Save (for) Yourself, Save the World

’Tis true that we are in great danger;
The greater therefore should our courage be.

Shakespeare, Henry V


I hope everyone had a great Valentine’s Day weekend. And what connotes love better than a meandering missive on personal finance, the economy and government policies? In an effort to spread the love, I am going to try an experiment with my blog. I know there are those who may not be enthralled with following my various diatribes about flawed fiscal plans, corporate greed, housing busts, misguided monetary policies, etc., and are simply looking for some practical advice. Alternatively, there are those that may already be well-versed in the basic elements of sound financial planning and even portfolio management. These people may only be interested in economic analysis and disquisitive ranting. So for a while I will try to cast a wider net – the first part of my blog will be dedicated to some (hopefully) practical household finance issues, while the latter section will be focused upon broader policy/investment issues. Hopefully, everyone will be able to find something of use or interest.

Our new president is also trying to spread the love, $787 billion worth of love to be precise. Upon signing the massive stimulus package into law today, President Obama said the occasion marked “the beginning of the end” to our nation’s economic troubles.

I really like President Obama. He is smart, earnest and hard-working. In many ways Obama represents the very best of our nation, and the principles upon which our country was built. He inspires hope and admiration. I would happily have him as a two-on-two basketball teammate (although I think I might choose a different bowling partner). Moreover, outside of Rain and Stephen Colbert, I can think of few more fearsome competitors in a dance-off. And while my political views may be to the right of his in several areas, unlike some conservative buffoons, I genuinely wish him great success.

Having said that, Obama may as well have been posing in front of the Hoover dam with his finger shoved in a noticeably growing crack while making that statement. Similarly apropos, he could have filed a five-story office building with hundred dollar bills and blown it up. Clearly Wall Street was unimpressed with the fact the Stimulus Plan is now law; the stock markets were savaged to the tune of 4% today.

Obama’s bold proclamation is not nearly as much of a blunder as the infamous “Mission Accomplished” banner above Bush’s head aboard the USS Abraham Lincoln. But it is certainly in the same vein. By raising the prospects that our economic woes may soon be a thing of the past, President Obama risks over-promising and under-delivering.

Rather than seeing this as the beginning of the end, I would argue that we may just now be seeing the end of the beginning. To me, there will be middle and end phases to our economic troubles yet to come. But more about this below.


Of Dead Car Batteries and Moribund Economies

Not long ago I was ready to leave the house to meet some friends for lunch. Upon trying to start my car though, I discovered the engine would not turn over. Marshalling every iota of my meager automotive skills, I attempted to jump the battery. Much to my chagrin, the battery would not even hold a charge.

After postponing what was sure to be a tasty Malaysian meal with excellent company, I called AAA (thanks to my better half’s preparedness/membership). Shortly thereafter a familiar looking gentleman arrived at our house prepared to assist.

“Nice to see you again!” exclaimed a gregarious man with a noticeable Ethiopian accent.

It then occurred to me that he had helped my wife and me before when her car would not start while we were downtown. He proceeded to attach cables to the battery and had me start up the car so it could idle for several minutes.

“How is business for you?” He apparently recalled my occupation as an investor.

“Oh, great! Thanks for asking.”

“Can I ask you a question?”

“Of course.”

“I came to this country years ago with my wife. We worked very hard. Eventually I bought this truck and started a business. We now have a house and children.”

“Congratulations! You have a great deal about which to be proud.”

“Thank you. I look around today and talk to people, and there is nothing but gloom. Nobody wants to start any business. People do not want to spend money. But by refusing to spend money or take risks, does that not just make everything worse?”

“Hmmmm. You are correct in that as people spend less that causes the economy to contract even more. And it is true that jobs are not created if people are not starting businesses.”

“Exactly! And with interest rates so low, does it not make sense to borrow money to do something?”

“Like what?”

“We were thinking about buying another house, or maybe starting another business.”

“Well, I tell people the first goal of investing is not to make money, it is to avoid losing money. The danger is that the economy will worsen, and you will not only lose your own money, but also the money you borrowed, while still owing interest on the loan.”

“But did you not say that the economy is deteriorating because people have these very fears? Isn’t it just these negative attitudes that make the economy worse? Is it not hope and positive thinking that will make things better?”

By this time, we were ready to see if the battery could maintain a charge on its own, and I was pondering the very good questions and observations posed to me. Upon removing the jumper cables and checking the battery with a variety of probes, my new friend said the battery needed to be replaced. While he sprung into action, two points sprung to my mind. But I only felt comfortable sharing one of them.

“What you describe is akin to something known as ‘prisoner’s dilemma’ in the social sciences?”

“Prisoner’s dilemma?”

