From Whence We Came Part II

"I don't have to tell you things are bad. Everybody knows things are bad. It's a depression. Everybody's . . . scared of losing their job. The dollar buys a nickel's work, banks are going bust, . . . and there's nobody anywhere who seems to know what to do, and there's no end to it."


Any guesses as to where the quote above is from? Perhaps an Op-Ed piece in the New York Times last week? Maybe some talking head on This Week's roundtable discussion last Sunday? A recent speech by some politician criticizing the manner in which the financial crisis has been handled?

Nope. None of the above. This is from an on-air monologue/rant delivered by the newscaster Howard Beale in the acclaimed 1976 movie Network (a fine flick if you have not already seen it). One of the reasons why the movie won four Oscars, including best screenplay, is that it adroitly captured the Zeitgeist of the mid-70's in the US. I am old enough to remember the era (although I was admittedly more concerned with cartoons, baseball cards and comic books than unemployment, inflation and poor stock market returns). Times were tough. Jobs were hard to come by. People worried about the future. What little extra money that did come into a household was oftentimes saved for an even rainier day.

Why dredge up a quote from a movie that is over thirty years old? To highlight the fact that up until about twenty years ago it was taken as a fact, albeit a sad one, that economies regularly experience busts. Accordingly, people acted a lot more responsibly, more cautiously, when it came to matters of personal finance. Debt was taken on only when necessary, and was paid off promptly. There was more fear about insolvency and potential unemployment, and less greed. Stocks were viewed as assets whose value could just as easily decline substantially as they could rise to the sky.

But something began to change, at first subtly and almost imperceptibly. I put the genesis of this around 1988. By then the economy had grown without interruption for six straight years. Perhaps even more importantly, the stock market had gone up dramatically since bottoming out in 1981. And despite "crashing" in October of 1987, it had already scaled new highs just months later. Indeed, people who panicked and sold were about 25-35% poorer than those who kept their heads and stuck it out. By this time communism had also been handily defeated. America was now the world hegemonic power, both militarily and, to a large degree, economically.

The movie Wall Street had also been released the previous year. The angst and despair of Howard Beale was replaced by the uber-confident and audacious Gordon Gekko. Fear? Doubt? Caution? No, no, no. Conquest, acquisition, and, above all, greed. Mr. Gekko, with all of his consumate charm and demure nature, made the case that "greed is good." This began to resonate with the masses, and became a new sign of the times.

For the next 20 years people were actually rewarded for "bad" behavior in the economy. Debt was not even called debt. It was "leverage." And the prevailing wisdom was that assets (which were taken for granted would appreciate) must be leveraged for maximum return. I mean even a society like ours in which 8th grade math skills are the norm could figure out the arithmetic. $1000 invested in an asset that increases 10% yields a $100 return after one year. The same asset using one's own $1000 plus $1000 of borrowed money yields $200. And with $9000 borrowed, the original $1000 of your own would fetch $1000 profit (minus interest on the borrowed money).

With banks and all forms of financial institutions being deregulated (see "From Whence We Came Part I below), and interests rates falling throughout this time, borrowing money was never easier, or cheaper. Remarkably, there were virtually no consequences for "bad" behavior on the part of corporations or individuals. The nervous Nellies, their portfolios comprising 60% bonds and living in apartments until they could scrape together a 20% down payment for a home, were left in the financial dust by those who bought their stocks on margin and their houses with little to nothing down.

Oh sure, there were minor hiccups along the way. Some regions experienced short-lived slumps, and there were two very shallow recessions in 92 and 2001. But even the tech crash of 2000 did not cause much of a stir; for most Americans, whatever losses they suffered in the stock market were more than offset by gains in the home prices.

And for this 20 year neo-gilded age, one man towered above all others in esteem and respect: Alan Greenspan, or the "Maestro" as Bob Woodward prefers to call him. Whenever the economy began to hit sour notes, the Maestro was there, baton in hand, to get it in tune once again. Shrewd and smart people on both Wall Street and Main Street began to take their cues from the respected economist turned central banker. He believed in confidence above all else. And he never met a bubble he did not love. People realized that here was the most powerful man in the world (really) prepared to do their bidding to keep the economy zooming along.

