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(Especially noteworthy articles’ dates highlighted in gold.)
WELCOME TO THE NEW YEAR, PART I
January 7, 2008
This coming year should be an interesting one. Too interesting, one might posit. Whether it turns out to be any more pivotal that any other year since W.I.L.'s founding in 2000 is uncertain. Some signal event, like the suspending of U.S. elections, could happen. Probably not, but it cannot be ruled out -- and that is the deeper point. But humans are not inherently good at predicting or preparing themselves against the occurrence of low probability/high consequence events. They are designed to worry about the lion behind the bush (pun intended) around the corner. That said, just about every trend we have ever identified anywhere on this site continues apace. For starters:
Hang on for the ride. Consider that every warning we have ever given is still valid. We see no reason to retract any of them.
WELCOME TO THE NEW YEAR, PART II
Take a look to your right and observe the rock. Take a look to your left, and notice the hard place ...
"More than any time in history mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray that we have the wisdom to choose correctly." ~~ Woody Allen
Hear the siren calls of the standard media pundits and your own human inertia. They tell you that while things might be a little sketchy just now, you do not need to worry too much. ... It is just the latest scare, or "correction", that markets go through from time to time before the secular bullish trend reasserts itself. Right? Those doom-mongers have predicted 25 of the last -- what, one? -- economic collapses. (A medley of their greatest hit would be Ludwig von Mises and the Austrian economists accurate foretelling that a severe contraction would follow the Roaring Twenties, although even they did not foresee how policy makers would transform the contraction into a total disaster.) Why should we think they are accurate this time?
In investing, as elsewhere in life, timing is all important. The saying that "Wall Street is littered with the graves of men who were right too soon" is an old one.
If you get in a car within the Continental U.S. and drive due east, you will eventually end up in the sea. That is certain. The fact that you may have been driving for days with no sign of water does not refute this. But nor does catching a whiff of salty air mean you will be axle-deep in the ocean within the next hour. An economic crisis is more abstract and less predictable that getting immersed in the ocean in a car, but today the signs that such a crisis is nigh are as compelling as an overpowering smell of salty air would be above.
It should be an interesting year.
WILL THE DENOUEMENT OF THE FIAT MONEY ERA BE DEFLATIONARY DEPRESSION OR HYPERINFLATION?
January 7, 2008
Inflation has been so ingrained in the U.S. dollar-based international financial system since the Great Depression in the 1930s that it is natural to assume that inflation is a permanent state of affairs. Historically, all fiat currencies (those unbacked by gold or some other scarce asset) eventually have fallen to their intrinsic value. Zero. So hyperinflation seems the inevitable fate of that system. Certainly recent price action of commodities, gold, etc. provides little counterevidence for this theory.
However, various analysts -- Bob Prechtor of Elliott Wave International being among the most prominent -- have argued that the credit expansion behind the inflation (it actually is the inflation, strictly defined) will eventually exhaust itself. Credit revulsion and contraction, i.e., deflation, will allegedly follow. Prechtor argues that both borrowing and lending depend on confidence by both sides of the transaction that the borrower will be able to repay the loan. This is the case in a generalized macro-sense as well as with regard to the particulars of any one loan. Once the general confidence is shattered, as happened in the '30s worldwide and in Japan after 1989, no amount of central bank prodding can reinflate the bubble. It has to run its course until John Maynard Keynes's "animal spirits" reassert themselves and a bull market in confidence reignites.
Since the investment implications of the two outcomes are apparently very different, getting accurate odds on the likelihood of the two outcomes appears highly desirable. Peter Schiff, author of Crash Proof: How to Profit from the Coming Economic Collapse, suggests in "Not Your Father's Deflation" that the outcome will actually depend on which yardstick you use. The U.S. Federal Reserve now has virtually unlimited capacities to monetize assets of any sort, e.g., witness its recent offer to effectively redeem a panoply of bad debt-backed assets at face value, where the market value would otherwise be a large or small fraction of face. Thus the Fed can always prop up nominal asset prices if it tries hard enough. "Nominal" value here means, asset prices will not fall relative to that book-entry accounting measurement device commonly referred to as the "U.S. dollar". But, Schiff maintains, the Fed can do nothing to sustain real asset values, meaning values when measured in terms of "real" money, e.g., a stable yardstick such as gold. So deflation properly defined and measured is in the offing no matter what the central banks do.
Antal Fekete takes a still deeper look into the matter in "Can we Have Inflation and Deflation All at the Same Time?" He notes that the various forms that "money" and "dollars" take are not perfect substitutes for one another, especially during a credit crunch and other times of monetary distress. The circulating Federal Reserve Note (FRN) "dollars" will not be freely exchangeable into electronic "dollars" if everyone goes to the local ATM and tries to drain his or her bank account. In this instance FRN dollars will trade at a premium to book-entry dollars, i.e., the former will deflate vis-a-vis the later. Purchasing safe U.S. government T-bills is a big-money equivalent of retail ATM withdrawls -- thus the collapsing T-bill yields of late, essentially putting a quality premium on T-bills relative to standard e-dollars, or an inflationary discount on the latter.
In a subsection of the article, "The curse of electronic dollars", Fekete notes:
Helicopter Ben has just made a most unpleasant discovery. Earlier he has promised that the Federal Reserve will not stand idly by while the dollar deflates and the economy slides into depression. If need be, he will go as far as having dollars air dropped from helicopters.
Time has come to make good on those promises in August when the subprime crisis erupted. To his chagrin Ben found that electronic dollars, the kind he can create instantaneously at the click of the mouse in unlimited quantities, cannot be air dropped. They just will not drop.
For electronic dollars to work they have to trickle down through the banking system. The trouble is that when bad debt in the economy reaches critical mass, it will start playing hide-and-seek. All of a sudden banks become suspicious of one another. Is the other guy trying to pass his bad penny on to me? In extremis, one bank may refuse to take an overnight draft from the other and will insist on spot payment. A field day for Brink's. The clearing house is idled, and armored cars run in both directions up and down Wall Street delivering FR notes and certified checks on FR deposits.
Under such circumstances electronic dollars will not trickle down. In effect they could be frozen and, ultimately, they may be demonetized altogether by the market. How awkward for Helicopter Ben. His boasting of air drops is an empty threat.
It what could have been the article's conclusion (what follows is in the nature of a polemincal addendum), Fekete writes:
In a few days during the month of August central banks of the world added between $300 and 500 billion in new liquidity in an effort to prevent credit markets from seizing up. The trouble is that all this injection of new funds was in the form of electronic credits, boosting mostly the top layer where there was no shortage at all. Acute shortage occurred precisely in the lower layers. This goes to show that, ultimately, central banks are pretty helpless in fighting future crises in an effort to prevent scrambling to escalate into a stampede. They think it is a crisis of scarcity whereas it is, in fact, a crisis of overabundance. They are trying to douse insolvency with liquidity.
I feel strongly that this aspect of research on the denouement of the fiat money era has been lost in the endless debates on the barren question whether it will be in the form of deflation or hyperinflation. Chances are that it will be neither, rather, it will be both, simultaneously. There is a little-noticed and little-studied continental drift beween the money supply of electronic dollars and that of FR notes. ... The tectonic plate of electronic dollars will keep inflating at a furious pace, while that of FR notes and T-bills will deflate because of hoarding by financial institutions and the people themselves. The Federal Reserve will be unable to convert electronic dollars into FR notes. Apart from lack of collateral, present denominations cannot be printed fast enough, physically, in times of crisis. If the Federal Reserve comes out with new denominations by adding lot more zero's to the face value of the FR notes, Zimbabwe-style, then the market will treat the new notes the same way as it treats electronic dollars: with contempt.
The conclusion of both authors, then, is that electronic book-entry dollars are going to hyperinflate and converge to their intrinsic value -- zero. The only defense is to convert them into assets that are protected from this hyper-depreciation. In Crash Proof, Schiff suggests a core holding of European and Asian blue chip stocks (his reasons go well beyond inflation protection per se -- the book-length treatise is concise enough) and a nontrivial residual holding in precious metals-related assets. Fekete's analysis suggests that at some point -- the $64 question is when -- Federal Reserve Notes will be a useful asset to hold. Hollywood mogul Samuel Goldwyn once said that "a verbal agreement is not worth the paper it's printed on." Perhaps U.S. FRNs will yet escape that fate.
U.S. ATTACKS COSTA RICAN ONLINE BETTING OPERATION
January 13, 2008
As reported by Tax-News.com, the U.S. continues to relentlessly attempt to crush all transactions between consenting adults that threaten government-run rackets:
Judicial authorities in New York announced ... that 12 individuals have been charged with gambling and money laundering offences relating to the operation of a Costa Rica-based gambling website and call center that served sports books in the U.S. ...