“Imagine a band of ten criminals in cahoots with one another are all rounded up. The police know, but cannot prove, they are responsible for a serious armed robbery in which several people were assaulted. However, they were all caught having broken into a warehouse. Let us say that should they all be convicted of burglarizing the warehouse, they would each receive a three-year sentence. However, if they were convicted of armed robbery and assault, they would each receive ten-year sentences. The police decide to separate and interrogate all of them. Each is made an offer: Rat out your crew and you will be given immunity from prosecution as well as witness protection.

“Interesting. So what happens?”

“Well based upon social science modeling and experiments, most people would choose to ‘defect,’ or rat out the gang. This, despite the fact that in that scenario, the group as a whole is worse off, serving a total of ninety-years in prison. If everybody stayed quiet, the group as a whole would be three times better off, serving only thirty-years of collective time.

“So let us apply that to the economy. It is true that in the short-term, everyone would be better off if we all began borrowing money and spending once again, as this would certainly stimulate the economy. But the individual will likely be better off saving money and avoiding debt during bad times. So it is safe to assume that households will do what is in their own best interests, even if they know that their actions, if imitated throughout the economy, will cause further economic deterioration. Should you borrow and spend in an effort to do your part to turn things around, you risk financially over-extending yourself at precisely the time when things will probably get worse.”

By this time a new battery was installed and it was time to test it. My engine turned over without hesitation.

“I see. So I should do nothing?”

“Have you started saving for your children’s higher education?”

“Hmmmm. No. Not really.”

“I suspect that will be an investment that will pay dividends far in excess of any stock, bond or piece of property.”

After a warm handshake we parted ways. I had a new battery. I am not sure with what my new friend left.

So what was the second point I did not want to bring up at the time? A concept that is probably heretical to most readers, and is certainly unconscionable to every policy-maker:

What this Country Needs is a Good Old-Fashioned Recession

Throughout the polemic debates raging on Capital Hill about what should be done about the financial crisis, there is one point upon which there is utter and complete consensus: the government must do something to bail out people and businesses who have buried themselves in debt and bad investments. This is a most grave misconception, and one that I am convinced will make things much worse in the long-run. I will make three points this week as to why the approach taken in DC is disasterous policy-making.

1. Capitalism is “creative destruction.” The primary advantage of capitalism is the way in which it efficiently and quickly allocates capital throughout and economy. Adam Smith called this the “invisible hand.” Essentially the market, left to its own devices, naturally adjusts to any economic circumstance based upon supply and demand. As we discovered 20+ years ago when communism collapsed under its own waste and inefficiencies, capitalism is the greatest system in the world when it comes to generating wealth. However, this system is not one without its costs. One of the great economists, Joseph Schumpeter, noted that capitalism's very essence is "creative destruction."

With very few exceptions, when the government intervenes in the marketplace, it does so at the cost of reducing overall wealth. This is not to say that such intervention is never justified (a topic that will have to wait until next week). But to do so to save businesses or people from bankruptcy based upon their own decision-making is horrific policy-making.

I grew up in an era of stereo 8 tapes (for those younger readers, please consult your resident octogenarian for information about this archaic audio format). Back in the day I felt quite cool popping in my Captain and Tennille eight-track tape and turning up the volume (did I mention I was a very pathetic child?) At some point in the late 70’s, people stopped buying these tapes and players. First cassette tapes, and then later CDs, were viewed by the marketplace to be superior formats (for instance, both actually had rewind capabilities). Stereo 8 accordingly died an ignominious death.

I am sure that there were thousands of people whose jobs were tied to the manufacture and distribution of eight-track tapes. The government could have stepped in to stave off corporate and personal bankruptcies by extending loans or subsidies to this industry. But intervention would have extended the production of goods the marketplace no longer wanted, and employed people in positions that would only continue so long as the government maintained its largess.

Moving ahead to the present, by stepping in to "bail out" those industries/market sectors that would otherwise go bankrupt, the government prevents the natural winnowing process inherent in efficient markets. So instead of our economy receiving the proper signals that we need a lot fewer investment bankers, mortgage lenders, auto assembly-line workers and the like, huge quantities of capital continue to be misallocated when Uncle Sam saves jobs/businesses that should go away.

2. A serious recession is both inevitable, and ultimately necessary. The Holy Grail of both economics and government policy-making is ending the business cycle. Actually, let me clarify. It is to eliminate the “bust” portion of the business cycle. Who does not like a boom after all? Booms are like attending weddings with open bars.

But let us return to the dreams of those hoping to make recessions a thing of the past. Somewhat ironically, the greatest hope on this front has occurred when the economy has been poised at the edge of great financial precipices. On the eve of the great stock market crash of 1929, noted economist of his day, Irving Fisher, proclaimed, “stocks have reached what looks like a permanently high plateau." I suppose from ground level, cliffs can occasionally be mistaken for plateaus.

