As fragile as China.

As I've remarked before (here and here), much of the current worldwide economic recovery is due to China. For that reason, the greatest sensitivity to continued recovery is what happens in and with respect to China.

This recovery is as fragile as China (meaning delicate plates as well as the country).

Demand from China has driven up commodity prices and kept production flowing from manufacturing-based economies. For evidence, look no further than companies like Caterpillar and the land-office business they are doing in the far east.

If something were to go wrong in China, the economic impacts would reverberate throughout the global economy.

What could go wrong? If you haven't noticed, there have been a lot of political issues surfacing between China and the U.S.

This includes the U.S.'s desire for China to allow it's currency, the yuan/renminbi, to appreciate. This would make U.S. manufacturers more competitive with China. China has no interest in making itself less competitive, so this creates a lot of tension between the U.S. and China.

And then, there's the spat between Google and China over censorship and hacking. It shows the inherent conflicts that exist between a command and control government like China's and free market enterprises like Google.

Of course, there's also the Dalai Lama. He represents the Tibetan government in exile and China doesn't like his concerns being heard by the most powerful nation in the world. President Obama met with the Dalai Lama this week, infuriating China.

Then, there's also our insistence on selling high-end weapons to Taiwan, whom China considers to be an errant state. It would be like Russia selling arms to Alaska, with Alaska being quite clear it would like to secede from the union.

So, there are a lot of political issues going on between the U.S. and China, not to mention they hold a ton of U.S. national debt. It's a touchy situation.

China, too, has its own internal problems. Approximately 700 million people live in poverty in the Chinese interior while another 600 million are growing rapidly nearer the coast. Growth and trade has been great to the 600 million and less so to the 700 million. That is why some 20 million Chinese, a year, are moving from the hinterland to the coast looking for work.

This dynamic means that China simply can't let growth slow too much. If it does, they will have a revolution in short order. Such is the history of China over the last...oh...2,000 years.

China is an island, geopolitically, and it has repeatedly cycled between external growth/interaction and internal strife/revolution. Until they change their political system from centralized command and control, as it's been for 2 millennia, this external/internal cycle will continue.

This internal dynamic is the main reason why China won't let its currency appreciate, and why they are working so hard to stimulate worldwide growth. China needs worldwide growth because they need someone to sell their low cost goods to.

The problem is that political tensions with large economies like the U.S., Europe and Japan are all working against this process. And, of course, the U.S., Europe and Japan all have major internal issues of their own that make them less than conciliatory towards China.

With all that on the table, how long until we see Chinese fragility? I don't know, and neither does anyone else. But, it's reasonable to assume the game can go on for several more years.

If China plays their cards right, then perhaps they can keep the game going long enough for the rest of the world to work out its problems and start growing again on its own.

If they slip up, though, which seems highly likely over the next five years, then that fragility could crack the delicate plate and lead to worldwide consequences.

We'd all like to see China succeed. If they do, then the world economy gets bailed out of its experiment with too much leverage. If not, it could lead to another major economic upheaval.

For now, expect China to keep the game in play. It should be good for stronger economic growth than most are forecasting. But, when the end-game arrives, it won't be pretty.

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 Greek

Markets were, again, disturbed by news from Greece this week.

For those of you who don't pay much attention to these things, Greece is in a serious fiscal bind. You see, their fiscal deficit looks to be around 13% of gross domestic product.

When a country typically crosses the double-digit barrier, their interest rates spike and their currency tanks. Markets don't like it when a borrower's revenue falls short of it's obligations by more than 10%. It indicates the borrower may default.

Greece, however, is in a unique position. It is part of the European Union and has adopted the euro as its currency. The result is that Greece's problem is really western Europe's problem.

It reminds me of the joke about borrowing from a bank. When you borrow $10 thousand and are having problems making payments, it's your problem. But, when you borrow $10 million from the bank and are having problems making payments, it's the bank's problem.

Greece is Europe's problem, and that has markets much more nervous than if it were just Greece's problem.

Economic and currency unions have not stood the test of time. None have lasted. For this reason, many are skeptical the euro or European Union will last, either.

Greece is exacerbating these fears because many market participants worry that Greece's problems could break up the union. The euro is down almost 15% from its peak (hopefully this trend will continue at least until my trip to Paris this May), and these issues are part of the reason.

What seems to be lost in this shuffle is that the rest of the world is going Greek, too. The movie in Greece may soon replay in the rest of the world, and by players too big to be bailed out by Germany or France. Niall Ferguson eloquently pointed this out in the Financial Times yesterday.

For example, look at the good ole U.S. of A. Our fiscal deficit is also in double digits this year. For that matter, Japan, the United Kindgom, Ireland and Spain find themselves with similarly difficult fiscal positions.

Some of the biggest economies are going Greek, and the investment implications are important.

For now, it looks like the global economy is recovering. This will likely provide a temporary respite from these fiscal problems. But, eventually, the piper will need to be paid.

When that happens, it might be nice to be far from government bonds and have some downside protection in place. When the world goes Greek, it won't simply "disturb" markets.

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 everyone knows.

My favorite Will Rogers quote: "It isn't what we don't know that gives us trouble, it's what we know that ain't so."

There's no better place to illustrate this principle than Wall Street. Stock prices reflect what everyone knows. The problem isn't what we don't know, but what we know that just isn't so.