The indictment ... alleges that from December 2005, Carmen Cicalese operated an internet website and telephone call center, known as a wireroom, in Costa Rica which charged United States-based sports bookies weekly fees of approximately $15 to $30 for each gambler that the bookie registered with the "Cicalese Wireroom". In return, registered gamblers were able to place bets on sporting events at odds set by the Cicalese Wireroom via a toll-free phone number, and through various websites maintained by the Cicalese Wireroom, including datawager.com and betwestsports.com.
The indictment stated that the Cicalese Wireroom did not itself take an interest in the outcome of these wagers; paying winners and collecting from losers was the responsibility of the bookies.
U.S. bookies are said by the authorities to have paid the fees owed to the Cicalese Wireroom to representatives of the Cicalese Wireroom in the U.S. It is then thought that the collectors, or "runners," in turn transferred the money back to the Cicalese Wireroom in various ways, including by using couriers, debit cards, and electronic funds transfers. According to prosecutors, on one occasion, the Cicalese Wireroom used a Pakistan-based "hawala" money transfer organization to move money collected from U.S. bookies. ... All 12 defendants were charged with gambling and with conspiracy to engage in gambling.
Fearing that online gambling operations based offshore could act as a conduit for money launderers and financiers of terrorism, the Bush administration has led a crackdown on foreign operators in the U.S. The Unlawful Internet Gambling Enforcement Act, passed by Congress in 2006, effectively shut down the U.S. industry for these companies by prohibiting the use of payment instruments by financial institutions to handle the processing of any form of internet gambling that is illegal under U.S. federal or state law.
The government has also not shied away from pursuing some of the biggest names in the industry, such as BetonSports, the UK-and Costa Rica-based company formerly listed on the London Stock Exchange, which pleaded guilty to racketeering charges in May 2007.
To cut to the chase:
(1) Offshore gambling threatens U.S. onshore operations such as state lotteries (accurately described as a tax on the mathematically disadvantaged), and Las Vegas and other heavily taxed and regulated gaming operations. The people behind these operations have (successfully) pressured the government to crackdown on their less regulated and taxed offshore competitors.
(2) Serving as a financial conduit for terrorists is about #33 on the U.S. government's list of concerns about offshore gambling operations. The USG would like to monitor and control all transactions that involve moving funds offshore -- and steal the funds involved if some convenient pretext can be found. The terrorist angle is just a stalking horse
THE REPULSIVE U.S. PRESIDENTIAL CAMPAIGN
Andrew Fischer's sets the tone for his article in the introduction, and then he gets really nasty:
None of the below applies to Ron Paul, of course, the only presidential candidate who is honest, principled, and consistently says what he believes.
The would-be presidents are all spouting "change" now, but of course none of them states exactly what kind of change. It is simply the buzzword of the moment. Vote for me and we will have change, they assert. Please tell us, then, what kind of change? More freebies for the indolent? More regulation and taxes? Inferior socialist health care for everyone? More government spending, manipulation and money creation? (Perhaps more liberty and a return to the Constitution? Don't make me laugh!)
They are all despicable prevaricators. Certainly there are degrees, and at the top of their parties are Hillary "Schoolmarm Knows Best" Clinton and Rudy "I Was There" Giuliani. The former claims, although her marriage was and is obviously one of convenience, that she was essentially Bill's "prez-partner" when he occupied the White House. ... [W]as Hillary truly a trusted advisor, perhaps representing Bill's female constituency? Or is she just a simple liar? These are questions which will never have answers, since the world's sleaziest couple refuses to make public the pertinent records of the Bill Clinton years. (However, we can infer the obvious.)
For his part, Giuliani campaigns on the mere fact that he was mayor of New York during the terrible 9/11 attack. Many say he did a great job, rallying his people. What everyone seems to have forgotten is that his popularity was at its nadir when the tragedy occurred. The attack clearly revived his moribund career, and was simply the best thing that could have happened for him. Furthermore, ... how hard is it to broadcast soothing platitudes penned by professional writers, to reassure the citizenry that "we'll get through this," to make lots of public appearances, and to stay up late "working"? Only a cretin would fail to see the opportunity for editorial-proof self-promotion, but only a cad (with a police-protected mistress, no less) would seize that opportunity and use it as a springboard to, and his primary qualification for, the highest office in the land. ...
When asked a question, all of them hedge, hem and haw, trying feverishly to concoct a response that will not alienate a single soul, while simultaneously attempting to incorporate the usual something-for-nothing carrots-on-sticks, which amounts to little more than buying votes with empty promises. ...
Getting elected president is now all about money ... It has nothing to do with genuine ideas, what is good, right, Constitutional or fair. It is about the continued aggrandizement of the presidency, and nothing about Congress making the laws, while the president merely enforces them. It is all about having a new "Fearless Leader" with "vision" (which seldom materializes, except in ugly forms). And it is all repulsive.
More dismaying than the candidates as such -- by now we expect no different -- is that a majority of American people (a) continue to buy ... and buy ... and buy ... from all these humbug hawkers, and (b) seem to have lost all ability to think critically. The absurdity of the democracy-peddlers' faith that the aggregation of ignorance can beget wisdom is all too apparent these days. Tune out the campaign as covered by the mainstream media if you wish to retain a vestige of faith in humanity.
Has any candidate articulated an intelligent set of hypotheses about what is behind the critical problems of our time, along with a set of policies that rationally address those causes? Has any one of them even offered anything of real substance, period? Only Ron Paul (other "fringe" candidates show incipient rationality while addressing some issues). Whatever Paul's true support level in the country may be, it is a minority. Why do the rest support who they do? Apparently for vague, emotionally-driven reasons, or because the candidate sounds good regarding a particular issue of interest (however counterproductive his or her approach may actually be). The neglected cerebral cortex has little say in the matter. It may always have been thus, but now the country can no longer afford to indulge whimsical motivations and the outcomes stemming therefrom. Our financial and social reserves have been depleted.
Lenin claimed that the capitalist would sell you the rope with which you hung him. The American people seemingly will give you the rope or, more bizarre yet, subsidize you to take the rope with which you will hang them. As Bill Bonner and Addison Wiggin expressed in Empire of Debt: The Rise of an Epic Financial Crisis, you may as well laugh.
By the way, does anyone expect that their property and due-process rights will be honored and protected amidst a sea of ignorance and anti-wisdom?
January 15, 2008
Eventually it was going to happen. The U.S.'s monetary and fiscal profligacy had to lead to a questioning of its AAA/"Safe Haven" rating/reputation. Now, Patrick Buchanon writes, Moody's has warned that if the profligacy continues for another decade, the U.S.'s credit rating will suffer. Do you really think ...?!
OK, basic point taken. But someone hit Moody's with a clue stick: The plummeting U.S. dollar shows the market has already docked the country's credit rating. The U.S. can always "print money" and technically avoid stiffing its creditors. U.S. creditors do not care about that. They want to get their loans back plus interest in invariant purchasing-power dollars. And they do not need a withdrawl of the Moody's imprimatur to understand that an AAA rating is a nonsense assessment of that default risk.
Since it began to give credit ratings to nations in 1917, Moody's has rated the United States triple-A. U.S. Treasury bonds have been seen as the most secure investment on earth. When crises erupt, nervous money seeks out the world's great safe harbor, the United States. That reputation is now in peril.
Last week, Moody's warned that if the U.S. fails to rein in the soaring cost of Social Security, Medicare and Medicaid, the nation's credit rating will be down-graded within a decade.
Our political parties seem oblivious. Republicans, save Ron Paul, are all promising to expand the U.S. military and maintain all of our worldwide commitments to defend and subsidize scores of nations.
Democrats, with entitlement costs drowning the federal budget in red ink, are proposing a new entitlement -- universal health coverage for the near 50 million who do not have it -- another magnet for illegal aliens. Moody's is telling America it needs a time of austerity, while the U.S. government is behaving like the governments we used to bail out.
The failure to even remotely address the financial reality of the country's situation is ongoingly noteable and puzzling. One might expect some politician, besides Ron Paul, to take a tack of: "We are about to hit a wall. I say we cut the Pentagon's budget so we can save Social Security." But the old something-for-nothing spiel continues to be the favored approach. Ultimately the blame rests with the voters.
California has already hit the wall. With an economy as large as a G-8 nation, the Golden State is looking at a $14 billion deficit in 2009 and a $3 billion shortfall in 2008. Gov. Schwarzenegger has called for slashing prison staff by 6,000, including 2,000 guards, early release of 22,000 inmates, closing four dozen state parks and a 10 percent across-the-board cut in all state agencies. The Democratic legislature is demanding tax hikes, which would drive more taxpayers back over the mountains whence their fathers came.
Meanwhile, Washington drifts mindlessly toward the maelstrom. With the dollar sinking, oil surging to $100 a barrel, the Dow having its worst January in memory, foreclosures mounting, credit card debt going rotten, and consumers and businesses unable or unwilling to borrow, we appear headed into recession. ...