As recently as 2007, Fed and Treasury officials were confident that economic fundamentals were “sound” and future growth prospects looked bright. Once cracks began to emerge in the very foundations of the world economic order, these same officials offered assurances that the government stood ready to act in a way to minimize any slowing of the economy. Now that a full-blown economic catastrophe is upon us, we are promised that ultimately trillions of dollars with be spent in a herculean effort by the government to revive the economy. Moreover, it is taken for granted that such action is necessary given the circumstances. Balderdash!

While I am skeptical that there will ever be an end to the boom-bust cycle inherent in market economies, of this I am certain: A bust cannot be avoided after the most pronounced and unsustainable boom the US economy has ever seen. Marc Faber likens the need for a recession to the human body needing sleep. In an expansive phase of an economic cycle all kinds of frenetic activity and growth takes place. In this euphoric time, companies expand business operations, consumers buy more goods, and everyone takes on more debt. But just as the body needs its time of inactivity and rest, so economies need times of contraction to purge excesses and repair balance sheets.

To push this analogy further, it is possible for the body to stay awake longer than is natural. Initially this can be done by sheer will power. Eventually artificial stimulants are required. Being an inveterate crammer throughout college and grad/law school, I recall the drill quite vividly. Determination was enough through about 2:00 a.m. A candy bar could take me through 3:00 a.m. at which point I started brewing coffee. By 4:00 a.m. I was double-fisting Mountain Dew. Anything beyond 6:00 a.m. and I was looking for a Red Bull IV drip. The later I pushed my body to stay awake, the worse the repercussions. After one grueling 38 hour stint without sleep, I did not stir for 14 hours. It took me a week to feel like myself.

So it is with the economy. Yet the Fed has for years been artificially stimulating the economy through below-market overnight interest rates (see blogs below). This is the economic equivalent of mainlining NoDoz. It should be no surprise that our economy soared to heights not previously achieved. But just as there is a law of diminishing returns when it comes to taking stimulants to stay awake, the current zero-interest rate environment appears to be doing little to revive our economy that has already begun to slumber.

By preventing a serious recession at all costs in the futile attempt at staving off inevitable, and painful, economic adjustments the economy must make (reducing debt and consumption), the government simply prolongs and intensifies the pain. Moreover, thanks to its massive non-market based intervention in the economy, it reduces the overall net wealth of the nation by untold billions. It is truly execrable.

3. The government’s solution to drunkenness? More alcohol! Listening to politicians, pundits and policy advisors alike, the one message that gets through is the need to “stimulate” the economy so we can get back to the business of our nation. What is that business? Why, it is getting the consumer confident enough again to consume! It is getting the banks stable enough to resume loaning money. And above all, it is getting everyone, individuals and businesses alike, secure enough about the future to start borrowing again. We are constantly bombarded with talk of the “credit crunch.” The solution, taken for granted by one and all, is to inject hundreds of billions of dollars into the banking system to make credit easier for all to obtain. Indeed, a particularly important and popular element of the of the stimulus plan passed last week are tax incentives and rebates for first time home-buyers as well as new car purchasers.

Am I the only one that thinks this entire plan will not just be ineffectual, but counter-productive? Just prior to the financial crisis, household debt relative to income soared to unprecedented levels, while at the same time net personal saving in the US went below zero for the first time in 80 years! Consumption as a percentage of the overall economy reached 70%, far exceeding its historical norm. The ratio of household debt to assets had soared more than 50% in less than a decade. According to a recent research report by Merrill Lynch, overall private sector debt exceeded $15 trillion by the end of 2007, reaching a new high even as a percentage of national income.

In the brief period of time since the financial crisis started, 10% of mortgage borrowers are either behind on their payments, or in a state of foreclosure (and indeed the new administration is proposing a $50 billion plan in an effort to arrest further foreclosures). And while savings rates have climbed to a paltry 2% of national income, this is almost 85% lower than the level it was at the beginning of the 80’s.

So let me get this straight, the uniform consensus on Capitol Hill is that the solution to the financial crisis is to do everything possible to encourage further consumption and borrowing? Does it even make sense to anyone that long-lasting economic growth can be achieved by consuming more and more consumer goods that eventually depreciate in value to zero? Or borrowing ad infinitum? As I have argued before, whether we are talking at the household or macroeconomic level, I have never heard of spending one’s way into prosperity. Nor can one borrow their way to riches (at least riches that will not have to be paid back with interest).

Real economic strength is based upon savings and investment, not borrowing and consumption. More than anything else, we need to encourage Americans to rebuild their balance sheets, eliminate debt and set aside money that can be invested. This is in the long-term best interests of the US.

But far from encouraging and fostering this transition, policy-makers are adamant in their efforts to eliminate the short-term pain that inevitably comes with such a paradigm shift for our economy. In so doing, I am convinced they will retard the very processes already naturally and necessarily at work in the economy.

Adam Smith had it right. This is obviously a sprawling, dissertation-worthy topic, and I have not done justice to any of the points above. But I will attempt to sum up my simple-minded perspectives.