For example, everyone knows China is a growth engine and that everyone "should" be invested there. If everyone knows it, then stock prices already reflect that fact. If what everyone knows turns out not to be so, then a lot of people are in for a lot of disappointment.

Another example. Everyone knows the cable industry is toast because everyone will download TV and movies over the Internet for free. But, if everyone knows, then stock prices reflect that fact already, so no profits can be made betting against cable. In fact, if everyone knows it, and it turns out not to fully reflect the facts (how will all those people download all those movies and TV shows, perhaps over cable?!), then it might be possible to make money betting the other way.

Everyone knows that bonds and cash are safer than stocks. Perhaps that is why retail investors flooded into bond mutual funds last year and a lot of people pulled their money out of the market and put it into bank accounts. But, what if inflation comes back with a vengeance? What everyone knows will turn out to be very painful for, well, everyone.

What else does everyone know? Old line software companies are toast. Every Apple product is a blockbuster. Google will provide everyone with software for free just because, gee whiz, they're such nice people. All airlines are lousy investments, always. Content providers will happily provide consumers with high quality entertainment for free over the Internet. Old line pharmaceutical companies are toast. Old line telecom companies are toast. Regulators can see problems coming and act to prevent harm. Global warming is occurring, caused by man, can be stopped, and should be stopped (the benefits outweigh the costs).

The trouble isn't what we don't know, or admitting that we don't know. The trouble comes when what we think we know turns out to be just plain wrong.

A lot of money has been made over the years in buying the opposite of what everyone knows. It's certainly worked well for me.

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.

China Pullback.

As I highlighted in the Stimulus Withdrawal section of my most recent client letter, when the governments of the world get serious about withdrawing monetary and fiscal stimulus, things could get ugly.

So far this year, the S&P 500 is down around 3% on a price-only basis. This may be a "healthy correction" in process, but it's curious why the correction started just recently.

There has been a lot of speculation about why. The most popular explanation is, of course, political. President Obama and former Fed Chairman Paul Volcker are threatening to take a hatchet to the big bad bailout banks (tip of the hat to Donald Coxe).

Large bank stocks have sold off, and regional bank stocks have done well. So, there is some substance behind the political claim. But, bank stocks have not been the most significant component of the sell off. In fact, one can more reasonably look at commodities to see what may be going on.

Oil and copper prices are off around 12% since their peaks in early January. Natural gas prices are off around 14%. Could it be that the threat to large U.S. banks is causing a sell-off in commodities? Doubtful. Or, is it a reflection of a more fundamental pull-back in economic activity. And, if so, why?

Okay, enough teasing. China decided to rein in credit expansion by raising bank reserves and increasing borrowing costs. I think markets are reacting to this credit tightening because they understand that China, and other emerging markets with respect to China, are providing the marginal units of growth to the world economy.

Not surprisingly, the Shanghai Composite is off 8.4% since January 21st. Perhaps the U.S., Europe and Japan are no longer leading the world economy, and markets are reflecting what is happening in the far east.

What will happen now? I don't know, and neither does anyone else. But, what China decides to do going forward with respect to government stimulus and credit creation is likely to drive markets for some time to come.

Unless you know someone with close ties to the highest levels of Chinese government, I don't think anyone will be able to guess what will happen next, either.

This is no time to be overly bold or assume that timing the market is possible. It's up to the whims of Chinese politicians in my opinion.

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 cash just aren't that safe

Bonds are seen as safe. So is cash. But, that's not necessarily true.

For starters, bonds and cash are susceptible to higher tax rates than stocks. Whether anyone likes it or not, interest on bonds and cash are taxed at much higher rates than dividends and capital gains on stocks. That differential may change with new tax laws, but even then, stocks are likely to be taxed at lower rates.

Most significantly, bonds and cash are more prone to suffer from the impacts of inflation. That may not seem as dangerous as a 50% stock market plunge, but 4.14% inflation over 10 years will do the same thing (and is much more likely to be a permanent 50% loss versus a temporary one for stocks). Does anyone really want to bet that inflation won't be above 4% over the next 10 years considering huge government debt and budget deficits?

Finally, bonds and cash can be defaulted on. This is probably the risk most people dismiss as too unlikely, but a low likelihood is not the same as no likelihood. Bonds are more likely to default than cash, and stocks are more likely to go to zero than bonds, but bonds are not without default risk. If you hold government bonds and think they can't default, a re-reading of the history of Germany, Argentina, Russia and the Confederate States of America is in order. Think cash is default free? Check again. History has many examples including Weimar Germany, France after the South Seas Bubble, or any other example of cash not backed by specie (not yet and never aren't the same thing).

Bonds and cash can be safer than stocks, but not always. Bonds are a promise to pay, but that promise can be broken. Cash is a note (debt) issued by the Federal Reserve as legal tender, and that promise too can be broken. Bonds and cash are much more impacted by inflation and have higher tax rates than stocks. They are not without risk.

I was reminded of this recently when I read that individual investors were generally selling stocks to buy bonds over the last year. They are rushing for a safe haven to avoid the pain of another downdraft. In the meantime, they have missed the market rally and are hoping to time the market. The history of individual investors, especially as a herd, being right on something like this is extremely poor.

The very fact that so many retail investors are racing to bonds together as a herd is enough to remind me of how badly bonds and cash can do. The next couple of years are likely to remind investors that not even bonds or cash are completely safe.

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.

Value investing principles

Value investing works.

