobile phone, music and movie-making industries and become what many consider the greatest CEO ever. It's sad to say it, but perhaps cancer saved Jobs' reputation from the fate of Bill Miller.

Look, too, at Robert Rodriguez, one of the best mutual fund managers alive. He under-performed the S&P 500 over 15 of 18 5-year periods from 1973-1991. But, if you invested with him in 1968, you'd have three times the money you would have had investing in the S&P 500. It pays to back the right horse, not the one who just looks pretty. Looking at Rodriguez's process, I could see he was great. Not so much with Miller.

Investors with the right process win in the long run, even if they don't rack up amazing, headline-grabbing statistics. Look at how they do what they do, not just the results. Look for the Jobs or Rodriguez that hasn't broken out instead of the famous show-boat who might be short-term lucky instead of long-term good. Look for single-minded focus, an ability to learn from mistakes, and an inherent love of the game and you'll likely find a winner. If you over-simplify the process and look for the bandwagon everyone else is jumping on, you're likely to find the odds will catch up with you, 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.

Profit magnitude AND duration

It's not enough to focus on a company's profitability--especially if it's huge; you must also understand the durability of that profitability.

A single payout of $1 million is not worth as much as a lifetime payout of $150,000 a year forever (unless you can get better than 15% returns forever). The same is true with buying businesses (whether in the form of a whole private business, or shares of stock).

This may seem elementary, but some investors lose this focus when they dwell on short term high or low profits. A couple of examples may help concretize this point.  

Exxon Mobile is a hugely profitable company. But, there are non-trivial questions about whether it can replace its current productive capacity over the next 10 years.  

Or, consider Apple. It's hugely profitable right now, but can that profitability be sustained and grown in the face of many smart and well-resourced competitors (that are spending 2x to 4x as much on research and development)? The answer to that question is vitally important for Apple's valuation.

Or, what about Sprint (the telecom company)? It's clearly not making money now, but the price paid for the company should reflect profits 5 and 10 years from now as well as this year. Does Sprint's valuation reflect its current profitability or its profitability over time?

Think about Research in Motion, the maker of Blackberry mobile phones. It had rapidly growing sales and profits within the last year, but both have started rolling over. Will that trend accelerate, continue, or reverse?  The value of the business hinges on the outcome.

I don't mean to imply that answers to these questions are easy--they aren't. In fact, I'll be the first admit I don't have the answers to any of those four questions. But, they must be thought about in order to achieve good investment results.  

I should know, I've fumbled that ball several times in the past (business analysis is extremely complex, and no one is omniscient). I bought Reebok and Novell in 1996 after years of outstanding profitability. Over the following 10 years, though, both saw profitability and their stock prices tank--a great lesson that durability of profits is more important than recent magnitude.

Think about stalwart companies like McDonalds, or Coca-Cola, or Proctor & Gamble. They have extremely high profitability and almost zero chance of seeing that profitability vaporize like we could see happen with Exxon, Apple, Sprint or Research in Motion. That's why their stock prices are almost never as low relative to fundamentals. Investors as a whole get this concept, even if they forget it at times (1999 and 2000 for technology, 2005 and 2006 for housing).  

As I said last week: it's not about market share, it's about profitability. Now, I'd like to add that it's not just about profitability, but also durability. Your investing future depends on both.

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.

Profits, not market share

As a shareholder of Dell, I must admit to being frustrated by all the focus both Wall Street and the media apply to market share. Listening to them, you'd think all that matters is market share. They're wrong.

What matters in business is profits.  Not market share, but profits and their sustainability. Market share is a measure of sales relative to other companies. It's a top-line focus. Profits are bottom-line. It's the money a company makes, it's a measure of value-added, and it's the money a business has to compete in the future.

In Wall Street and the media's defense, there are some businesses where market share is all important. In Internet search, for example, Google dominates with high market share and very high profits. There's a network effect in search that hugely rewards number one. Number two and below not only don't make much money, they lose big-time (just ask Yahoo! and Microsoft (another holding of mine)).

Let me give you a quick theoretical example of how to gain very high market share but lose in the end.  Buy $30,000 Honda's sell them for $15,000. I guarantee you'll have #1 market share. But, you'll be out of business so quickly it won't matter. Now, buy those Honda's and sell them for $29,000. Once again, you'll have very high market share and you'll last longer, but you'll still be out of business in the long run, guaranteed.

Now, back to the computer market.  

A couple of years ago, Acer overtook Dell by grabbing the #2 market share spot. Was that #2 in profits? Not at all. In fact, Acer gained #2 market share selling netbooks. Remember those. Perhaps not, because they've been almost completely supplanted by tablets--mostly Apple's iPads. Acer gained market share selling a cheap, low profit margin product. Dell didn't follow. Since then, Acer has fallen back below #2 and Dell continues making profits and competing successfully. Dell focused on profitability, not market share, and it worked.