To stave off recession, the Fed appears anxious to slash interest rates another half-point, if not more. That will further weaken the dollar and raise the costs of the imports to which we have become addicted. While all this is bad news for the Republicans, it is worse news for the republic. As we save nothing, we must borrow both to pay for the imported oil and foreign manufactures upon which we have become dependent.
We are thus in the position of having to borrow from Europe to defend Europe, of having to borrow from China and Japan to defend Chinese and Japanese access to Gulf oil, and of having to borrow from Arab emirs, sultans and monarchs to make Iraq safe for democracy. We borrow from the nations we defend so that we may continue to defend them. To question this is an unpardonable heresy called "isolationism."
Buchanon then goes into one of his typical rants against "globalism". The less rational elements of his populist philosophy undermine his point. Government managed and manipulated trade is the issue, not free voluntary exchange among people who happen to live in different countries. As any resemblance between what we have today and free trade is strictly coincidental, Buchanon's rant does not undermine his conclusion. But it grates. Skipping the rant:
America, to pay her bills, has begun to sell herself to the world.
Its balance sheet gutted by the subprime mortgage crisis, Citicorp got a $7.5 billion injection from Abu Dhabi and is now fishing for $1 billion from Kuwait and $9 billion from China. Beijing has put $5 billion into Morgan Stanley and bought heavily into Barclays Bank.
Merrill-Lynch, ravaged by subprime mortgage losses, sold part of itself to Singapore for $7.5 billion and is seeking another $3 billion to $4 billion from the Arabs. Swiss-based UBS, taking a near $15 billion write-down in subprime mortgages, has gotten an infusion of $10 billion from Singapore.
Bain Capital is partnering with China's Huawei Technologies in a buyout of 3Com, the U.S. company that provides the technology that protects Pentagon computers from Chinese hackers.
This self-indulgent generation has borrowed itself into unpayable debt. Now the folks from whom we borrowed to buy all that oil and all those cars, electronics and clothes are coming to buy the country we inherited. We are prodigal sons, and the day of reckoning approaches.
A Byron Katie aphorism seems particularly apropos here: "I always lose when I fight with reality. But only 100% of the time."
ON SOUND FUNDAMENTAL PRINCIPLES OF (PASSIVE) INVESTMENT
January 17, 2008
To be a successful speculator one needs a statistical edge and a sound approach to managing risk. It is that simple. The edge has to overcome frictional trading costs and taxes as well as better all the competitors that are trying to do to you what you are trying to do to them. Even with an edge that delivers "on average", you will encounter losing streaks. Risk management is required to keep you from losing a fatally large piece of your stake during such streaks.
Most people get mesmerized by all the news and information out there. They overtrade, burdening their results with the large transaction costs thereby incurred. They do not even have an trading methodology worthy of the name. And they tell themselves they are "investing", not realizing they are speculating, writes Michael Rozeff. They come up to the plate with two strikes against them -- maybe three -- before the first pitch has been thrown. The chance of this approach working out in the long run is immeasurably small.
There are many sound approaches to speculating available, e.g., the Benjamin Graham/Warren Buffett fundamental value methodology, or various implementations of the related contrarian/go-where-the-crowd-ain't path. They do not necessarily involve much in the way of trading. Many are actually simple to follow in principle -- too simple for overactive minds. People say they want to make money, but they also want excitement and that sinful but delightful feeling of getting something for nothing. Watch what people do, not what they say.
Michael Rozeff explains what investing is as compared with speculating, and offers some advice for implementing a sound investment plan. It is as good an investment primer short of a book that we have seen in a long while. It sounds pretty dull, which in investing is usually a Good Thing™.
Whenever I write on anything remotely connected to securities, people ask me many questions. Why is M1 flat and gold rising? Should I follow M1 or M2? Why did the Fed discontinue M3? When will the housing market recover? What is a good investment during a recession? They are more than curious. They want to know what to do with their money.
I think that most of these people are making a basic mistake. They are seeking information in an attempt to speculate. I think they would be better off if they became passive investors and left the speculating to speculators (or traders). Most traders lose money.
How should one invest? The textbooks on investing run almost 1,000 pages. Such a mass of material overwhelms and confuses many people. For example, these texts distinguish between active and passive investing. They use the term active investing to avoid using the term speculation. But active investing, which is an attempt to beat the market, is speculation. To my way of thinking, investment is passive investment.
This article provides counsel on investing viewed solely as passive investing. In this way, I answer many of those individuals whose queries I have not answered. Naturally, no matter what I say, it will not be enough.
Investment and speculation in securities are two different things. They require very different fundamental principles. One should not confuse them. The investment and speculation I discuss here both involve placing funds into securities or asset-related securities. That is about all they have in common.
Speculation is an attempt to profit, that is, earn an above-average rate of return, by forecasting the future price movements of specific securities. ... Speculation is a business and a very difficult business. The number of people who make a profit by starting and running businesses is relatively small, especially in lines of business that are highly competitive. Speculation is a highly competitive business. There are very few highly successful people in any field of endeavor. The average person who attempts to speculate is very likely to fail at it. Studies of brokerage and commodity trading accounts show that upwards of 80% of traders who speculate lose money.
The reason for this is that most amateur speculators do not follow sound fundamental principles of speculation. They do not know what these principles are. ...
Whatever the sound fundamental principles of speculation are, they are based upon a knowledge of those factors that provide an accurate guide to future stock price movements. Knowledge always is the basis of true basic principles. You will not find revealed here the fundamental principles of speculation. If you search for them yourself, you will find many competing claims and little evidence to back up most of them.
Warren Buffet has sound principles. His wealth and success prove that. Is Warren Buffet engaging in speculation, investment, or something else? Should we look to what he does in order to find basic principles that we can apply? Buffet is in large measure a businessman. He buys whole companies after meeting the owners and managers. His holding company has a structure for managing these purchased enterprises. This part of Buffet's procedure is not security investment. It is investing in real assets. This is not our subject, which is investing in securities.
Buffet also buys individual securities. His usual strategy is to buy first-rate companies at prices that are at a discount to the values he perceives them to have. Buffet concentrates wealth in a few of these securities that he likes a great deal. This is a variant of what is called value-investing, which ... is actually not investment. It is active investment, which is speculation. ...
One need not be too concerned over this. Properly executed, value-investing is a good way to speculate. My only reason for explaining it and calling it speculation is to steer the average investors toward passive investment and not let them detour to any of these alluring side streets. If you insist on detours, then what you should do is divide your money into two piles. One pile will be for passive investment, the other for speculation. One will be for money you do not want to lose, the other for money you can afford to lose. Keep them absolutely separate and you will have fewer regrets. Mix up the two and you will find yourself getting nowhere as the years pass.
What then is involved in investment? Various states-of-the-world can happen in the future, in fact, an infinite number of possibilities. The investor makes no effort to discern what these will be and which ones are more likely to occur. He makes no attempt to speculate on the future. The first sound fundamental principle of investment is not to speculate in any way, shape, manner, or form. The investor swears off trying to forecast the future. This means he pays no attention to the investment markets, to changing prices, to the news, to economic data, to political events, etc. ... He will not be constantly on edge about the markets. He will not constantly be in a state of confusion wondering why stocks fell when he thinks they should have risen.
An old John Denver song (confession time ...) goes: "Blow up the TV, throw away the papers ..." Good advice for investing, not to mention sanity.
The second sound fundamental principle of investment is to buy and hold a value-weighted, highly diversified or market portfolio. One may rebalance that portfolio on occasion as new securities become available, but low turnover will be a hallmark of a portfolio that is following sound fundamental principles. Investing will be a boring sideline, requiring very little of one's time and effort. One will not be doing much buying and selling, and this will keep both transactions costs and taxes low. The effort will go into finding out what one's asset allocation should be, that is, finding appropriate value-weights and diversifying properly. Diversifying properly means really diversifying. This goes well beyond merely buying the major stock index of one's country.
Those two principles are the main ones that you need to get you into the investment ball game in good shape. A third sound fundamental principle is to start investing as early in life as possible. This means saving and not consuming. It means not going into debt.
If there is one thing that the finance literature shows definitively, it is that diversification pays. ... You may disregard those who laugh at diversification because it is merely average investing. These giants of active investing all claim that by focusing on a few well-chosen securities, they can do far better than average. They are speculating, however. That is for your other pile of money, the money that most people lose. ...
How shall you diversify? Very, very, very broadly; the more broadly the better. There are many asset classes. The ones that provide most of the market value are domestic securities, foreign securities, stocks, bonds, real estate, and real assets. These are the mainstream investments. Stay with them. There are some potentially attractive classes that the average investor will find it difficult to get into, such as venture capital. There are some securities that one should simply avoid, like hedge funds. One may avoid abstruse derivative-based securities.