Whether you look at academic research, or successful value investors like Warren Buffett, or examine it from a behavioral finance perspective, or just understand it intuitively, value investing is an investing discipline that beats all other methods (that I've examined).

The ideas behind value investing aren't very complicated, but can be difficult for people to grasp:
1) a business has a value that can be determined
2) part of that valuation is based on an unknown future, so you want to buy far below assessed value
3) buying below value--with a margin of safety--reduces the cost of errors due to a) judgment, and b) an unknowable future.

The concept, then, is to value a potential investment and then compare that value to the price one can buy it from the market--its stock price. If the price is significantly below value, you should buy it. If the price is equal to or above assessed value, you shouldn't buy it or you should sell it.

That's it in a nutshell, but it's more complicated to implement than that, and the main reason is psychology.

It's very difficult for people to buy something going down in price because 1) it's almost always cheap for a good reason, and 2) they think it will keep going down in price. Also, it's difficult to sell something that's gone up in value because people tend to think it will keep going up.

This psychology is the main reason, in my opinion, why most people either don't get or can't apply value investing principles.

Value investing also seems counter intuitive to a lot of people. They can't stand buying what isn't doing well, regardless of price to value. They want to buy what's hot, not what's not.

I've tried to explain value investing principles to many people over the years, and they either get it or they don't. If they get it, you can see it in their eyes. If they don't, they tend to say, "but...but...but...."

I say things like, "it's not an issue of whether a $150 sweater is better than a $50 sweater, it's an issue of whether you should buy a $150 sweater selling for $200 or a $50 sweater selling for $25."

People who get value investing quickly grasp that analogy. People who don't, don't. In fact, they tend to reply, "But...but...but...the $150 sweater is nicer." To which I reply, "For $200?"

The cold, hard fact is that people who pay $200 for $150 stocks get lousy returns, and people who buy $50 stocks for $25 build wealth over time.

The evidence supports that proposition quite convincingly.

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.

Measuring long term performance

One of the things that really hurts individual investors is not focusing on long term performance.

In repeated studies by Dalbar, they find that individual investors, on average, receive only about one quarter of the return generated by the average mutual fund. When funds are up 12%, they get 3% returns. When funds are up 8%, they get 2%.

One reason is bad advice. Not all planners and advisors are experts in their field. In fact, many have huge conflicts of interest in the advice they give (like a 5% commission on the gross value invested into a fund they "recommend" to you).

Another reason is fees. Investors are frequently unaware of the up front, on-going, and back end fees they are paying (especially in 401(k) plans). High fees eat into returns over time, sometimes dramatically.

A third reason is chasing performance. Investors, whether through bad advice or on their own, tend to sell what does poorly and buy what does well. The Dalbar study mentioned above showed that investors as a whole would actually do better if they stayed put. That may sound counter-intuitive, but it works.

One element that complicates this investment selection process is that most investors don't understand the numbers they're presented. Specifically, many investors focus too much on short term returns when they need to focus on much longer time periods. This is through little fault of their own; no one sits students down in high school or college and explains compounding interest and the noisiness of market data (why not!?).

Let me give an example of my performance over time to illustrate this point. For my growth investors I've beat the market (after fees) by approximately 1.7% annualized over the last 4 years and 8 months. But, that performance didn't come smoothly (just ask my clients). It came in fits and starts that would confuse anyone looking solely at short term returns.

For example, I beat the S&P 500 only 45% of the 56 months invested. How could I beat the market if it were only 45% of the time? Like I said, because performance comes in fits and starts. If I beat the market by a large amount 45% of the time and lose by a small amount 55% of the time, I can still beat the market.

I beat the market 51% of the quarters invested, 67% of the years, and 100% of the 3 year periods. Longer periods are more meaningful.

Does that mean 3 years is enough time to measure? No! Looking at my personal portfolio over the last 14 years (after deducting a simulated fee), my numbers are 53% of months, 53% of quarters, 65% of years, 69% of 3 year periods, 89% of 5 year periods, and 100% of 7 and 10 year periods. Once again, longer periods reveal more information.

Does that mean 7 years is enough? No! Even the best money managers under-perform over long periods. A lot of great managers have racked up poor results over the last 10 years even though they will probably do better than average going forward.

Measuring long term returns is only a part of the equation of selecting a money manager. Selecting someone because they out-performed one month, quarter, year or even 3 year period is foolish. There is too much noise in markets to use such short periods.

Consistently beating over 3 year periods is more meaningful than having beat over one 3 year period. 5 year records are more meaningful than 3 years, 7 over 5, and 10 over 7.

In addition to good long term records, investors have to find someone who has the right process and a disciplined manner of applying it. They need to understand what the manager is doing, in layman's terms, and believe in that methodology strongly enough to stay put when things look scary (and they will look scary at some point--just count on it!).

Most importantly, investors have to find someone they trust. A charlatan with the right process, discipline and convincing methodology will still rip you off.

Measuring long term performance is but one element in selecting an investment manager because investors must also judge the character of the person they are considering. I'm not saying it's easy, but it is important.

(for full disclosure on performance calculations mentioned, please see my website; please note that my website won't reflect year-end performance until 1/18/10)

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.

2009; 2010 to 2019

Lessons learned from 2009:

1) When the Fed pours $1.2 trillion and the U.S. government pours $787 billion of financial booze into the economy, you get one heck of a party.

2) When banks can borrow from the government at below 0.5% and lend at 4+%, they can experience HUGE loan losses and still make TONS of money.

