The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

14 May 2006

Standing perpendicular to the world

I participate in a private email circular, which activity helps me to hone my mind and perceptions. Recently, another participant responded to one of my posts to the email group, as follows...
"I foolishly traded out of gold stocks back around when NEM dropped back to 39 IIRC and now find myself in the all-too-familiar territory of regret AND fearing to chase a move that already has gotten away from me. (To my credit I took a pretty substantial position in silver play PAAS when it was in the 8s and it now approaches a triple.) Yet the recent threads similar to this one of yours have me thinking I need to "do something" more in this vein. I know you often post pieces because you find them interesting even though you personally have a different perspective. Would you be so kind as explicitly summarize your thoughts for the mid to long term? For me, although I continue to dabble in the market, I am more interested in my work than the market and therefore find myself thinking more in terms of sound portfolio diversification to protect myself from adverse trends and perhaps benefit from them. I already do have solid sized positions in XOM, SUN, BR, BP and some others of that ilk. I have a fairly substantial position in cash and near cash at the moment-- and have been so for long enough for this money to have missed a goodly amount of movement up."
To which I replied...
I think you needlessly confuse yourself; in fact, I believe most investors needlessly confuse themselves. Investing is easy; consistently successful investing is simple. We each choose to confound ourselves in the quest to make the simplex and the elegant into the complex.

You yourself state your interest is more in your work than the market, so why do you fret over every squiggle in the market? Define the time frame that is important to you — i.e., how much time you can look away to meanwhile pursue other goals — and then remain true to that understanding, to yourself. For example, because I am a swing trader who hopes to catch the bulk of each primary movement, my time frame is ~6 months; in thi role, I note certain patterns that fit within that time frame, and pay heed. Oh, and make money.

None of the preceding answers your direct question, of course. So let me state the following: everything — allow me to repeat that, EVERYTHING — hinges on the course of the US$. I think Stephen Roach [to be] something of a simpleton for believing a declining value of the US$ is not merely helpful but would cure all that ails the global economy. I understand his thesis re global imbalances but I disagree that a notional decline in the value of one currency (US$), key currency though it is, will change those imbalances except on global (not corporate) income statements and balance sheets.

I have been alone (here, at least) for a long time fretting over the course of the US$; long time readers here know that. I also have been alone fretting over a possible implosion of the obvious credit bubble. And for those readers who believe real estate is not a bubble — and whether or not it is one, it is dwarfed by the credit bubble — any one of many pins that might prick the credit bubble will rapidly deflate the real estate bubble, despite the bulls' shopworn cries of "Location, location, location!" A credit implosion, itself brought on by a collapsing value of the US$, would wreak havoc with our economy and the global economy. Enough said re this tired topic.

Re precious metals, and your feeling bereft because of bad timing… I would suggest you stop perceiving investing as a zero sum game — "If that declines in price/value, then this will increase in price/value, and I want to be aboard the latter" — and instead perceive your investments something like I do. I want to make more money than I lose with the declining value of the home currency; i.e., on an absolute and relative basis. To create a hypothetical example: if the home currency declines by 50%, then I must not only generate a positive absolute return but I must earn 100% on a comparative basis to retain PPP (purchasing power parity). It matters not at all to me what instrument garners the return; only that I generate the return. For those here who travel abroad often, they will understand immediately the urgency of this task. You are one of those people.

One more item: stop thinking this thought process: "I own it, so of course it will decline at some point. Oops, here is the decline now, SELL!" and "I am NOT long, and the stock is running away without me aboard — it will never again return to a comfortable place to buy." IOW, reconcile these two notions that cannot co-exist in our reality. Either stock prices oscillate. Or they do not.

And a final item: I am as dumb as they come. Knowing the limit of my bounded intelligence, my goal is only to make money, not be right. Once relieved of the emotional burden of having to prove myself right even when wrong, I was freed to make money. All the time, and under all market conditions.

My reply caused a 'conversation' to ensue between Scott Grannis (Chief Economist at Western Asset Management) and me. To wit...

Scott Grannis:
David, there is an inherent conflict in your concerns. Yes, the dollar is falling, and could fall more. Yes, there is a lot of credit out there. But a declining dollar will only add to the inflation pressures that are already significant, and rising inflation is a debtor's best friend! If you were certain that the dollar would decline significantly over the next 5 years, then my strongest recommendation would be to borrow as much money as you possibly can today. By the same logic, the "inflated" prices of US real estate will not seem so inflated in 5 years if all other prices rise by a considerable amount.