Whether it has been from my closest and smartest friends, or new friends that know how to replace a car battery, I often get questioned about the “savings paradox.” This is the concept that during economic crises individuals who look out for their best interests by saving more actually do harm to the economy as a whole, and hence ultimately themselves, since they are not spending as much. And once this behavior is replicated, the economic damage spreads.

My response: By saving money you are actually helping the economy make what will inevitably be a painful, but necessary, transition towards sustainable growth. This process would occur naturally, thanks to the “invisible hand” at work in the marketplace. But allowing this process to unfold in the least destructive manner possible would require courage, and lots of it. Americans must be courageous enough to suffer through a painful period of economic dislocation. Moreover, courageous politicians must emerge to tell Americans what they need to hear, not what they want to hear. Sadly, courage appears to be in short supply, and no where is this more evident that in DC.

So the main danger is that in a desperate attempt to prevent exactly the contraction process the economy needs to purge the excesses that have built up as a result of a rampant and malignant credit bubble, the government will waste hundreds of billions of dollars and prolong the recession/depression.

This is not to say that the government should stand idly by and allow the effects of economic dislocation ravage the members of society already living at the margin. But that discussion, along with the ways in which the current government policies violate basic tenets of social justice, will have to wait until next week.

Portfolio Reclamations Project

"We haven't the money, so we have to think"
-Lord Rutherford


Times change so very quickly. Fifteen months ago the US stock market was scaling new all-time peaks. Unemployment was comfortably under 5%. Consumer confidence was near six year highs. Goldman Sachs was paying its average employee in excess of $660,000 a year. Banks were, well, solvent. Home prices in my region (Seattle) were very close to their all-time highs. In short, life was good. People were feeling ebullient, at least when it came to the economy.

Fast forward to the present. The overall stock market is down almost 45%. Unemployment is over 7% with many (myself included) thinking it is headed towards 9%. Consumer confidence readings are at record lows (and they have been charted since before I was born!) Home prices have declined between 20-25% nationally, with some markets being savaged even more brutally. Hundreds of billions of dollars have been needed to prop up a banking system that would otherwise be insolvent. On Monday of last week alone, IBM, Texas Instruments, Pfizer, Sprint, Phillips, Home Depot, Caterpillar and ING announced layoffs totaling over 50,000. Here in Seattle, Boeing, Starbucks and (gasp!) Microsoft have all announced layoffs as well.

Even the poor suffering souls at Goldman have had to tighten their Italian belts and figure out a way to get by on average salaries that barely exceed $360,000. Oh, the horror! By the way, we the taxpayers paid for about 91% of those salaries thanks to the $10 billion bailout package the former investment bank received from Uncle Sam (find your happy place Mark, find your happy place)!!!

I do not bring up these sobering statistics to boost the sales of anti-depressants. Rather, given the regular influx of inquiries I receive from people about what in the world one should do in this catastrophic economic climate, I am breaking with my general policy to avoid providing specific investment advice. These are very dire times. Individuals in this country have collectively lost trillions of dollars, largely based upon the actions and recommendations by the very financial service professionals that either directly caused the present crisis, or failed to see it coming.

Let me provide a few provisos and one general observation before proceeding. First, each household has unique financial needs. Hence, one should not simply apply these thoughts without first determining what your unique financial circumstances are, and which of these investment ideas are appropriate for you and your household.

Second, as an investor I simply try to find assets that in my estimation have the best risk-reward profile. But there is no investment of which I am aware that has no risk in the long-term (including US Treasury bonds). And usually the investments that offer the greatest opportunity for reward carry some of the largest risks. Hence do not take any of these thoughts to be the equivalent of "sure things."

Third, I believe in long-term investing. This means I am using at least a ten-year horizon. I do not attempt to divine the direction of any asset class in the short-term. Indeed, I am probably the world's worst market timer. I am used to purchasing assets and seeing them decline in value for months, and in some instances years. So there is a real possibility that even if some of these ideas are successful in the long-term, one may see ongoing short-term losses.

As for the general observation - act defensively when it comes to financial matters. If given the opportunity, savings should be favored over spending (even more than would be the case in normal economic times). Debt reduction should be one's highest priority (particularly consumer and other high interest debt). The main reason for the economic crisis we are in is debt (see blogs below). There are those (whose glasses are generally roseate) who think that we will see the economy come roaring back to life sometime this year. I do not fall in that camp. The problems we face economically are systemic and chronic. While assets markets may rebound significantly in the short-term as news becomes "less bad" (again, I am not the person to ask), there is not any easy fix for our broken economy.