Hence the term "Greenspan put" entered the financial lexicon. A put is a particular type of option that pays off only if an asset goes down in value. The concept was that should any significant asset in the economy (homes and stocks being the two most important) go down in value, Greenspan would be there lowering interest rates to whatever level necessary to stimulate borrowing and spending enough to get the economy growing again. Hence asset prices would return to their previous levels and keep going higher. That was the theory at least.

In this environment, fear was seen less frequently than investment bankers dining at McDonald's. Money had never been easier to make. With interest rates cut to levels below inflation for a good portion of the new millennium, leverage increased to levels heretofore never seen. Greed was ever more pervasive.

Bob Woodward's moniker for Mr. Greenspan was indeed apropos, but for a reason not contemplated by the revered journalist/author. In reality, the Maestro was conducting a national symphony serving as the source of a grand game of financial musical chairs. As long as Greenspan could his orchestra playing ad infinitum, the party would continue.

But alas, just as no musician can play without rest, and no reveler can imbibe forever, neither can any economy pile on ever mounting debt without it eventually choking. And that, dear reader, is where we find ourselves presently.

And it will have to be next time (sorry Matt), that I take up the savings paradox. Simply put, it is the fact that when individuals do the right thing in a bad economy (save more, spend less), it actually further weakens the economy, and thus all the individuals who are acting in their own best interests.

My So-Called Life (as a Contrarian)

Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference

Robert Frost


Life is hard enough. But some of us seem to magnify its difficulty in a variety of ways. Me? I have held views about the markets and the economy that were/are not only in the minority, they were/are deeply unpopular. Being a contrarian inherently means that a (usually vast) majority of other people think you are stupid. As if that were not bad enough, when you are a contrarian during good economic times (and particularly economic bubbles), people can actually be hostile to the content of what one has to say.

Accordingly, I am used to being a social pariah by now. During the late 90's through the turn of the millennium I would attend a variety of casual parties and social events. While most people would prattle on excitedly about XYZ.com and the dramatic gains they were realizing, I would be the dour-faced attendee warning people of a crash that was quite likely in the offing.

Flash forward five years. The same cocktail parties and the like. Now it is ebullient discourse concerning the real estate market. Oh, the glory of zero-down payments, retirement homes, vacation properties, remodeling, buying up, flipping, etc. It was all so intoxicating. Money had never been so easy to make (and the quantity of cash-out home-equity loans evidenced that). But morose Mark was there trying to take away the punch bowl, worrying about such inconvenient things as household indebtedness, variable-rate mortgages readjusting at higher levels, unsustainable price gains, and overinvestment in residential housing. It was the social kiss of death. Indeed, one woman stopped seeing me after we had a tiff over whether her planned condo purchase would be a good investment.

But this social phenomenon actually speaks to a very important investment principle - one must not let emotion cloud analysis and judgment when it comes to investing. I think it is a basic tendency in most human beings to be generally optimistic. I actually view myself to be of this ilk. Accordingly, when presented with the same bullish drivel that has been rife in the financial and popular media for roughly the last 20 years, or analysis that warns of bad economic tidings, it is more comfortable to focus on the former and write off the latter.

Great investors simply perform risk/reward analysis. It is very similar to seeing somebody with an umbrella under there arm on a cloudy, yet presently dry, day in Seattle. It is safe to say that the typical person in that situation is not hoping it will rain. Rather, it is more likely that the person checked the forecast and discovered that rain was likely.

Similarly, I cannot imagine any investor that actually hopes for an economic crisis such as one we find ourselves in today. After all, it is far easier to make money when asset prices are increasing. However, if rigorous analysis indicates such a crisis is coming, it is simple prudence to manage one's portfolio in a manner so as to profit from such an event (or at least lose as little money as possible).

I bring all of this up because I remain convinced that the only was an investor is able to achieve exceptional returns is by being a contrarian during times of extreme optimism or pessimism. Indeed, I look forward to the day when not only is there caution in the marketplace, but something more akin to revulsion (a point I do not believe we have yet reached). From a long-term investing perspective, that will be a great time to be a bull.