3) When you combine 1) & 2) above, you get a HUGE rally in bonds, stocks and commodities, even without fixing the underlying problems that caused the economic mess in the first place.

Educated guesses of what may happen between 2010 and 2019:

1) Bonds will turn out to be much less safe than most people think.

2) Stocks and commodities will climb, then crash, then rally, then crash. Commodities will do better than stocks during most of the upcoming decade. When everyone thinks commodities are the only smart investment and stocks are for idiots--which will happen before 2019--a new secular bull market in stocks will be born.

3) China's experiment in command "capitalism" (not just a ridiculous oxymoron, but an invalid concept) will go form boom to bust, then from boom to wipe-out. Unless things change dramatically in China, it will end up looking like Japan over the last 20 years, but with civil war/revolution in the mix.

4) Gold will become a fad investment that will end in tears, but not until after dramatically out-performing stocks, bonds and other commodities for most of the decade.

5) The Middle East and South Central Asia will be a mess (that seems obvious...). At some point over the decade, oil prices will rocket because of conflict there, most likely due to problems with or in Iran. The influence of this part of the world will diminish toward the end of the decade as the issues of commodity scarcity fade into the background.

6) Japan will wallow in freakish misery for half the decade, then finally get to work solving its governmental debt problem and demographic issues (after multiple crises). It will lead the global bull market that starts in the second half of the decade.

7) Europe will continue to play fiddle as Rome burns. Western Europe will continue its decline as Eastern Europe continues its ascendancy, but both will become less important to the rest of the world (accept as a wonderful tourist destinations!).

8) The U.S. dollar will do much better than most think, then much worse, then much better. It will continue to climb because "everyone" thinks it must decline, then tank when markets fully grasp the U.S. debt (& obligation) to GDP ratio, then rally as policy changes finally emerge after multiple crises (like Japan, but over less time).

9) Canada, Norway and Australia will become more rich and powerful as commodities out-perform and each government remains more prudent than most.

10) Latin American and Africa will thrive during the early part of the commodities boom, but will succumb to the corruption that must result from a boom without the right political structure.

Happy New Year!

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.

Roaring into 2010

Merry Christmas Eve from cold and snowy Colorado. My gift to readers this year: short term optimism.

Optimism, you say, from me? Not possible! Yes, it's true. I'm optimistic about short term stock market returns.

How accurate is this short term prediction? Perhaps as good as flipping a penny, and worth about as much.

The reasons for my optimism?

1) The tsunami of government stimulus from all corners of the globe.

2) Extremely positive year over year comparisons with dreadful numbers from last year at this time.

3) Mutual fund investors are buying bond funds as if the sky is going to fall, and retail investors are almost never right

4) Most of the smartest investors I know are skeptical about the recovery, and almost always wrong in the short term.

Over the next 6 years, I expect 0-10% returns from the stock market. But, in the short run, I'm guessing we'll see much better than that.

Short term positive (next several months), intermediate term negative (6 months to 5 years), long term positive (5 years plus).

Have a very Merry Christmas!

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.

Sovereign subprime

In my opinion, the next default wave (other than commercial real estate, Alt-A residential, and option adjustable rate mortgage residential) will be public instead of private debt.

Greece is working hard to illustrate why I'm worried about this, as is Argentina, the Baltic states, Spain, Italy, Portugal...you get the picture.

But, it's not just smaller countries that are getting into the subprime spirit, it also includes (currently) prime credits like Japan, the United Kingdom, and (shock, horror!) the United States.

And, it's not just countries, it includes other public debtors like California, New York, Dubai World, Fannie Mae, etc.

How did this mess get so bad? The same way subprime borrowers and lenders got into trouble. Namely, public bodies are spending more than they are taking in, and lenders are doing a lousy job making sure borrowers can repay. This is not rocket science.

Whether it's California, the U.K., or Greece, the problem is incurring too many obligations while not taking in enough revenue to pay.

Japan is unique in that it's as much of a demographic time bomb as anything else. Their real estate, stock market and banks collapsed 20 years ago, but they decided not to face the music. Added to this, their population isn't having enough kids to replace the elderly, and they won't allow enough immigration to make up for that deficit. Finally, a big dash of inflexible labor markets and decreasing savings rates and you get a country most likely unable to pay its debts.

How do countries go into default? If they are small, they tend to get bailed out by bigger countries or the International Monetary Fund. Big countries, on the other hand, tend to inflate their way out of debt. The trouble there is that when lenders (bond buyers) realize inflation is the solution, interest rates take off. Not a pretty picture.

The financial crisis of the last two years has made this problem dramatically worse. Instead of letting bad borrowers and lenders face the music, governments of the world have bailed out uneconomic borrowers and uncritical lenders. We haven't eliminated the debt problem, we simply shifted it from private to public. But, the scale is so large, as are the promises governments have made to pay future benefits, that the end-game is much sooner than anyone thought.

When will these defaults come about? Probably not for several years in the case of prime credits, but much sooner for smaller sovereigns. This is likely to stir credit markets and cause a lot of volatility in commodities and stocks.

It used to be you could count on countries, or at least the right countries, to pay their debts. But now, it costs less money to insure against the default of IBM than it does the U.K. May you live in interesting times, indeed.

This is a good time to be very selective of investments (especially debt), to be prepared for very volatile markets, and to expect higher interest rates and inflation. It may take some time to arrive, but when it does, you won't want to own low interest debt or highly indebted companies.