So, in light of all of that, the investments I like:

Treasury Inflation Protected Securities (TIPS). Never heard of them? Well do not feel bad, you are not alone. In essence, these are US Treasury bonds (considered by many to be the safest investment in the world) that pay two types of interest. The first is a base amount that is guaranteed to be paid every year. It is typically quite small, a handful of percentage points. Not very exciting or interesting so far. But the second is based upon what the Consumer Price Index is each year. So in effect, you receive back your money, plus the rate of inflation, AND the base interest rate. In times where preservation of capital is paramount, I can think of no better place to have money parked where it is both secure, and is assured of providing positive after-inflation returns (the only returns that should matter for any investor).

Gold. I know gold is neither considered a traditional asset class, nor is it recommended by the vast majority of investment professionals. It is after all, a "non-performing asset." It is not like investing in a business, where one can at least hope for/expect revenue growth. Nope. Gold just sits there. But that is sort of the point. You see gold will buy you roughly the same amount of food and other basic necessities as it did back in the times of Christ. There is not much gold. The entire world's supply of gold would occupy a cube 60 feet by 60 feet by 60 feet (granted it would weigh 160,000 tons). It is a storehouse of value. And in today's environment, where "Helicopter Ben" Bernanke (see below Looking Ahead to 2009) promises to litter the landscape with increasingly worthless dollar bills, having a tangible storehouse of value whose supply is not subject to any electronic printing presses is a nice thing. Furthermore, it is one of the few assets that is not someone else's liability. Other tangible assets potentially worth having some interests in are silver, platinum and oil, along with those companies that dig the stuff up.

High Quality Stocks. Now this is not a recommendation that I expect will yield the kind of returns to which people have grown accustomed. Again, I am pretty bearish on the future state of the US economy. And if the economy is not zipping along, it is hard for corporations, and their stock prices, to excel. Having said that, I think there is some upside, and not a ton of downside, in stocks that meet at least four of the following five criteria: 1) have little to no debt; 2) pay solid dividends; 3) are "wide moat" businesses (dominate an industry or area of business in such a way so as to make entry by competitors difficult, if not impossible); 4) trade at very cheap valuation multiples (such as price-to-earnings, price-to-book, price-to-cash flow); and 5) are not in the financial services industry. Frankly, there are not a lot of those companies around (although I understand one of them has some campus in Redmond).

As for investments to be avoided:

Residential Real Estate. I do not expect houses to be a good investment as an asset class for the rest of my life. Seriously. My favorite question I posed to housing market bulls during the heady earlier years of this decade was: For the 105 years prior to 1997, what was the average annual after-inflation returns for residential real estate in the US? I typically had guesses as low as 5%, and as high as 10%, or even 15%. The answer: -.5%. That is not a typo (forgive the others). Houses, as an investment, did not even keep pace with inflation for over a century. And when one thinks about it, this should not be surprising. Like gold, a home is a non-performing asset. Unlike gold, it actually falls into a state of disrepair over time. Roofs must be replaced, paint reapplied, pipes fixed, etc., etc. I always encourage people to view their home as a way of avoiding paying rent, not as an asset likely to intrinsically appreciate beyond the cost of living. Unlike stocks, I will be shocked if housing prices rebound in the near term. In addition to all the bad news regarding prices well known by one and all, the following should be a sobering fact for those expecting an imminent upturn in the housing market: according to the Census Bureau, a record 19 million homes were uninhabited at the end of 2008. Think we might have some more over-supply to work through?

Long-Term Treasury Bonds. I have already written about the basis for thinking these are terrible investments below (see Looking Ahead to 2009), so I will not rehash. Suffice it to say that since I wrote that blog, long-term treasury bonds have declined in excess of 15% in value. There should be considerable downside yet to come.

US Financial Institutions. This is the call that has the biggest chance of going awry. Indeed, the wise, hoary Warren Buffet is on the opposite side of the trade with me on this one. The argument for investing in these companies is two-fold: 1) they have been absolutely bludgeoned senseless, and have to be cheap at these levels; and 2) the big ones now have the express backing of the US Government, and are thus not going under. As a deep contrarian, I am quite sympathetic to the first point. And I do not rule out the possibility that there are well-run banks out there that have been taken to the woodshed and smacked silly by the market along with all the culpable/incompetent financial institutions. But as a whole, I still think the risks for the sector exceed the potential rewards. As a nation, we are still choking on debt. Banking bulls pin some of their hopes on the scuttlebutt concerning the creation of a US "Bad Bank" that would pool all or many of the toxic assets held by US banks and transfer the losses to . . . (any guesses?) the US taxpayer. Well, in addition to being yet another "Bad Idea" that has come from DC in its handling of this financial crisis, I do not think that will be enough. As long as the housing market languishes (and we know my thoughts on that), more impaired assets will find themselves on the balance sheets of many US banks. And while bondholders get bailed out when the US government takes over a failed bank, the stockholders generally do not.

There you have it. As things stand now, you could do a lot worse than simply squirreling money away in a low-interest bearing account. And again, I think being cautious and defensive at this time makes a great deal of sense. Nevertheless, there are always opportunities to judiciously put money to work.