Fast forward to today, and Lenovo just overtook Dell for #2 in market share. Instead of selling netbooks, Lenovo is dominating sales in China and doing very well in emerging markets. Their profit margins?  1.85% at last report on an accounting basis. Dell's profit margins? 5.8% on an accounting basis (7.6% on a cash basis).

Now, think about that. Profits are what is used to buy inventory, innovate new and better products, build supply chains, hire productive employees, etc. Just for the sake of the argument, let's assume Lenovo is selling a product that's just as good as Dell's (which is unlikely with so much lower profit margins). Lenovo is essentially selling $30,000 Honda's for $30,555 and Dell is selling them for $31,740.  Lenovo is making $555 on each sale and Dell makes $1,740--more than three times as much!

That's the money each company has to pump back into the business. Lenovo would have to have over three times the market share to have the same amount of profits to plow back into the business in order to be competitive. Does Lenovo have three times Dell's market share? Not even close. In other words, Lenovo cannot compete by focusing on market share, it must either focus on profitability or risk losing that market share over the long run.

I'm simplifying the argument a bit to make things clear, but my point is still valid. For a company to survive and thrive over time, it's about profitability, not market share. An over-focus on market share is the wrong way to think.  It's a focus on effects, not causes.

In the long run, Dell doesn't need high market share to succeed. It needs profitability. That, it has.

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.

Euro-Scary!

I've been writing since December 2009 about how sovereign debt will evolve into the next sub-prime credit crisis, and how it will all start to come apart with Greece.

One of the first really ugly steps down this path began this last week as members of the European Union decided to write down Greece's sovereign debt by 50% (only 21% for government holders--"All animals are equal, but some animals are more equal than others").

To commemorate this unraveling, I decided the scariest thing I could turn my Halloween pumpkin into this year was the euro--Europe's supposed common currency.  At right, that's my Jack-O-Lantern at the top, with my wife's cat and my daughter's Blue from Blue's Clues below.

My mother-in-law was not, I think, amused by my choice (she's German), but I was.  Not only was Europe's plan inadequate, but it also set in motion some market dynamics that may reverberate for some time.

One of the games European officials decided to play was to describe the 50% write-down as a voluntary restructuring instead of a default.  This may seem like a minor technicality, unless of course you own Greek debt and bought insurance on its default (which won't be honored, now).  It sounds like the Europeans are going to violate the sanctity of contracts, and that has left a lot of folks who bought insurance scrambling, and with big questions.

Can you buy insurance on sovereign debt and really be insured?  It doesn't look like it.  In fact, the market's rally last week may very well have been due to investors having to cover investing positions rather than a positive evaluation of Europe's "solution."

No, Europe has not solved Greece's debt problem.  They just kicked the can down the road a little farther (a 90% write-down will more likely be necessary, followed by major structural reforms to Greece's economy).  

No, this solution will not build confidence that Ireland, Portugal, Italy or Spain's debt problems can be solved, not to mention Belgium and France (French, German and British banks own a ton of Greek, Irish, Portuguese, Italian and Spanish debt--now you know the real reason why they are searching for solutions).

No, this will not be good for the economy in the long run.  No, this is not a model for solving the same huge problems that exist in Japan and the U.S. (due to Medicare, Social Security, Illinois, California, New York, etc.).

This problem will be with us for a while--probably another 5 to 10 years.  But, when we get past it, the global economy and stocks will go on a 15 to 20 year bull market.  

Until then, we'll have to be satisfied with lower returns, preservation of capital, and a little amusement as Greek Tragedy justly punishes those who haven't learned from history.

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 Inflation Path

To most people, inflation seems quite mysterious.  This is not without good reason.  

First of all, it's an abstract concept.  Inflation is not when the price of some things go up.  Just because the price of gasoline or wheat increases doesn't mean inflation is happening.  Inflation is when the price of everything, on average, goes up.  This concept isn't just abstract, it's almost impossible to measure over the short run.  Inflation isn't usually obvious until it's really climbing.

Another reason inflation seems so mysterious is because so many misunderstand when it is or isn't happening.  Politicians and economists are notorious for saying inflation isn't happening when it is, and saying inflation is happening when it isn't.  Anyone paying attention would think inflation is completely inexplicable.

It's not.  Inflation is simply when the money supply increases faster than production of goods and services.  That doesn't mean it's easy to measure, but we do know what it is.

Inflation is also terribly destructive.  As Keynes said, it is a very easy way for governments to confiscate tremendous amounts of wealth without the populous seeming to notice.  That is, until inflation gets very high.  Then it rips an economy and government apart (starting with the poorest, I might add).  

A quick look at history will reveal that few governments collapse because they have bad policies or default on debt, per se.  The thing that will destroy a country more easily than anything (besides war) is inflation.  The record is quite clear.

The path to inflation is also easily understood.  Many writers have described the process accurately, usually after an exhaustive study of history.  Peter Bernholz perhaps describes it best in Monetary Regimes and Inflation: History, Economic and Political Relationships.  