David Gordon:
Thank you for chiming in with your comments, Scott. As you know, I respect your insights.

I recognize the truth of what you say, especially in light of historical precedent (specifically, the 1970s). Back then, the quip quickly became, “It is not what you own, but how much you owe” that was the true measure of wealth. And that quip came about solely because of the truth of what you say: inflation debases the debt at the same time it erodes the value of the underlying asset. There comes a moment when one’s ability to repay the loan principal is of equal importance to his or her ability to service the debt on that loan. Consider the sub-prime loan market, in which loans are made to bad credit risks who lack the financial capacity to repay the principal, leave alone continue to service it (make regular interest payments). Many private RE loans today are 100% financing; no money down! For the right person, there is nothing inherently wrong with these loans. Unfortunately, they are made available to all. I understand that no bank in its ‘right mind’ shelves loans any longer; each instead seeks the fee income for the loan origination. Then the loans are packaged, and passed off to Wall Street’s clients. I see two primary risks for those investors...
1) Desirous of monthly income the loans instead are quickly re-paid causing the investor to scramble in his search for yield (especially in a declining interest rate environment).
2) Who seek the return of the principal and the borrower instead defaults.
When these birds come home to roost, who will be left holding this particular bag of tricks? Most investors, especially the retail investors, do not understand the potential for true calamity. Wall Street, and the mechanism of the markets, is a transferor of risk, not a guarantor.

On an economic and financial basis, the world today is more inter-connected (is that an oxymoron?) than ever before. Certainly, more so than the 1970s. (Perhaps only the 19-teens in recent memory represent a close parallel. I think we all recall the fallout then.) I liken it all to our (humanity’s) vainglorious attempt to (re-)build the Tower of Babel. The story always remains the same; only the facts change. A US$ that declines below a certain threshold — it need not precipitously collapse nor crash — could usher in certain changes in the global scoreboard. Stephen Roach and I agree on one item: the US is the engine of the world economy. We consume so much that if our consumption were to stop suddenly, the global economy would grind loudly, if not fall off its treadmill. We (Roach and I) part company when he states his belief that a declining US$ corrects the imbalances he sees: we must produce and sell more and consume less, whereas other nations must in turn produce less and consume more. (This is a horrid over-simplification of his belief.) And the world would be set to rights.

But rarely, if ever, does it work out that way. Although I disagree with several of its tenets, the HARPERS article shared last week is a helpful primer, especially with regard to the global recycling of the US$. I believe, as it indicates, that a declining US$ would slow, possibly even halt, inflows into the US; that rate of change alone would change global financial and economic dynamics. In fact, it might usher in outflows of capital. Which in turn could exacerbate a bad situation. The potential for disaster — if not, at minimum, calamity — is present. Whether it occurs is a different story altogether. The world typically muddles through each crisis, although many people are crushed by the Caterpillar tractor of history.

Because the world is predicated on the US$, its stability — nay, its strength — should be viewed as sacrosanct (the history has been anything but). And because the US represents the global consumer of first and last resort, negative changes here — a repatriation of foreign assets to other shores, etc — would have a ripple effect elsewhere, yes, but felt first here. The virtuous circle of the global recycling of $$ quickly becomes a vicious cycle; ever lower. The specific pin that pricks the credit bubble need not be a declining value of the US$ (heck, it could hold once again at this 85-80 level). It could be anything: a loss of confidence in the US, etc. There are many problems and potential fallout a collapse of credit and the decline of the US$ would bring about. Our nation has a history of debasing the value of its currency; embarrassingly so. At some point, the world will recoil; it always has. And then we no longer will be able to, in the words of Michael Haseltine, “Punch above our weight class.”

There are so many problems out there that afflict us: the dumbing down of our society, the hollowing out of our manufacturing base, etc (I just deleted an entire listing of concerns as OT) that this problem only weighs as one of many. In the end, a loss of confidence in the US$ would have negative repercussions for all. Thanks to seignorage and the primacy of the US$ -- at least as it exists for the nonce -- we would not immediately feel the impact, as you note. Inflation would play its part, and we would continue on our merry way. (Insert here Dorothy Parker’s quip.) Hell, for all I know, that is what we do now. That, in fact, we are on the downside of our hegemony.