In an effort to address the specific interests and concerns of those of you who follow these periodically penned meandering thoughts, please feel free to pass along any question, comments or suggestions.

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.

Looking Ahead to 2009

"There are two times in a man's life when he should not speculate: when he can't afford it and when he can." - Mark Twain

Happy Holidays from Indonesia! I am traveling with my new in-laws and enjoying a marvelous trip that started in Seoul, took us here to Jakarta, and will conclude in Bali. As we rapidly approach the New Year, many of us take this time to both look back, reflecting upon the year that was, and look forward, thinking about what we hope to accomplish in the next twelve months. While I typically eschew giving general investment advice for a variety of reasons in a medium such as this, breaking from the historical analysis I began last blog to offer some contemporary observations may be timely.

If there is one thing last year should have conclusively proven, it is the perils of speculation and greed. For years, nattering nabobs of negativity such as myself have been concerned about the unsustainability of an economic boom predicated upon the inflation of paper assets and home values. US incomes after inflation have barely gone up in the last ten years. Yet first stocks and then real estate values escalated rapidly. People spent more and saved virtually nothing.


Worse, the housing bubble encouraged people to pile on mortgage debt at levels that were literally unprecedented. It was as if people collectively lost their senses, believing that by buying and selling their homes to one another, vast wealth could be created. Of course, in reality this massive misallocation of capital (which is what always occurs during financial bubbles) has led to the unprecedented destruction of wealth and crushing debt burdens.


As far as 2009, do not expect any quick rebounds in the real estate markets. I have heard some make the pitch that with home prices this depressed, tremendous opportunities exist. I could not disagree more strongly. For years residential real estate construction and investment exceeded population growth by a factor of roughly five. For over a year, more than one in three homes was being sold either as a non-primary residence or for investment purposes. The combination of over-supply and hyper-speculation will likely take much longer to work itself out than 22-24 months (roughly the point at which US home prices peaked). Weak to dismal job prospects coupled with huge numbers of adjustable-rate mortgages resetting at higher rates in the coming months will mean that foreclosures and falling prices will be the likely hallmarks of the US real estate market.


Beyond buying homes, let me identify what I believe to be the worst investment for 2009: long-term (30-year) US Treasury bonds. As I write this, these bonds are yielding a most paltry 2.61%. There are three main reasons why this represents a catastrophic investment for anyone with a long-term horizon. First, the US budget deficit is exploding. It is likely to get much worse as the US government seems hell-bent on saving every heretofore well-heeled Wall Street financier whose Hermes wallet happens to be empty. This will lead to the US Treasury flooding the market with bonds to finance this spending/bailout orgy. Basic laws of supply and demand indicate that the US must offer higher yields in order to goad investors into absorbing future US debt issuance. This would mean that the value, or price, of currently issued US debt will go down.


Second, the Fed in its inestimable wisdom has put the world on notice of its intention to inflate the economy by any and all means. This means printing dollars. Indeed, even before Bernanke was hand-picked by Greenspan to succeed him, the current Fed Chairman's nickname was "Helicopter Ben." He got this name as a result of his response to a question about the prospect for America falling into a deep depression like that of the 30's with price levels falling. Bernanke noted that such a prospect could be averted, as the Fed could drop money from helicopters if necessary. While this may be comfort to pilots currently out of work, it scares foreign holders of US bonds to death. Such action (running the printing presses to pump money into the economy) erodes the value of the dollar vis-à-vis other currencies. Yet we rely upon those same foreign investors to buy the majority of US bonds. Any appreciable decrease in purchases from these overseas investors will also cause long-term bond values to decrease in the future.

But the third, and most important, reason to avoid long-term US Treasury bonds is precisely because Bernanke (or his successors) will at some point likely succeed in their efforts to reinflate the economy. Over the last 200 years, average returns on long-term US Treasury bonds have been more than 3.5% above inflation. So to achieve just average returns, a holder of a 30-year US Treasury bond at today's yield, inflation would have to average -1% through 2040!!! Essentially, the US would have to be in one generation-long depression. As bearish as I have been, even I think that is almost impossible. If inflation simply returned to its post-WWII average level, investors would have negative after-inflation returns, despite tying up their funds for 30 years. Far worse, should inflation return to levels seen in the 70's, investors would see massive capital losses on 30 year Treasuries. In sum, it boggles my mind how any long-term investor would for a moment consider such an investment.

Accordingly, I think it is highly prudent for individuals in the New Year to liquidate any mutual funds they own which have significant holdings of long-term Treasury bonds. Obviously, if investors directly hold such instruments, they should be sold now.

There is actually a way to make money in the event that long-term Treasuries decline in value. However, I would not recommend it for most individuals. ProShares UltraShort Lehman 20+ Year Treasury Bond (ticker symbol TBT) is an exchange traded fund (like a mutual fund, but trades like a stock) that goes up in value 2% for every 1% decrease in the price of long-term treasuries.