I will explain next the basic idea. ... The basic idea is to buy a value-weighted market portfolio of these assets. The reason for the value-weighting is as follows. There are many thousands of securities that investors and speculators are valuing. Their valuations are better than yours. They have more information and more money that they are hazarding. You cannot possibly keep up with all the new information and how it affects security values. The market will sometimes be valuing various securities too richly and others too poorly, but you don't know which is which and neither does the market. But it is doing the best that it can, and its valuations are reflecting huge amounts of information that you have no access to or knowledge of. The market's valuations across all these securities are more likely to be accurate than for any one security. If you buy the entire market in value-weighted proportions, you will be mimicking the actions of all investors collectively in all their assessments, using all the available information. You cannot do better than that if you tried. If you try, do so with your speculative pile.
The reason for the market portfolio is that it, by definition, includes every existing security in the world. This gives the maximum diversification and the maximum gain/loss ratio. ... The problem of passive investing comes down to determining appropriate market-value weights and then determining appropriate securities that match the asset classes. Obviously one cannot buy every single security everywhere, so one must find index funds that mimic these assets. The passive investor of today is extremely fortunate! There is an ample number of exchange-traded and mutual funds that provide very low-cost access to a portfolio that approximates the world value-weighted market portfolio.
Harry Browne in his little book Fail-Safe Investing explains and justifies a similar passive investment approach. If it will make you feel more comfortable, read his book. It will supplement what I am saying even though it is saying different things. Browne ends up recommending a four portfolio worry-less investment policy. He has equal proportions in long-term bonds, short-term bonds, gold, and stocks.
No one knows, including me, what the world market portfolio's asset proportions are. You can search the internet as well as I can. I believe that the proportions are roughly 40% real estate, 25%, and 25%. Gold and other real assets such as timber may account for 5–10% of total assets at most. Hence, one might think about a portfolio like 25%, 25%, 40% real estate, and 10%. If one alters these proportions, it will not make much difference.
The main idea is to apply sound fundamental investment principles. They are: do not speculate, and buy and hold a highly diversified value-weighted portfolio. ... Within the relevant categories, one should diversify further. Suppose one has 30% stocks. Find out how much market value that American stocks have compared to foreign stocks. Then adjust the portfolio to those proportions. One might split the portfolio as 20% American stocks and 10% foreign stocks. Similarly, one can diversify the bond and real estate portions over domestic and international securities.
This kind of portfolio will be as worry-free as one can make it. It will have the lowest risk for the highest return. In absolute terms, its return will probably be something like 6–8% a year. The bond and real estate portions will cause its return to be lower than if you held an all-stock portfolio, but the risk will be a lot less. You will not endure the sharp fluctuations that stocks quite often deliver.
The risk of investing is not always easily observed until it is too late and the investor discovers to his dismay, after his stocks or bonds have fallen drastically, that his investment portfolio was risky. I cannot too strongly stress that a highly diversified portfolio of this kind has far lower risk than investing in any single asset class and far, far lower risk than investing in a handful of securities as speculators do. The goal of such a portfolio is to preserve and grow capital, earning an average return, with a minimum of risk.
Some pointers on Passive Investment in the World Market Portfolio
January 24, 2008
Michael Rozeff follows up his excellent article of last week, "On Sound Fundamental Principles of Investment" (above). He argued that one should put one's investment funds, as distinct speculative funds that one can afford to play around with and lose, in a pool of assets that replicates a meta-index of all the world's investable assets -- or the "world market-value weighted portfolio". This is easier said than done, so now he is back with implementation suggestions.
This article ... clarifies some questions and provides more specifics. My goal is, at low cost, to get the average investor into a reasonably sensible investing ballpark. In my view, investors should not be spending very much of their capital paying for portfolio construction or portfolio management services. I have two reasons for saying this. One is that a do-it-yourself approach is feasible. There are many index funds that are easy to buy and sell on exchanges as ETFs using a good discount broker, like Scottrade, or through no-load mutual funds. Second, the fees that many portfolio management services charge are too high. The market bears it because many investors lack financial knowledge.
Investors vary in age, income, occupation, tax status, risk preference, and other personal variables. There is no one investment solution suitable for everyone. But, with adjustment to one's cash position, one portfolio of risky securities can serve surprisingly well to achieve the investment goals of preserving capital, obtaining some growth of capital, and keeping risk to a minimum. That portfolio is the world market-value weighted portfolio.
Suppose W is this world portfolio. Suppose you have money to invest, say $1,000. You can vary the risk of your portfolio by what fraction you place in W and what you keep in short-term liquid securities like Treasury bills or a bank account. A risk-tolerant person might place $1,000 in W and none in T-bills. A person more risk-averse might place $500 in each. The fact is, however, that W has rather low risk. Many people will want to invest most of their investable funds in it.
The proportions that the values of major asset classes have within the world portfolio are suitable for a passive investor to mimic. (He repeats from the previous article the reasons this is a good idea.) ... The world market portfolio is likely to be of moderate risk, and the return it might provide of 7% will seem too low for some. But it will provide the highest return for that level of risk that one is likely to find. ...
Some will want to go for the 9% or more that stocks may deliver. ... [T]his is feasible, but it has added risk because one is undiversifying. It is a form of speculation. The fact that stocks have made 9% or more in the past and outperformed bonds does not mean they will do it in the future. In fact, bonds did as well as stocks in the '80s and '90s as interest rates fell. You could place all your money in stocks and be making 9% for many years. Then suddenly you could run into that rare occasion when stocks decline by 90% and then do not recover for 20 years. Stocks are risky. If you place all your eggs in the stock basket, you are speculating. ... Most of us will do some speculation. I suggest keeping one's speculations separate from one's passive investments. Management of them requires very different knowledge and principles.
So far this a recapitulation and reinforcement of what was expressed in the previous article. The bottom line philosophy is, when you deviate from an asset allocation corresponding to the world portfolio ("W") you are speculating, not investing. This is not bad per se. Just do not fool yourself about what game you are playing. Don't bring a knife to a gun fight.
Now, debt. If you want to build up wealth through investment, you must postpone consumption. You must avoid going into debt to finance consumption. $1,000 invested at 7% doubles in about 10 years. ... If you borrow to buy something, not only will you not see that $16,000, but you will be paying someone else interest. Your wealth will not only not grow, you will be enduring something akin to slavery. You will have sold off the rights to your future income from working. ...
When I speak of real estate investment, I most definitely do not mean your home. You should not consider your home as an investment no matter how economists define the term. It is better to think of it as a consumption item. You are buying a bundle of future housing services when you buy a home. Any price change in it is incidental. ... Unless you intend to specialize in homes as a speculative business, forget it as an investment. ... A home eats money. This is not what you want in an investment.
By real estate, I mean commercial real estate. This includes such things as office buildings, warehouse and commercial space, malls, and apartment rentals. It means that you are the landlord. You collect the rents. Now, you are not going to do this yourself. You will do it by buying shares in companies that own and manage commercial properties. ... [R]eal estate investment trusts provide a stock investment that serves the purpose.
By bonds, I mean corporate bonds. I do not include government bonds in the market portfolio. The market portfolio contains securities behind [it] which are real assets that produce income. Behind corporate bonds are the company assets, which provide net wealth. Behind government bonds are future tax payments that come out of taxpayer income. There is no net wealth in these bonds.
It is difficult to submit to the market's pricing and not have a speculative view of our own. ... If you have strong views about the pricing of some sector and you still want to hold the world portfolio, consider phasing in your investment over time. If you think bonds are too high in price, select some horizon, like 12–18 months. Then gradually buy into the bond market. You will be mixing in a moderate amount of speculation into your investment decision. This may satisfy your urge to act upon your own views.
The world portfolio involves a global asset allocation. Investment results hinge primarily on the asset allocation proportions. Managers that advertise tactical asset allocation are speculating on the pricing of various sectors. Passive investment avoids this. Its asset allocation depends on the market value weights.
I have two different methods to estimate market value weights. Both are rough, but they come out close. If the numbers do not all add up, do not worry about it. I have had several classes look into this over the years, and the results always come out about the same. They are approximate, but good enough for practical purposes. We are not sending a rocket to the moon here.
First, for high net worth investors, who hold most of the world's wealth, these weights in risky securities (disregarding cash assets) are about as follows: 35% in stocks, 24% in bonds, 18% in real estate, 23% in other assets. The other assets include all sorts of real assets like gold, timber, art, and commodities. They include foreign currencies, hedge funds, venture capital, private equity, and managed funds. The average investor will not be concerned with many of these things, but we reserve some allocation for real assets below. If and when these assets prove themselves and can be bought by individual investors at a reasonable fee and if they are diversified, then some part of the portfolio could be allocated to them.
The second method uses all sorts of estimates. ... One estimate places world investable wealth at $123 trillion (including government debt). Starting from $123 trillion, subtract $13 trillion for government bonds. That leaves $110 trillion, of which $32 trillion is bonds, $35 trillion stocks, and $43 trillion is other, mainly real estate. The proportions are: 32% stocks, 29% bonds, 39% real estate and other.