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.

Got Growth?

The U.S. economy has really taken it on the chin over the last 2 years.

U.S. Gross Domestic Product shrunk the most since the Great Depression. Unemployment hit double digits for the first time since the 1970's. Our housing market dropped like a stone.

Added to this, the world economy turned down pretty much because of the economic collapse in the U.S. This makes sense when you think about it; the U.S. economy is larger than the next 3 largest economies combined. How could the world keep growing when it depends so much on U.S. consumers and capital markets?

At the height of the crisis, many Europeans seemed to bask in the glow of American failure. They seemed to wag their fingers at us and say, "I told you so!"

In some ways they were right, but not in the most important ways.

You see, the U.S. economy returned to growth last quarter, a whopping 3.5% annualized growth rate. This was far faster than anyone, including yours truly, predicted 9 - 12 months ago. And, economic growth in the current quarter looks good, too, projected at around 2.5%.

Amusingly to me, the European Union grew in the third quarter, too, but at only 0.4%. I'm not surprised we aren't hearing as much from European know-it-alls.

Why such a big difference in growth? I'm sure every economist and armchair economist has an opinion, and I do too: I think it's mostly due to our more flexible labor markets.

America has its share of problems, but we still have one of the most flexible and adaptive economies in the world. One reason for this is that U.S. companies are relatively free to hire and fire when compared to places like Europe or Japan.

This is not a one-sided benefit for employers, it benefits employees, too, who can quit and find better employment when they want. I think not being able to quit is as bad a sin as not being able to fire.

Contrary to popular belief, what will get U.S. and world economies growing again will not be stimulus, but adjustments of the economy to new economic realities. And, it's unlikely bureaucrats in any government position will be able to see this before businesses and entrepreneurs.

The places where labor and business flexibility are stifled, like Europe and Japan, will be mired in slow growth until they change. The economies that are flexible and adaptive, like the United States, will return to growth more quickly and will re-establish high growth rates.

That doesn't mean the U.S. will grow faster than Brazil, China, India, Korea or a host of other emerging markets, but compared to any developed market, I'll place my bets on the good ole U.S. of A.

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.

Dubai debacle

I don't know what surprised me more about the debacle in Dubai last week, the fact that such a big deal was made or that anyone was surprised it happened.

Dubai World, a Dubai government-backed development group, said they wanted a 6 month pause in paying back a $60 billion loan. This may seem like a lot of money to you and me, but its chump change in the big scheme of things.

The financial crises over the last 2 years tended to be focused on multiple trillions, not billions. Added to this, Dubai is the second largest of 7 United Arab Emirates (UAE), with Abu Dhabi being the largest. Abu Dhabi's sovereign wealth fund is over $300 billion in size, so bailing out little brother wouldn't cause it to even break a sweat.

So, what was the big deal that tanked global markets? It simply shows that the credit crisis is not truly over and everyone is still sitting on pins and needles, despite their protests that everything is A-okay.

Credit markets are not healed, and the tremendous bad debt burden has simply been shifted from the private sector to government. The market sold off, in my opinion, because many expect credit problems to happen in the fullness of time and they were worried this was the first of many tremors.

This raises my second point. Why was anyone surprised?

Dubai only gets 6% of their gross domestic product from the petrochemical business. It decided to borrow a ton of money to build islands (shaped like palm trees and the earth), the tallest building in the world, an indoor ski mountain in the desert (I wish I were making this up) and vast ports so that it could become the world's new Hong Kong. This was Field of Dreams writ large--build it and hope they will come.

Unfortunately, not enough people came.

What a startling surprise! Someone borrows to build a tremendous real estate project only to find there's no real end demand for it. Sound familiar?

What did surprise me is that anyone didn't expect this.

Just think what could happen if another entity, say commercial real estate in the U.S., has trouble rolling over debt and doesn't have a rich big brother to bail them out, or that rich big brother (Uncle Sam) is so saddled with debt he can't help without going into bankruptcy himself!

We saw what happened when a measly $60 billion defaulted for 6 months, what will happen if a bigger problem arises?

It is for this reason I'm de-risking my clients' and my portfolios. Things look calm on the surface, but underneath the earth is trembling. Taking risk now may work well for a short time, but not over the long run.

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.

Appearance versus substance

One of the most frustrating parts of being a professional investor is being pleased with how an investment company is doing only to see Wall Street sell it off time after time.

It's bad enough to invest other people's money into investment companies that do poorly, but when the one's that are doing well get crushed, it's hard not to heave a big sigh.

I was reminded of this ever-present need for patience watching a couple portfolio companies report earnings this week.

In both cases, I was pleasantly surprised to see things were going better than expected only to find Wall Street selling the companies down to the tune of 5% and 10% one-day losses. Why, oh why?

The answer may be frustrating, but it is simple. 1) Wall Street doesn't focus on the same metrics as rational owners. 2) Wall Street is focused on 6-9 month results because that's its average holding period.

Wall Street is enamored with certain metrics that business owners care much less about. In retail, it's same store sales. In computers, it's market share. In telecommunications, it's new customer additions.

I don't mean to imply that such metrics would be unimportant to rational owners, but they wouldn't necessarily be the all-consuming focus that it is to Wall Street.

What matters most to owners? Cash flow. How much money came in and how much money did was spend to get it. That's it.