While I personally own it, there are several reasons why typical investors will want to eschew it. To begin with, just because long-term Treasury prices have reached record/bubble-like levels does not mean they can go even higher. Indeed, TBT is down substantially from the level I first bought it at. Most investors hate losses more than they love commensurate gains. This problem is magnified by the fact that the fund is leveraged 2-1, thereby increasing the amount of money lost to investors in the event long-term Treasury bonds continue to go up in price. Finally, I am a firm believer that individuals should not own investments, the nature of which they do not understand. Since most individuals do not find the bond market to be enthralling (who can blame them?), few possess the knowledge critical in determining whether TBT is appropriate for their portfolio.

In general, I expect 2009 will continue to see extreme levels of market volatility. While the real economy throughout the world will likely worsen appreciably, it is possible that stock markets may see significant run-ups. However, with weakening economic fundamentals, I continue to see few investment opportunities on the long side that represent real value for the investor (as opposed to speculator). Having said that, keeping a few gold coins under the mattress may not be such a bad idea.

I hope everyone has a very Happy New Year!

From Whence We Came Part I

"Those Who cannot Remember the Past are Condemned to Fulfill It."
- George Santayana

My doctor has recently informed me that my blood pressure has escalated. Having had a front row seat to the unbelievable policy-making that has emerged from our nation's leaders in response to our economic crisis, it is no wonder.

Before launching a whole series of invectives in a future blog concerning the unjust and incompetent decisions emanating from what was once, and should have remained swamp, aka Washington D.C., a little review of past history is in order. There was once a quaint and innocent time in American economic history when: people used to be required to put at least a 20% down payment before buying a house; bankers used to be dour individuals, reticent to lend money to those but the most credit-worthy; and investment advisers used to caution people about the steep losses that might befall those investing/speculating in potentially risky assets (i.e. stocks and real estate). It was a more sober time perhaps. People were worried more about the prospect of capital losses than capital gains. While less fun than the carefree modern era of finance, it was also more stable. Most people relied upon setting aside part of their incomes on a regular basis in the event that rainy days should come to pass. Great fortunes were not gained as frequently, but neither were vast fortunes lost.

But starting in the 80's, change began to occur. Not, from my perspective, all for the worse mind you. Far from it. Paul Volker proved himself to be perhaps the most courageous and talented central banker in American history. By raising interest rates in a time of economic crisis and inflation, he arguably caused the most severe recession since the depression. But in so doing, he also broke the back of what had been rampant inflation since the days of LBJ's The Great Society programs. Moreover, the economic power of unions began to wane significantly, thereby unshackling to a large degree human capital, and leading to greater employment. Absolute and marginal tax rates were lowered, providing greater incentives for both individuals and corporations to work hard.

But with the good, usually comes the bad. As corporations prospered, particularly in the financial sphere, so did their influence grow in DC. This, coupled with more conservative politicians, led to legislation pushing all forms of deregulation concerning financial institutions. As the good times of the 80's continued into the 90's, something quite pernicious began to develop. Fewer and fewer controls and oversight were in place to regulate financial institutions.

Increasingly egregious conflicts of interest arose for financial services companies as they tried to serve the interests of their clients and their shareholders. Similar conflicts confronted individual brokers and financial advisers, as they were compensated through commissions only received by selling certain financial products. And the more they sold, the higher their incomes.

All of this came to a head as we approached the turn of the millennium. Stock prices, and particularly those in the tech sector, had achieved returns that exceeded anything seen in modern US financial history. They were so fantastic that anyone with a cursory understanding of investing history should have been aware of the fact that it was unsustainable. There has never been a major asset class which has appreciated ad infinitum without facing serious price declines along the way.

Had the financial institutions safeguarding the vast majority of American savings and investment funds been properly serving the interests of their clients, two types of warnings would have been issued. First, the institutions themselves would have disseminated "sell" recommendations on hundreds of tech companies, and the sector as a whole, based upon the gross overvaluation of the sector. Ahhhh, but Wall Street was reaping billions and billions of dollars in fees creating IPOs and providing other services to the very tech companies it was making buy and sell recommendations about for its retail investment clients. Often it was the very same individuals at investment banks that first launched an IPO for a company and then issued the bank's "analysis" of the company from an investment perspective. Virtually without exception, every tech company was a great "buy" for the investing public. Far be it for Wall Street to have the courage to bite the hand that was feeding it by declaring that the vast majority of these companies being rushed to market: had no track record of success; operated in wholly speculative market sectors; were largely run by tech wonderkids who had little, if any, management experience; and were massively overvalued by any objective finance metric.