These numbers are close to those found for high net worth investors. It is not worth getting too fussy about all this. If other real assets are 10%, that leaves 29% for real estate, which is $32 trillion. ... The precious metals, art, timber, commodities and such are not as large as one might think in contributing to overall world investable wealth. Without going through an elaborate calculation, they add up to 10% at most. I allocate 10%. That is generous. One might make it 5%.
Putting all this together, I suggest these approximate proportions for the world market portfolio: 35% in stocks, 25% in bonds, 30% in real estate, 10% in gold. Then I suggest dividing the bonds into half domestic and half foreign bonds. The real estate may be divided into 1/3 domestic and 2/3 foreign. However, I could not argue with a 50-50 split. The stocks can be divided as 40% domestic and 60% foreign, based on estimates above. We then have:
This portfolio definitely avoids the "home bias" that is typical of many investors who stick too heavily to their own countries. Furthermore, it leans toward the faster growing and less socialistically constrained corners of the globe.
- 14% U.S. stocks
- 21% foreign stocks
- 12.5% U.S. bonds
- 12.5% foreign bonds
- 10% U.S. real estate
- 20% foreign real estate
- 10% gold
The next step is to choose mutual funds for these categories. I can do that in many ways. Whatever selections I might make will be merely suggestive. I have not done a thorough study of all the available indexes and what they contain. I have not broken down the above classes into finer categories. There is a great deal I have not done. It is not clear that it pays to do a great deal more. This is where you can do your homework. You also can subdivide some of the categories still further if you like. My job is done. I have shown you what the passive investing ball game is about.
Mr. Rozeff proceeds to suggest, but not necessarily recommend, various Vanguard -- renowned for its low fund management costs -- funds and ETFs for stocks, bonds, and real estate, both foreign and domestic.
In sum, with about 6 mutual funds and/or ETFs in the proportions suggested, plus a commitment in gold, one can attain an overall portfolio that will be about as worry-free as one can make it. Not only has one diversified very well across sectors and the world, but also within each fund are hundreds and sometimes thousands of securities. Your bet is on the world economy. You cannot make it any more basic than that. You are not speculating on any individual sector, country, company, or type of security. You are so well diversified that a catastrophe in one area should leave you almost unscathed. If the world survives and grows, you will earn a normal rate of return on your investment.
There will be taxes to pay. This is very disturbing. Having paid taxes on your income, you will then pay taxes on what you save. When you die, there will be more taxes. You will wonder why you bothered building up wealth. The government encourages us to be wastrels. It is a wonder that some of us still save. In America, the official saving rate is zero or negative.
Perhaps your best investment is in travel. You can find another place in the world to live, one that does not tax investments the way the U.S.A. does.
FOREIGNERS TURN AWAY FROM JAPANESE STOCK MARKET
January 15, 2008
But is now the time to be thinking of getting in?
"Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it." ~~ Will Rogers
Japan has tried using hyper-aggressive fiscal and monetary stimulus to reverse the stagnation that set in following the popping of the property/stock market bubble in 1989, to no avail. In many ways, the government's policy has been in line with the advice of those who thought they had figured out where policy went wrong during the 1930s. But 19 years after the Crash of 1929 it was 1948. The U.S. was at the beginning of a massive (and relatively sound) economic boom, despite having blown up a good deal of wealth during the War. No sign of an impending boom in Japan, even without the major war. What gives?
It looks to us that in trying to avoid the pain of coming clean about the malinvestments made during the boom, Japan has also avoided the necessary adjustments that would enable it to move on. For example, regulators allow banks to avoid writing down bad loans, with the result that the banks have no capital to fund truly viable projects. Now Tokyo Stock Exchange president Atsushi Saito has dropped a dime on the regulations the keep the exchange an also-ran among major world financial centers, and that hurt company profitability and stifle needed rationalizations:
Over the past month, Saito has been sending out blunt messages to his constituents and to the Government about the urgent need for deregulation.
Noting that only Italy's stock market among the 30 OECD economies performed worst last year, he told the Nikkei Financial Daily last weekend: "Japan at the moment is not a place where overseas investors are willing to invest.
"Government regulations and court rulings regarding hostile takeover bids prompted many foreign companies to leave the country last year. The Japanese Government and the financial industry want to turn Tokyo into an international financial center, but it has all been talk so far, with few concrete actions taken."
Last year, the Nikkei 225 index lost 11.1%, when even Wall Street managed 6.4% growth. ... Trading by foreign institutions and funds (which appears also to include Japanese funds domiciled abroad) last year accounted for two thirds of the ¥907 trillion combined turnover of Tokyo and the two smaller exchanges, Osaka and Nagoya.
In [the second half of 2007], the Tokyo market shed 15.6%, principally because for the first 6-month period in the market's 5-year recovery, foreigners became net sellers. Large international funds that have the discretion ... have become significantly [underweighted in] Japanese securities against the benchmark MSCI index.
This is despite the Nikkei 225 selling about 15 times forward earnings, very low by historical levels, while profitability continues to strengthen, though growth is likely to ease this year.
The relative cheapness of the Japanese stock market is intriguing. It is one of the few markets where speculative juices did not run rampant last year.
The average 1.6% dividend yield for the entire TSE first section, 1747 companies, now exceeds the 10-year bond rate (1.45%). This crossover is generally considered one of the strongest buy signals for Japanese equities but so far it goes unheeded. Given the profitability of leading companies, given that the sub-prime mess has barely affected the Japanese banking sector, and given Japanese markets' liquidity and depth, the question for policymakers is why Japan has not become a safe haven in the turmoil since August.
An astounding statistic from financial market history is that in the late 1940s, as the great post-War bull market in U.S. stocks was just getting underway, blue chip stock dividend yields were greater than government bond yields. You got partial inflation indexing and a lien on the companies' growth for less than nothing. It indicated the low regard in which stocks were held -- and thus was a great, low-risk opportunity to buy -- and the extreme risk aversion of the day. That the same phenomenon is showing up in Japan is certainly food for thought.
And why, in fact, foreign funds and institutional investors that have piled into Japan for five year -- soaking up heavy domestic selling most of that time -- are now looking elsewhere. ...
Saito does not accept the conventional explanations of a prospective U.S. recession, higher oil prices, the deleterious effects of an appreciating yen on exporters and persistent deflation in the domestic economy.
Not entirely anyway. Though he spent most of his career with Nomura Securities, Saito's last job was in charge of the Industrial Revitalization Corp. of Japan. He spent those four years confronting the consequences of Bubble-era hubris, and particularly of the commercial banking system's inability to change course, even on the brink of collapse.
A business leader who recognizes what has gone wrong. Hopefully a favorable portent.
Saito argues that the opportunity remains for Tokyo's financial services to become a driving force for the domestic economy, and the supreme Asian financial center -- which, unlike his predecessors, he acknowledges it cannot now claim to be against competition from Hong Kong, Singapore, Shangahi, Sydney and even Shenzen.
If that became the case, however, he thinks Japan's financial sector workforce would be closer to London's 7 million than the current 2.7 million.
To that end, Saito's hopes are pinned on legislative approval early this year and rapid implementation of a market liberalization blueprint agreed between the TSE, the Financial Services Authority and the Economy Trade and Industry ministry. ...
The enabling legislation for these reforms is not yet before the Diet and the current fissile political situation is no guarantee it will pass unmolested through the governing parties, let alone the opposition-controlled Upper House.
As Saito has been arguing, the reforms required to make Japanese markets attractive again to international investors and companies also call for a profound change in Japanese official mindsets.
Intriguing characteristics of Japan and its stock market include, but are not limited to:
Will Japan ever escape a system seemingly designed by the Red Queen in Through the Looking Glass, who proclaimed "jam tomorrow and jam yesterday -- but never jam today"?* It certainly bears close watching.
AMERICA -- A BANKRUPT EMPIRE
January 25, 2008
Financial instability rooted in economic "blowback" from our disastrous foreign policy.
The headline subject has been treated extensively by many others than Justin Raimondo of Antiwar.com. But you can depend on an informative and contextually comprehensive treatment of most any subject from Justin, and usually not be disappointed. In addition to being the editorial director of Antiwar.com, he is the author of An Enemy of the State: The Life of Murray N. Rothbard (2000), among other books.
The "disastrous foreign policy" in the sub-headline is actually more. It is rooted in the theory, "military Keynesianism", is that we can have guns and butter both without damaging the economy. Crazier still is the coincident assumption that the government needed to stimulate the consumption of both to avoid another depression -- in turn derived from the false theory that World War II had pulled America out of the Great Depression.
As the stock market gyrates, and Federal Reserve Board meets by videoconference to inject emergency funds into the system, Chalmers Johnson's warning that the U.S. empire is not sustainable -- that "this is the way empires end" -- resonates rather ominously.