Warren Buffett calls it owners earnings--the earnings an owner could use to build the business, buy back stock, pay off debt or pay a fat dividend.

An easy way to think about this number is to look at a company's cash flow statement: subtract maintenance capital expenditures (capex required to keep the same level of sales and profits) from cash flow from operations.

Perhaps a couple of other adjustments may be necessary, but in general that's it.

Both of my portfolio companies reported strong free cash flows.

A retailer reported 12 month free cash flows that are a mere 5.6x current price, or a free cash flow yield of 17.9%. It's price was down 5% that day.

A computer company reported quarterly free cash flows that are a mere 5.7x current price (minus cash on the balance sheet), or a 17.5% free cash flow yield. It's price was down 10%.

Owners of such companies would be salivating to have such returns in a lousy economic environment like this. But, Wall Street is not full of stock owners. It's full of renters.

Renters don't care what will happen over the long term (even 3-5 years, it seems). They are just in it for the quick "kill." Does anyone wash a rented car?

With a time horizon of 6-9 months, Wall Street doesn't care about free cash flow yields. All they want is to beat "estimates." Estimates of what? You may have guessed: market share, incremental revenues, same-store sales, new customer adds, average revenue per user, etc.

What matters to owners? Free cash flows to price. That's the bottom line.

I know I'm whining, but I also know that patience is well-rewarded in the end. Eventually, Wall Street does wake up to free cash flow yields. Eventually they notice how much value resides in businesses that throw off a lot of cash relative to price.

It takes a lot of patience to wait for that fish to come in. But, when it does, my whining sighs turn into war-whoops of triumph.

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 more attractive the package, the greater the chance of a scam

Ancient Egyptians were so fond of both pets and what specific animal breeds symbolized, they frequently mummified animals to be buried with them.

These mummifications were usually done with loving care because animals symbolized special earthly and other-worldly qualities in addition to an owner's personal feelings.

Unfortunately, like so many other things in life, some of these mummifications were not done honestly.

As a recent National Geographic article put it, "Despite the lofty purpose of the product, corruption crept into the assembly line." A researcher's x-rays "revealed a variety of ancient consumer rip-offs: cheaper animal substituted for a rarer, more expensive one; bones or feathers in place of a whole animal; beautiful wrappings around nothing but mud." In fact, a generalization emerged from this research, "The more attractive the package...the greater the chance of a scam."

That last sentence is worth it's weight in gold and worth repeating: the more attractive the package, the greater the chance of a scam.

I'm surprised how frequently I see this with investing or other parts of my life.

When I read an annual report that's super-glossy and makes it sound like the company and its management have never made a mistake in their life, there's almost always something wrong.

When a salesperson makes a pitch to me that sounds too good to be true, it almost always is.

When I read marketing material that highlights all the benefits but none of the risks, I start to become skeptical.

I was struck by the ancient Egyptian example, because it shows it's as old as man. If human beings exist, there's bound to be someone making the package look attractive and stuffing it with fluff.

Just because somethings looks and sounds good doesn't mean it is. It's easy to be taken in by flashy materials and a polished presentation, but that doesn't mean you have to buy into it.

Sometimes the right product or service doesn't look flashy and the presenter isn't terribly polished. One look at my website or one hearing of my "pitch" would convince you that I'm a heavily biased on this matter. I'll readily admit (or rationalize), flash and polish aren't my strong points.

But, I'm guessing that if the attractive package approach has been around for at least 5,000 years, it's probably not going to go away any time soon. The line to be ripped off will probably be around the block because it works as well today as it always has.

Or, perhaps I'm wrong, and people really do learn. That, too, is as old as man.

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 dash to trash

When the stock market climbs or falls, it's always interesting to see which segments are doing best or worst.

Not surprisingly, the stocks that have done best since the March bottom are some of the junkiest companies out there. This makes some sense because such companies were priced for bankruptcy last spring.

As early investors realized junky companies weren't going under, they jumped at the chance to bag 200%, 300% and higher returns.

The problem with staying with such an approach, now that the trash rally has had its day, is that it's hard to see how it can continue. Junky stocks have junky business models with weak competitive advantages, low margins, too much debt, etc. From here, there isn't a lot of upside, and the downside is becoming more perilous.

In contrast, the best-run companies have hardly participated in the rally since March. Granted, they didn't go down as far, but it's nonetheless surprising that investors haven't turned back to them now that the dash to trash has become stretched.

This is most likely due to the pervasive influence of momentum. Momentum investing is the process of buying what's moving. If it's climbing, buy it. If it's sinking, sell it or sell it short. This process can continue for quite some time...until it doesn't.

Predicting when is impossible, but predicting that it will end is a given. Or, as Herb Stein put it, "If something cannot go on forever, it will stop."

At some point in time, investors will realize that junky companies have problems and aren't delivering. That's when investors will fall over each other trying to buy franchise, high-quality businesses that make money regardless of how well or poorly the economy is doing.

It's no fun to be under-performing as the market makes a continued mad dash to trash. But, I'm not foolish enough to chase the heard, and I know it doesn't work over the long run anyway. Or, as our mothers rhetorically asked us, "if your friends jumped off a bridge, would you follow?"

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.

That sinking feeling

I wrote last week about central banks trying to figure out how to remove the "stimulus" they've injected to get economic growth going.

This week, the central banks of Australia and Norway started removing their stimulus by hiking interest rates.

Markets were not impressed.