Second individual brokers and financial advisers would have been calling each of their clients warning them of the dangers of an precipitous fall in US stocks. Remarkably, from the anecdotal evidence I gleaned at the time form talking to friends and colleagues, the opposite occurred. Brokers and advisers were mostly encouraging their clients to "follow the returns." Even though the gravy train had long left the station, and was about to be utterly derailed, the average retail investor was still being sold on the story of vast profits to be made by investing in companies engaging in tech endeavors that few brokers/advisers took the time or effort to understand. As these financial service professionals usually generated more revenues for themselves by having their clients purchase stocks or equity-based mutual funds, it appears that greed and neglience trumped prudence.

This takes us to the precipice of the new century in our story, as well as the role (or lack thereof) played by the Fed and the agencies tasked with overseeing financial companies. But that will have to wait for the next installment.

The Greatest Failure

"Where are the customers' yachts?"

-Anonymous (possibly apocryphal question posed to a New York City tour guide when showing a group the dock in Manhattan where most of the yachts belonging to Wall Street executives were moored)


Apologies for my long hiatus. Many things have changed since I posted my first blog here. For starters I am married (not the most newsworthy development nationally perhaps, but that which has mattered most to me). More relevant to America and the world writ large is the incredible melt down in virtually every asset market, the ongoing deterioration in the real economy, and the election of Barack Obama as President of the United States.

As noted back in July, I have been expecting large losses to occur in the financial and real estate markets. Now it did not take any particularly keen or arcane insight on my part to see this coming as an investment professional. My entire professional life is focused on nothing but analyzing the world economy and asset markets, and then identifying particularly good places to put money to work. Conversely, I, like every other investor must also spot those areas to avoid. For reasons I will go into momentarily, it was obvious that real estate and stocks presented huge risks, with little opportunity for profit.

Therefore, I find it both startling and confounding how 95% (perhaps an underestimate) of investment professionals failed to warn their clients about the likelihood of massive declines in asset prices. From my simplistic point of view, a crash in the housing and equity markets was absolutely inevitable (and indeed necessary - a point that will have to be fleshed out another time).

There were a variety of reasons for this. The most basic being that the US has been in a lifestyle bubble for almost a decade. We have gone from a savings based economy to one predicated (precariously) on debt; from an economy that was sustained by increases in real (after-inflation) income increases to one that relies upon ongoing asset appreciation (first stock, then houses). This hit a critical mass level when financial institutions gave loans to people with little, or even no collateral, to buy houses they could not afford at interest rates that were held temporarily low. The only way this house of cards could persist is if housing prices kept rising to the sky. Ah, but the laws of gravity apply even to the ethereal realm of finance.

Could you blame people if they looked around and saw all their neighbors getting rich simply buying and selling each others' houses and did not want to get in on the action themselves? Well, maybe a little. Nevertheless, the greatest failures can be attributed to the banks, real estate agents,mortgage companies, PMI insurers, Wall Street brokers and the like who induced and encouraged THEIR clients, like lambs being led to the abattoir, into making some of the worst financial decisions imaginable. Whether that was: buying the house they really could not afford at the top of an obviously bubbleesque market; purchasing the stock of banks and mortgage lenders who stood to lose trillions collectively when the bubble burst; or refinancing homes with cash-out mortgages used to fund lifestyle purchases.

Do not get me wrong. There is plenty of blame to go around for the intractable mess in which we find ourselves. But it seems to me that there should be a special inner circle of perdition for those financial and real estate professionals, most of whom had fiduciary duties to protect the interests of their clients, who failed to wisely counsel them. Of course compounding my outrage is the fact that so many of these professionals have massive conflicts of interests. Most earn the majority of their incomes by peddling particular products, whether it makes sense for their clients to buy them or not.

Sadly, having studied financial bubbles and their aftermath for some time now, I cannot say there is a great deal of hope for an imminent recovery. Global stock markets have collectively lost more than $35 trillion from their recent peaks (making the combined $1.35 trillion government infusions from the US and China look rather anemic). Many more trillions have been lost in world real estate markets. Yet as the global economy continues to founder ever more gravely, I have heard most financial professionals urge people to stay the course. Paying heed to such advice so far has lead to 45% losses over the last 13 months in the overall US stock market. Hopefully, people are beginning to regain their senses, if only slowly and one by one.

So what is one to do? Well, a comprehensive answer is beyond the scope of this particular missive, and there is no cookie-cutter approach to asset management that works for all anyway. But everyone can and should assess the manner in which their money is being managed. Do you have a financial professional whose livlihood is connected to how your money is specifically invested (i.e. commissions for sales of particular assets)? If so, you should seriously consider either educating yourself and then managing of your own assets (a topic for another time) or at least finding a well-regarded financial advisor who charges an hourly rate. That way, s/he does not have a vested stake in steering you towards particular investment vehicles.

Finally, if you do have an investment professional that did not warn you that the stock/housing markets were at least at risk of falling precipitously by the end of 2007, you should seriously consider firing the person regardless of the manner in which s/he is compensated.

If the last year has proved anything, it is that through greed and incompetance the financial service industry has utterly failed in being good stewards of our money.