For Joe and Jane Six-pack, they would feel it initially in their role as traveler. And they feel it now at the gas pump, as rising prices there take another nibble from their hide. Soon, they will notice that foreign goods purchased here will be more expensive, too expensive, to continue to purchase. So they will decide to purchase American. Only to discover that we don’t make anything here any longer. They discover their money buys less and less and less. So they must sell assets to pay current bills. It is then that those “For Sale” signs resemble surrender flags. “I give up!,” they seemingly cry.

I did not intend to wander into the land of potentiality, as I obviously have. I prefer to invest with what is; the reality of the marketplace: thousands of decisions made by thousands of investors, each smarter than me. And, in aggregate, way smarter than l’il old me. I did intend to indicate, however, that the financial climate today is an outgrowth of the 1970s, thanks in large part to people like Walter Wriston. Too, that a declining US$ would have a deleterious effect for everyone. And that the game of relative values (‘The discounted present value of future inflation,’ etc) is only that, a game. That the phrase “full faith and credit” once meant and stood for something; and it still should.

Increasingly, I grow horrified to learn that most people lack the financial wherewithal to live in a changed -- nay, changing -- financial world. Perhaps that means less income; perhaps it means the same level of income but that it purchases less. You and I, Scott — and probably everyone here — have the means and resources to ‘continue’ should a global financial and/or economic calamity strike. Most people, I daresay, do not. I am frightened for them. As such, I hope none of the dire forecasts come true.

But certainly, global markets make their bets. Every day. We, you and I, can see that. We might not agree as to the outcome, we might not even agree as to the potential, but we likely agree that the markets are priced for perfection while under the surface, the waters boil.

I think I will continue as I have; to live within my means. Who needs grief?
In all the years I have read Scott’s commentaries, I rarely, if ever, have known him to be as direct, straight-forward, and cogent, as he is in the message below. There is a lot packed into each sentence and paragraph. Please pay heed to Scott's next reply... Of course, you could continue your quest to find ‘answers’ elsewhere, but Scott’s message below is as clear as they come.

Scott Grannis:
The dollar is clearly under siege. On the one hand the Bernanke Fed has decided to announce that it is considering a "pause" in its tightening campaign, at a time when sensitive prices are signaling that the market desperately wants more. On the other hand the Bush administration is completely disregarding all common sense and appears eager to embrace a weaker dollar vis a vis all Asian currencies (which would be the likely result of any significant revaluation of the yuan).

In this context, it is not surprising to see precious metals soaring and the yield curve steepening and breakeven spreads on TIPS widening and equity prices declining. Most amazing, from my perspective, is that bond market is still in deep denial of the inflation risks that are surfacing in every direction. All are part of the same story. Not good, not good at all. The parallels to the 1970s are growing stronger with every passing week. Complacency is rampant, as reflected in a relatively low VIX and a very low MOVE index (implied volatility in bond options).

This all adds up to a reason to be worried, since the current state of affairs is not something that can persist for very long. Something has to happen, and it could be any of a number of things. But unless some major change in Bernanke's mindset occurs, the result of all this in the end will be higher inflation and higher interest rates. Buckle up, its going to be a wild ride.

I've been searching for ways to hedge equity exposure, and so far the best thing I've come up with is to short long-dated eurodollar futures contracts (1, 2, and 3 years out). Rising inflation will eventually get the Fed's attention, and the result would be substantially higher short-term interest rates, thus giving this position a nice profit. If I'm wrong, then not much happens to short-term interest rates, which is what the bond market in all its wisdom is currently projecting.
And how about that "standing perpendicular..."? The ultimate in stability is to remain in one place for a specific measure of time, while the ultimate in change is to travel a specific measure of space while remaining still in time. Investing confounds this understanding because investing conflates the two: price trends transcend the dimensions of space and time while remaining circumscribed by them. As long as the world is a flux system, I prefer to remain mutable.
by Percy Bysshe Shelley
We are as clouds that veil the midnight moon;
How restlessly they speed, and gleam, and quiver,
Streaking the darkness radiantly! -yet soon
Night closes round, and they are lost for ever:

Or like forgotten lyres, whose dissonant strings
Give various response to each varying blast,
To whose frail frame no second motion brings
One mood or modulation like the last.

We rest. -A dream has power to poison sleep;
We rise. -One wandering thought pollutes the day;
We feel, conceive or reason, laugh or weep;
Embrace fond woe, or cast our cares away:

It is the same! -For, be it joy or sorrow,
The path of its departure still is free:
Man's yesterday may ne'er be like his morrow;
Nought may endure but Mutablilty.

-- David M Gordon / The Deipnosophist

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