Monday to Wednesday, the S&P 500 was down 3.4%. On Thursday, the market rallied 2.3% on a better than expected report of Gross Domestic Product (read here for my take on why GDP isn't the best measure of economic health), but then tanked on Friday (currently down 3.8% for the week).

This just goes to show that what the government can giveth, it can taketh away. Now that economic props are being removed, investors seem very worried about how well the economy can stand on its own.

This should not be a surprise.

And it seems like the worst is yet to come. If a Norway (population 5 million) and Australia (22 million) can tank markets, just think of what happens when Europe (500 million), the U.S. (310 million) and China (1.35 billion) raise rates. Ouch!

Don't get me wrong, I think central banks have to stop printing money or we'll have the much bigger problem of hyper-inflation. It's good that world governments are getting around to removing props.

But, you have to wonder about people that get overly excited about markets going up when it's clearly just due to government stimulus.

At some point in time, the props had to be removed. And, just like every other time in history, markets aren't happy when that happens.

Nor do I mean to indicate that markets can't keep going up. Governments can keep trying to prop things up. In fact, their props could lead to high inflation, in which case markets should be expected to go up (though perhaps not in real, inflation-adjusted terms).

This all comes back to the inflation/deflation concerns I've voiced in the past (here and here). If we get high inflation, you don't want to be sitting in cash. If we have deflation, you won't want to own commodities.

As the Chinese curse goes: may you live in interesting times. These are interesting times, and call for a sophisticated investment approach.

This is an amazing opportunity for investors.

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.

Exit strategy

It's no secret, the world economy was propped up last fall and winter by the governments of the United States, Europe and China. If it weren't for those props, we would probably still be on the way down.

The question now becomes, how will the governments of the world remove those props?

In ancient Rome, building an arch required props, too. Once construction was complete, the props were removed and the arch would stand firmly in place. It is rumored that the builder would stand underneath the arch as the props were removed to show how confident he was in his construction.

The reason why such a builder would confidently stand under his arch is that he knew the arch would hold when the props were removed. My question is: how confident is anyone that world economies will stand on their own without props?

I think current builders have demonstrated their confidence by both not removing the props and by only tentatively talking about their exit strategy, which is a euphemism for removing the props.

How can the central bankers of the world and various treasury departments know when to remove their props? This is a tricky question.

If they remove the props too early, the economy will go back into recession. If they wait too long, then high interest rates and high inflation may do the same thing. The governments of the world have a very difficult task ahead of them. I don't envy their position.

But, as an investor, I have to wonder what will happen.

Will the world economy stand on its own even though the fundamental underlying problems really haven't been addressed?

Are government bureaucrats aware that a huge number of mortgage loan resets are coming up and may send the housing and credit markets back into decline?

Have individuals and companies trimmed expenses enough to foster self-sustaining growth?

I don't have any answers to those questions, but I know I'm not going to be standing under this particular arch as the props are removed.

Instead, I'm repositioning my clients and my own money to prepare for the possibility of a wobbly arch. That means buying high quality companies and perhaps a little insurance against the downside. It means being prepared for the possibility of both deflation and inflation.

It will be interesting to see what happens, even more so a good distance away from the arch.

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.

(Innate) Talent is Overrated

I just finished reading a truly incredible book: Talent is Overrated by Geoff Colvin.

In it, Colvin highlights that world-class performance is not something you're born with, but the result of years of deliberate practice.

Academics have long studied what differentiates world-class performers from everyone else. They've looked at experience, inborn abilities, and intelligence and memory, among many other things. None of these sufficiently explain world-class performance.

What does? Deliberate practice.

After studying Berlin's best violinists in the early 1990's, and how they differ from good and mediocre violinists, researchers found that world-class performers had practiced much more, and much more intensely, than others. This research has since been confirmed in many other fields, including sports, chess, science, investing, business, music, fine art, etc. Deliberate practice is what made Jerry Rice, Mozart, Tiger Woods, Sir Isaac Newton, Yo Yo Ma, Benjamin Franklin, Warren Buffett and too many others to count great.

Let me be specific here. Deliberate practice isn't just practicing, but practicing in a very specific way. It's activity designed to improve performance (often with a teacher's help), it can be repeated a lot, feedback on results is continuously available, it's highly demanding mentally, and it isn't much fun.

Deliberate practice requires that you identify specific elements of performance that need to be improved and then work intently on them. That's not just going through the motions. That's figuring out exactly what's necessary to be good and then working hard on those areas. It's working at the edge of one's ability. Think of a violinist practicing a very complex passage of an exceedingly difficult work over and over again until they get it right. Think of them analyzing the way they play and what they must change to get better.

It must be repeated--a lot. Deliberate practice must be done for 4-5 hours a day for around 10 years, or around 10,000 hours, to reach true excellence. It's not enough to practice every now and again, but to practice at high intensity over many, many years. Imagine a violin player practicing 4-5 hours a day for 10 years, and that such repetition makes them better than someone who practices 2 hours a day for 5 years.

Feedback on results has to be continuously available. It's not enough just to practice, but to get objective feedback on your performance. This can come from a teacher or other expert. Or, it can come from simply analyzing your performance over and over again. Think of a violinist getting feedback from an experienced teacher, or recording their practice and listening to it over and over again to master a passage.