Johnson, whose most recent book is Nemesis: The Last Days of the American Republic, the third volume in his "Blowback" trilogy, argues that military expenditures are a drain on the productive capacity of the economy, and that the mistaken idea of what he calls "military Keynesianism" will eventually be our economic undoing. The U.S. economy, he avers, has become increasingly dominated by what President Dwight Eisenhower dubbed the "military-industrial complex." Rampant militarism has diverted vital resources away from productive use and lines of research, and given other countries -- Japan and the EU -- the technological edge. This trend has also hollowed out our economic base, caused a debilitating decay in the physical infrastructure, and led to a growing debt -- that is an economic time-bomb that seems to be exploding ... now.
The idea that diverting a large portion of the economy into manufacturing and servicing things that you then blow up leads to a decrease in economic well-being is plain common sense. But common sense is sorely lacking in the U.S., and you still have lots of people believing the military spending "stimulates" the economy.
How many Americans realize the U.S. military budget is greater than that of the rest of the world combined? This does not include our "off-budget" expenditures in the Iraqi and Afghan theaters, which surpass the combined military budgets of Russia and China. For the first time, the bill for the "defense" of the U.S. -- a task left to the Department of Homeland Security, not the Defense Department -- exceeds $1 trillion. And that is just what is public: the secret "black budget" costs are unknown, and on this score Johnson advises us to heed economist Robert Higgs, who advises us to take any official Pentagon figures and simply double them.
Empires are expensive, and the American version has a peculiarly altruistic twist to it, in that, as Garet Garrett remarked, "everything goes out, and nothing comes in." We have financed it all with deficit spending, and rather than impose direct taxation -- always a risky proposition -- the powers that be have simply set the printing presses of the Federal Reserve on overdrive, creating a huge bubble that is about to pop. As Chalmers Johnson points out, the whole system is financed by massive borrowing ...
Just as the worldwide Islamist insurgency sparked by Al Qaeda is blowback visited on us by the exigencies of the cold war era, so what we are experiencing, today, is economic blowback from our reigning ideology of military Keynesianism, which has built an economy embedded with a fatal flaw.
In the wake of World War II, the fear of another great depression was rife, and this was a motivating factor in the growth of the "defense" sector -- neatly rationalized, as Johnson points out, by the Pentagon's NSC-68, a document outlining U.S. strategic doctrine authored by Paul Nitze, which proclaimed the cold war dogma of "guns and butter":
"One of the most significant lessons of our World War II experience was that the American economy, when it operates at a level approaching full efficiency, can provide enormous resources for purposes other than civilian consumption while simultaneously providing a high standard of living."
Except it was not, and is not, so.
Public works, in the form of ever-higher military spending, created an ever-expanding war-industry that sucked vital resources into avenues that led to a cul de sac, i.e., that had no productive use, such as nuclear bombs. Our mighty nuclear arsenal, which continues to expand even after the Soviet meltdown, represents trillions of dollars in frozen resources which go nowhere -- that is, which produce no goods, and yield no continuing economic benefits. This has led to the fatal distortion of the American economy, and the massive misallocation of scarce resources: it is the root cause of the collapse of the U.S. manufacturing sector. As Johnson puts it:
"Over time, a commitment to both guns and butter has proven an unstable configuration. Military industries crowd out the civilian economy and lead to severe economic weaknesses. Devotion to military Keynesianism is, in fact, a form of slow economic suicide."
Not only has America fallen behind by failing to modernize its capital assets and losing its technological edge, it has also corrupted its own currency. By exponentially expanding credit, the Federal Reserve is weighing down future generations with an unprecedented albatross of debt. The sheer weight is crushing the vitality out of the American economy, as military development crowds other investments out of the market. The dollar is no longer the currency of choice: the euro has taken its place. All that has to happen, as Johnson points out ... is for the Saudis and other oil-producers to demand euros instead of dollars, and we are sunk.
What is likely to stop the rise of the American empire dead in its tracks is not a sudden upsurge in the antiwar movement, the election of a rational President, and/or a sudden radical reversal by the policymaking elite after more than half a century of folly -- it is bankruptcy that will do it, long before any of these possibilities have a chance to take shape.
Not that this is anything to anticipate with glee: It means social and political disruption on a scale we have scarcely experienced before in this country, perhaps even a revolution. It surely means the end of our republican form of government, and the institution of something less free, less secure, less faithful to the teachings and traditions of the Founders. It almost certainly means the end of constitutional government in America, and the beginning of our long, slow decline -- or, perhaps, a more dramatic, meteoric descent than anyone now imagines.
The would-be "rational" President is, of course, Ron Paul. He is the only one who even acknowledges the problem, never mind proposes solutions that address the problem. Assuming he fails to get elected -- and perhaps even if he does -- it would appear American is doomed to reenact to collapse of the Soviet Union. Get some of your assets out of reach now, lest they be part of the compensation paid to America's creditors.
HOW FREE IS THE "FREE MARKET"?
January 22, 2008
Imagine watching some TV show, DCPD Blue perhaps. The show episode leads off with a murder, and a suspect with a smoking gun in his hand is apprehended near the scene of the crime. A ballistics test shows the gun fired the fatal bullets. No one else's fingerprints are on the gun handle but the suspect's. His fingerprints are found on the bullets too. The suspect then claims ... he was framed! He accuses one Mr. X, who was not even in town when the murder happened, of being the one who did the dastardly deed. The detectives and cops then spend the rest of the episode investigating Mr. X. They rough him up and tell him he must have done it, and no confession is even necessary. The show concludes with the revelation that Mr. X did indeed do it, but without explaining how. Nor is it explained why the evidence pointing to the original suspect was misleading.
Question: How interesting and credible would this plot be? (More than most TV fare, but we digress ...) Yet, substitute in government for the suspect, the free market for Mr. X, and for the detectives and cops substitute government and its media and academic acolytes and concubines, and you have exactly this movie plot. Jeffrey A. Tucker explains:
See if you can spot anything wrong with the following claim, a version of which seems to appear in a book, magazine, or newspaper every few weeks for as long as I have been reading public commentary on economic matters:
"The dominant idea guiding economic policy in the United States and much of the globe has been that the market is unfailingly wise ... But lately, a striking unease with market forces has entered the conversation. The world confronts problems of staggering complexity and consequence, from a shortage of credit following the mortgage meltdown, to the threat of global warming. Regulation ... is suddenly being demanded from unexpected places."
Now, a paragraph like this one printed in the New York Times opinion section on December 30, 2007 -- an article called "The Free Market: A False Idol After All?" -- makes anyone versed in economic history crazy with frustration. Just about every word is misleading in several ways, and yet some version of this scenario appears as the basis of vast amounts of punditry.
The argument goes like this: Until now we have lived in a world of laissez-faire capitalism, with government and policy intellectuals convinced that the market should rule no matter what. Recent events, however, have underscored the limitations of this dog-eat-dog system, and reveal that simplistic ideology is no match for a complex world. Therefore, government, responding to public demand that something be done, has cautiously decided to reign in greed, force us all to grow up, and see the need for a mixed economy.
All three claims are wrong. We live in the 100th year of a heavily regulated economy; and even 50 years before that, the government was strongly involved in regulating trade.
The planning apparatus established for World War I set wages and prices, monopolized monetary policy in the Federal Reserve, presumed first ownership over all earnings through the income tax, presumed to know how vertically and horizontally integrated businesses ought to be, and prohibited the creation of intergenerational dynasties through the death tax.
That planning apparatus did not disappear but lay dormant temporarily, awaiting FDR, who turned that machinery to all-around planning during the 1930s, the upshot of which was to delay recovery from the 1929 crash until after the war.
Just how draconian the intervention is ebbs and flows from decade to decade, but the reality of the long-term trend is undeniable: more taxes, more regulation, more bureaucracies, more regimentation, more public ownership, and ever less autonomy for private decision-making. The federal budget is nearly $3 trillion per year, which is three times what it was in Reagan's second term. Just since Bush has been in office, federal intervention in every area of our lives has exploded, from the nationalization of airline security to the heavy regulation of the medical sector to the centralized control of education.
With "free markets" like this, who needs socialism?
So, the first assumption that we live in a free-market world is simply not true. In fact, it is sheer fantasy. How is it that journalists can continually get away with asserting that the fantasy is true? How can informed writers continue to fob off on us the idea that we live in a laissez-faire world that can only be improved by just a bit of public tinkering?
The reason is that most of our daily experience in life is not with the Department of Labor or Interior or Education or Justice. It is with Home Depot, McDonald's, Kroger, and Pizza Hut. Our lives are spent dealing with the commercial sector mostly, because it is visible and accessible, whereas the depredations of the state are mostly abstract, and its destructive effects mostly unseen. We do not see the inventions left on the shelf, the products not imported due to quotas, the people not working because of minimum wage laws, etc.