To start, you have a government conservatively financed with low taxes and limited power.  As the government extends its power over time, it gets to the point where it cannot raise taxes enough to further grow its power (people eventually refuse to pay the higher taxes either direct protest, or indirectly by violating the law).  At that point, a government starts to borrow.  The borrowing starts low and gets higher as time progresses.  At a certain point, the borrowing becomes high enough that those lending to the government demand higher interest rates.  That's when things start to come apart, and that's when the government starts creating money much faster than economic growth.  And, that's when inflation goes ballistic and things finally come apart.

This path is not followed precisely each time, but that's generally the path to high inflation.  

For example, some governments realize they are creating money too quickly and reign things in.  This is possible not solely because the people or government decide to be more rational, but because the size of government debt and spending is not too large relative to the rest of the economy.  It wasn't hard for the U.S. to get inflation back under control after the Revolutionary War, Civil War, World War II, and the 1970's (Vietnam War), because our government debt and spending weren't yet too high relative to the productive capacity of the economy.  But, it's not necessarily the case that cooler heads can prevail if the debt is too great.

The best defense against inflation is a precious metal standard, usually gold or silver (and gold has been far superior to silver, historically).  

The next best thing is a paper money standard with an independent central bank (independent of political authorities--particularly elected officials).  Unfortunately, this "next best thing" has always and everywhere been an intermediate step on the way to high inflation, usually by way of making the central bank beholden to elected officials.

I mention this because Barney Frank, a Congressman more responsible for the housing crisis than Wall Street and all the banks in the U.S. put together, is currently suggesting we make our central bank, the Federal Reserve, beholden to elected officials.  Like F.D. Roosevelt tried to stack the Supreme Court to force his policies through, Barney Frank wants to make the Federal Reserve more directly swayed by the Congress.

Now, I'd like to step back to put my above comment into context.  The U.S. government has gone from being conservatively financed (we've had an income tax for less than half our history), to grabbing more and more power (economically, militarily, socially, etc.).  That power has been expensive, so much so that we had to start issuing larger and larger amounts of debt to finance that growth in power.  As that occurred, the U.S. went off its domestic gold standard in 1933 and off the international gold standard in 1971.  Since then, we've had higher and lower inflation (to the degree our independent central bank kept things in check--almost always against the will of politicians!).  With the growth of our welfare state, particularly in the form of Social Security and Medicare, our government has racked up tremendous financial obligations, far out-weighing our military spending or any other spending (including those dreadful bank bailouts).  

Governments get into trouble when debt grows to exceed 90% of the economy.  That's when the economy slows because of the debt millstone around its neck.  We're either there, now, or very close.  We also know that governments get into trouble when the deficit of spending versus tax revenues grows to over 20% of spending.  We're around 30% now.

So, as our government has grown in power, it has gotten into so much debt that it is close to preventing the economy from growing its way out of the problem.  And, it has abandoned the best thing to prevent high inflation--a precious metal standard.  Added to this, there are elected officials who would like to remove our last line of defense--the independence of our central bank.  

Not good.

High inflation doesn't have to happen here, but we are getting farther and farther out on a limb that can lead us to tumble off into serious trouble.  We can decide to turn around and scramble back toward the tree.  That would require us to keep our central bank independent at a minimum, and then get back on a precious metal standard.  It will also require us to reign in our government's size relative to our economy (that means spending cuts and the restructuring of our tax system).

The inflation path is clear, and we keep taking steps down it.  Perhaps it's time to turn around.

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.

Why is anyone surprised?

Great article by Jonathan Weil last week from Bloomberg.

Less than three months ago the European Banking Authority said Dexia SA (DEXB) had passed its so-called stress test with ease.  The French-Belgian lender's July 15 new release carried this headline: "2011 EU-wide Stress Test Results: No Need for Dexia to Raise Additional Capital." 

Then last weekend, 86 days after getting its clean bill of health, Dexia took a government bailout to avoid collapsing. Nobody was surprised this happened.  Nor should anyone have been.

The regulators who gave Dexia a clean bill of health were not incentivized to do a good job of credit analysis.  They were incentivized to "calm the markets."  

If investors had listened to the speculators, who were incentivized by the profit-motive, they would have avoided Dexia.  If investors listened to the government's appraisal, they were led to the slaughter.

This has happened time and again, but people keep expecting the government will rescue them from the "bad guys."

Look at Barney Frank and Fannie Mae, or the SEC and Bernie Madoff, or Ben Bernanke and the housing market.  The list goes on and on and on.

The short-selling speculators have a huge incentive to get their analysis right.  And, in general, they do.  Look at government officials and their record in uncovering malfeasance.  It's terrible. 

So why do people run in fear from the "bad guys" who almost always get it right, and run to the arms of the government officials who almost always get it wrong?  

Beats me.  But, they get what they deserve.  

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.