It's highly demanding mentally. The intensity of the practice is such that world-class performers break their 4-5 hours a day into 1 to 1 1/2 hour blocks. It frequently takes years to even work up to the point where 4-5 hours a day can be accomplished. Think of a violinist practicing 3 or more times a day to the point of utter exhaustion, and then doing that 5 days a week for years.

It isn't much fun. If my description so far hasn't convinced you, then perhaps the research will. The best violinists, as a group, consistently reported that deliberate practice "is not inherently enjoyable." It requires a lot of effort and self-discipline to practice at this level for years.

I found this research confirmed my own experience with investing. I started teaching myself investing around 14 years ago. Initially, it was a hobby, but within one year I was spending 20 hours a week analyzing investments, expanding my knowledge, learning from the masters, and analyzing my results.

I quickly learned I needed to know a lot more about accounting, valuing companies, analyzing industries and management, etc. I spend several hours a day analyzing new companies. It's especially easy to get feedback with investing because you can readily calculate your performance relative to the market and other investors. Researching particular companies is very demanding mentally and, although I find the work very rewarding and fulfilling, I don't necessarily find the process of intense investment analysis fun. As I like to tell my wife, it's not like drinking a beer and watching a sunset.

Talent is Overrated is a great read. It's almost a guidebook on how to achieve excellence in a chosen field. I would highly recommend it to anyone interested in achieving world-class performance or helping someone else get there.

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.

Interesting indicators

I don't put a lot of faith into watching economic indicators. They seem to tell you more what has happened than what's going to happen.

On the other hand, I do watch a couple specific industry indicators that do, in general, give me a flavor of what may be going on economically.

For instance, the price of copper is an interesting indication of worldwide demand for basic materials. Copper goes into so many things that watching copper prices gives me an interesting view into overall economic growth. Copper prices peaked in late August and have been holding relatively steady below that peak.

I also watch the price of oil and natural gas. Oil and gas are also fundamental inputs to many types of production, so watching their prices is also informative. Oil prices, which reflect global demand, peaked in early August and have been trending down. In contrast, U.S. natural gas prices, which reflect local demand, bottomed in late August and have been trending up.

The Baltic dry index, which reflects worldwide dry bulk shipping rates, bottomed in late September and have since climbed over 20%. This indicator lets me know how much shippers are charging to move large amount of dry bulk materials, like wheat or iron ore. When shippers are charging higher rates, worldwide demand is up.

Each week, the Association of American Railroads reports rail traffic for the U.S. and Canada. This indicator shows how many rail cars of containers, coal, bulk materials, etc. are moving around North America each week. This indicator recently peaked in early September and has been trending down over the last 4 weeks.

Add it all up, and what do you get? A mixed picture.

Copper prices are down only slightly. That could be due to higher copper production, lower demand, or some combination. It's not a very bullish sign.

Oil prices are down, too, and this reflects global demand for a fundamental input to everything. This is also a bearish sign.

Natural gas is climbing again, which seems to be bullish for U.S. demand, but it could also reflect the huge slowdown in natural gas production that has occurred over the last year.

The Baltic dry index is up, which seems bullish for global demand. It could also reflect that global shippers are on the ropes with high debt loads.

Railroad traffic is down in the U.S., which seems a bit bearish, but seasonal factors may be impacting the numbers and traffic isn't down by a large amount.

Do you see why watching economic indicators can be problematic. There are no obvious blinking lights and ringing bells. That's part of the reason why economic forecasters and market strategists have such a lousy record of predicting even the direction, much less the magnitude, of markets.

One of my favorite jokes is that market strategists (who forecast market direction) are like diapers; they need frequent changing and for the same reason.

It looks like global demand may be doing better than U.S. demand. But, then again, maybe not.

That's why the smartest thing to do is buy great companies at good prices or good companies at great prices and just ride the market up and down. It works.

Market and economic forecasting? Not so much.

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.

Quality will rule

Now that financial Armageddon seems to have been avoided and the stock market is up over 55%, a lot of investors are wondering where to invest next. My answer: quality.

Quality is always a good place to invest, but it may be particularly important going forward. There are a couple of reasons I think this.

One is that quality companies have mostly been left behind in the rally since March. They haven't completely been left behind, mind you, but they aren't up 55% like the rest of the market. They're not up as much because...they were never down as much.

The companies that tanked most from September 2008 to March 2009 were those many thought faced significant bankruptcy risk. When investors realized they wouldn't go bankrupt (at least, not yet), their prices took off. In some cases, those companies doubled and tripled in price!

Looking forward, such low-quality companies are unlikely to continue out-performing. Significant economic and financial risks still exist, and such companies weren't exactly healthy to begin with. That's not the strongest vote of confidence for future returns.

The second reason I think quality companies will out-perform is because they hold all the cards. They weren't overly indebted to begin with, they had strong market share and superior products, they tend to have excellent growth opportunities due to international markets, they have the financial resources that allows for growth, and they have the management talent to execute.

Add those positives to prices that haven't really taken off, and you have an ideal situation. When you combine a quality company's excellent prospects with low historical prices relative to fundamentals, you have a recipe for excellent returns.

As Warren Buffett once said, "If a business does well, the stock eventually follows." I can't make any promises about when the quality stocks will follow fundamentals, but I'm very confident it will take place within a 3 - 5 year time horizon.

For those of you interested, I recently reworked my website. I tried to make it more straightforward and my value proposition clearer. Please visit and tell me what you think. I also added my business, Athena Capital, to facebook. Become a fan if you're so inclined.

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.