Because of this, we are tempted to believe the unbelievable, namely that government serves the function only of a night watchman. And only by believing in such a fantasy can we possibly believe the second assumption, which is that the problems of our society are due the to the market economy, not to the government that has intervened in the market economy.
The abstract nature of the state's depredations might explain why the average citizen is gulled/lulled into the naive view. But there is absolutely no excuse for academics and other so-called scholars, never mind for the policy makers who actually legislate or execute the interventions, believing the fantasy. And it appears that some really do believe, e.g., Paul Krugman in the New York Times among others. Kevin Gutzman wrote in The Politicially Incorrect Guide to the Constitution that something in the typical intellectual finds the idea of the philosopher king appealing. And once installed in the position, they believe their own press releases.
Tucker procedes to explain how the current housing crisis has government's fingerprints all over it, top to bottom. And also how the very idea that government intervention is an effective, never mind efficient and humane, approach to solving complex problems is a nonstarter: "Anyone who has experience with public-sector bureaucracies knows that they cannot do anything as well as markets."
In one respect, the New York Times is right: there is always a demand for economic intervention. The government never minds having more power, and is always prepared to paper over the problems it creates. An economy not bludgeoned by powerful elites is the ideal we should seek, even if it has a name that is wildly unpopular: capitalism.
Those who directly benefit from intervention would naturally be expected to support and rationalize the intervention. More surprising is the wide support it enjoys by those it actually hurts. It goes beyond ignorance, to an unquestioned faith in the beneficence of government and the maleficence of the free market. It brings to mind the Kierkegaard quote that "People demand freedom of speech as a compensation for the freedom of thought which they seldom use."
IS REAL ESTATE A GOOD HEDGE AGAINST HYPERINFLATION?
January 30, 2008
A hard asset such as real estate is a potential hedge during an expected increase in inflation. But is housing really the right place to hedge your bets? Dr. Krassimir Petrov of the American University in Bulgaria, writing in Whiskey & Gunpowder, offers his thoughts.
As the markets continue bucking wildly, and the Fed slashing rates with more cuts to come, we can expect more volatility with our currency. The U.S. will likely spin into a long era of high inflation. The coming years will look like the 1970s. There is also a good risk of hyperinflation, which is a particularly severe bout of high inflation. Thus, the vital question for every investor is how to hedge, or protect, your wealth against inflation. Some, especially realtors, urge to hedge this risk with real estate. So should we really hedge with real estate?
To answer this, we need to consider two closely linked topics. First, what is an inflation hedge? Second, what makes a good inflation hedge? The first answer is simple. An inflation hedge is an asset that loses little value in periods of rising prices. Thus, it holds its value and purchasing power during inflation. This also applies to hyperinflation. An investor expecting inflation will buy this asset to hedge against inflation.
The answer to the second question requires understanding of the two basic types of assets: real assets and financial assets. Real assets have intrinsic value. They have value of their own. People value them for their direct or indirect usefulness. Examples include books, TVs, cars, wheat, gold, real estate, land, etc.
Financial assets, on the other hand, are a claim on the income or wealth of a firm, family or the government. Their typical form is a certificate or a receipt. Examples include paper money, stocks, bonds, mortgages and ETFs. All money market and capital market instruments serve as examples.
In general, real assets hedge better than paper assets. By definition, real assets have a value of their own. Inflation does not erode their value. Thus, any real asset can be an inflation hedge. It follows that real estate is also a hedge -- but it is not the best.
Good hedges have a few key properties. We mention here only four. One key property of a hedge is that it holds its value. It should lose little value over time. Cars and eggs lose value over time. Land, silver and wine do not.
Another key property is marketability. This means that it is easy to sell. Other people will easily take it for payment. Hence, it is good for barter. Chairs and clothes do not sell. Corn and gold do.
A third key property is divisibility. This means that the asset splits into smaller parts without a loss of value. Houses, cars and cows are not divisible. Rice, wine, gas and gold are.
The last key property is financing. It is vital. Experts prefer to fully ignore it. Investors buy assets with either cash or credit. Cash-based hedges are good. Credit-based hedges are bad. History repeatedly shows that assets bought on credit are prone to speculation and bubbles. The hedge might be already overvalued. In this case, investors should avoid it. Credit clearly drives real estate. Moreover, real estate recently went through a wild bubble. It is grossly expensive, so a poor hedge.
The verdict is clear. Real estate is a hedge, but a poor one. It fails all of the above four tests. On the other hand, gold is a far superior hedge. Gold aces all the tests of a good hedge. That is why it is the ultimate inflation hedge. Better yet, now gold is cheap, while real estate is dear. Thus, as a hedge, gold handily beats real estate.
This refers to real estate as a general class, as opposed to any specific property. Farm land, e.g., might rise along with food prices during an inflation. This is still a speculation within the real estate asset class -- just as one might bet that certain stocks will rise in the face of a bear market.
These pages often highlight articles extolling the merits of real estate in different countries around the world. Investing in property in those countries may well provide some hedge against inflation. An additional virtue would be the moving of some of your capital out of your home country. You may also have personal reasons for making an investment in offshore real estate, such as that you are planning to eventually expatriate and the opportunity is available now. But the point remains that if the primary goal is to hedge against inflation, there are better ways to accomplish this than real estate.
Real estate bought with cash, free and clear of any debt, might be a poor hedge, but it is nevertheless a hedge. It will protect the value of your money. It is not as good a hedge as gold, but it will do the job. However, we emphasize that real estate bought on credit (with a mortgage) creates substantial new risks to the investor. It is possible to hedge one risk by assuming another, but not recommended.
So what are the risks, or traps, associated with leveraged real estate? We mention here four. First, we could be wrong! What if prices actually fall -- or you have what people commonly call a deflation? Deflation kills those who borrowed to hedge with real estate, because it makes those debts more difficult to pay. Even worse, deflation triggers recession, unemployment and falling income. Similarly to what happened during the Great Depression and to Japan during the 1990s, deflation results in massive foreclosures and business failures.
Another trap for leveraged real estate is that the possibility of another credit crunch might spook the market. We saw this in February; we saw it again in August. Real estate was no place to hide then. The third trap concerns how investors finance real estate. An ARM, or adjustable rate mortgage, can be a risky way to finance. Rising prices drive interest rates higher. Mortgage rates may rise from modest a 3-4% to 12-15%. This actually happened during the 1970s. Thus, monthly payments could easily triple. Obvious, yet millions of Americans fell for it once again in the early 2000s. Sure, they fell driven by greed. Still, many hedgers are oblivious to this.
The last trap is by far the most insidious, for it is the hardest to see. Inflation overwhelms the borrower; it eats him alive. Before long, food prices double, gas doubles, electricity doubles; prices of all the basic needs double in short order. Yet salaries do not; they lag far behind prices. Oftentimes, as in the 1970s, salaries lag many years behind. Similarly, prices of basic goods, such as food and energy, have more than doubled since 2002. Eventually, there comes the time that after paying for your basic needs, there is not enough left to pay the mortgage. ...
Thus, leveraged real estate is not only a poor hedge against inflation, but also a very risky one. However, if you must hedge, then hedge with gold, not with real estate.
GERMANY’S STABLE ECONOMY
January 30, 2008
Many perceive Germany as a stodgy welfare state. How justified is this unflattering reputation? Antony Mueller, writing in Whiskey & Gunpowder, explains a thing or two about Germany.
Maybe you have heard about Germany as the sick man of Europe. You may also have heard that the German economy is paralyzed by a web of strict labor laws. In contrast, you may have heard less or nothing at all in the news that Germany has been the world's export champion for the third time in a row -- exporting more goods than China, or Japan, or the U.S. Private financial wealth in Germany rose to a new high in 2007. Employment is on the rise. No wonder the German stock market has been a top performer in recent years.
I lived in Germany for much of my life and I can assure you that the Germans are very self-critical. Unless it is the very best, it cannot be good. As long as there is room for improvement things deserve to be criticized. I recommend that in order to get a correct picture of Germany, do not listen to what Germans say about their economy; they are consistently negative. Also, do not read German newspapers to learn about the German economy; they are always pessimistic. To get a more accurate picture, check the economic stats and compare them with stats from other countries.
It is true that after the end of the European unification boom in the late 1990s, the German economy experienced malaise until 2003. The high cost of unification put a huge burden on the people. Domestic demand was weak. Yet in these years of slow growth, German companies did their homework. Today, the German industrial sector is at the top of the world when it comes to modern capital equipment. Infrastructure in East Germany has been has been brought up to Western standards.
That is a credible accomplishment. At the time some characterized the reunification as the West doing an LBO of the whole East. The difference is that instead having to pay down debt as quickly as possible as in a normal LBO, the West had to hastily modernize the capital stock of the East.
German carmakers are household names. So are chemical and electronics multinationals like BASF and Siemens. But these large companies represent only a part of the German economy; mid-sized companies are its backbone. These companies possess very specialized technological know-how. They are extremely competitive and industrial companies all over the world seek their products. ...
Many of these so-called "Mittelstand" companies produce tangible capital equipment. Linked together by a well-established network of cooperation, they are capable of executing large-scale projects -- including the planning and construction of whole factories.
The competitive position of "Mittelstand" companies helps them cope with cost increases. Currency appreciation does not hurt them as much as it hurts most other export-oriented companies. The recent strength of the euro has barely affected demand for the products of these companies. This was also the case in the past when the German mark was in a decade-long uptrend.
The German economy will continue to profit from the investment boom in emerging economies. Demand from Asia is only part of the story. German companies are in a leading position when it comes to infrastructure projects in Eastern Europe, Russia, and the Former Soviet Union. Oil rich countries are showing little price sensitivity in their capital equipment orders from Germany. Demand from the Middle East and elsewhere is so high that the order books of many German capital equipment producers are full for years to come.
For these German mid-size companies, a quick hire and fire system is out of the ordinary. Intensive in-house employee training provides the specialization these companies need. Company loyalty is relatively high. Performance hinges on a culture of trust that runs from the top to the bottom.
Nevertheless, structural problems plague the German economy. The welfare state is overextended and the population is ageing. There is a shortage of young engineers. Social contributions and taxes are high. The steep cost of labor has driven German companies to invest in technology and equipment that enhance worker productivity. Like the U.S., the market for specialized German labor is tight. German unemployment may be relatively high, but it mainly affects less skilled workers.
An ageing population limits the chance that Germany will experience a new "economic miracle." Domestic demand should remain relatively soft. And most economists think Germany is too dependent on exports. Yet they seem to ignore the worldwide appeal of German exports. ... In the eyes of foreign multinational companies, Germany has even regained its position as an attractive place to build manufacturing plants. ...
Unlike the U.S. and a few other European countries, a housing bust does not plague Germany. In fact, it had a short housing boom immediately after unification. Since the late 1990s, German real estate has been flat. Some observers criticize Germany for its stagnant domestic consumption. But this was actually a blessing in disguise. Resisting the temptation to artificially stimulate the economy, the government opted for structural reforms instead. ...
Economics pointy-heads are prone to advising high savings rate countries that they really should consume more. Such countries -- China, e.g. -- are further advised to engage in "financial innovation", such as vehicles for making loans that will not be paid back, in order to fill in that consumption gap. Germany no doubt has a rich assortment of public policies that are unnecessarily hindering of the citizenry's welfare, but the idea that high savings -- which provided the source funding for the country's world-leading capital goods industry -- and "stagnant" consumption is a "problem" is preposterous. And now that all the economies that artificially stimulated consumption are on the verge of reaping the whirlwind, Germany's stodginess suddenly looks attractive.
Bank credit and the stock market are not as important to the German economy as they are to the U.S. The fallout from the current credit squeeze should not have much effect on German industrial companies. The same holds for a stock market decline. Among the major industrialized countries, Germany's economy may be the best equipped to weather the coming storms.
Even if the U.S. officially enters recession, the global economy will not stop in its tracks. The BRICs (Brazil, Russia, India, and China) in particular have a lot of cash to spend. These countries have clear plans to modernize their infrastructure and make their factories more efficient. One major area of investment in these countries will be in environmental protection. German companies are world leaders in the area of environmental technology ...
The German stock market, measured by the DAX index, performed well in 2007. This index rose more than 20% even as the euro gained 10% against the U.S. dollar. ... So while things may seem bad here, do not believe that they are all going wrong for everyone. The Germans might not be the most chipper people in the world, but don't let their pessimism fool you, things in Germany are all right.
The chart of the German DAX Composite stock market index accompanying this article showed the index rose from about 4400 at the beginning of 2005 to a little over 7800 at the time of the writing -- a 75%+ rise in 3 years.
MAURITIUS’S NEW BUSINESS FACILITATION ACT GOOD FOR INDIAN IMMIGRANTS
January 30, 2008
There has been a long-running pas de deux between India and Mauritius over the double tax avoidance treaty between them. Tiny Mauritius wants whatever will bring in jobs and revenues. India wants to prevent Indian companies from rerouting otherwise purely domestic profits through Mauritius in order to reduce their taxes. A fairly standard plot line. This news item concerns a related but distinct issue.
Mauritius's dealings with India have evidently given it a taste for the offshore "tax haven" business. They want more. A new 15% flat tax rate for companies is an upshot. Having attracted companies and jobs, just how easy is it for an employee to relocate to Mauritius. Very easy, it turns out:
India's double tax avoidance treaty with Mauritius may be causing sleepless nights for both tax authorities and businesses, but for different reasons. However, the new business facilitation Act that Mauritius has implemented will go a long way in helping individuals and businesses from India in setting up shop or moving to the island nation.
The deputy prime minister and minister of finance and economic development of Mauritius, Mr. Ram Krishnan Sithanen, who was recently in Delhi along with the Mauritius Prime Minister Navinchandra Ramagoolamm's delegation for the Pravasi Bharatiya Divas 2008, made a strong case for investments in the infrastructure sector in Africa from India, which could be routed through joint ventures in Mauritius.
Mr. Sithanen highlighted the business facilitation Act as a step towards making Mauritius a globally competitive nation. ... "Mauritius is becoming one of the lowest tax jurisdictions in the world, with a 15% flat rate which will give our enterprises an important competitive edge," he [said].
Under the new Act, Mauritius has made it much simpler for expatriates to work and live in the country. A new category of occupational permit combines the old work and residence permits into a single document. To apply for occupation permits, investors have to generate an annual turnover of more than $100,000 while professionals need to have jobs with a salary of around $1000 per month.
Self-employed individuals need to generate an annual income of $20,000 a year. Applications for occupation permits have to be submitted to the board of investment (BOI) in Mauritius, which will help the qualifying candidates to secure an occupation permit for themselves and residence permits for a spouse and dependents.
Any firm can apply through BOI for an occupation permit for any foreign employee it pays more than $1,000 a month and a residence permit for the spouse and children of that employee. An important feature of the new Act is that a non-citizen retiree, providing evidence that he/she will bring in at least $40,000 annually, can also apply through BOI for a residence permit.
However, he or she will have to provide a bank guarantee of $2,000. The same will apply to self-employed professionals. All foreigners applying for occupation or residence permits have been allowed to provide health certificates issued by any accredited doctor in Mauritius instead of a health clearance only from government hospitals.
Significantly, the occupation permits for investors and professionals and residence permits for their dependents will be issued within three working days. In a fast-track procedure, BOI will forward the applications within one working day to the immigration department, which will provide a document acknowledging the date and time of application.
If after two working days the immigration department has not raised any objection, the document will automatically become an occupation and residence permit valid for three years from the stamped date, in line with the silent agreement principle.
This kind of guarantee from a private sector business is routine, but it is startling to see a government agency provide the same. Anyone for working in or retiring to Mauritius?
LEARNING TO BE A VALUE INVESTOR
January 30, 2008
An offbeat introduction to the concept of value investing:
Marty Whitman of the Third Avenue Value Fund is one of my favorite investors. With any luck, he will be one of my wife's, as well. My wife, like Marty, loves to buy things cheap. And she is not afraid to haggle.
It is not uncommon for me to sit on a mall bench with a book while she peruses store to store, negotiating a discount. "You'll be so proud," she says on a routine stop to my home base. "Neiman Marcus has a stunning Monique Lhuillier dress for half price, and I convinced the lady to take off another 10%."
I, of course, say to myself (and let me stress myself) that 50% off at Neiman Marcus is still 50% more than at most places. But my thought more often than not remains, well, just a thought. "What's the intrinsic value?" I ask.
My wife tilts her head, raises those eyebrows and without hesitation assures me it is more than the price. "And furthermore," in a tone that assures me the discussion ends here, "it's Saturday. Leave the finance downtown."
I chuckle. So goes the wonderful cadence of marriage.
My obsession with intrinsic value got her thinking. The other night, she opened up her brokerage statement. A few minutes later, she says, "Why does my broker have me in Apple? I thought you said Apple was too expensive."
"Maybe he likes iPods," I muse. She fails to find the humor.
"Seriously, Apple's price-to-earnings ratio is well above 30. That's expensive, right?"
"You should see the price-to-book," I quip, trying to focus on the latest episode of The Wire. She grabs the remote and pushes pause. We walk to the bookcase. 30 minutes later, I find my wife 10 pages deep into Christopher Browne's latest work, The Little Book of Value Investing.
It has been three days now. Last night, she started reading an advance copy of Chris Mayer's latest book, Invest Like a Dealmaker. So the first thing this morning -- and I mean first thing -- she asks, "How do you compare EBITDAs around various industries?" Not your typical teeth-brushing conversation, but nonetheless, I am very proud.
She has what it takes. She focuses on what she may lose well before she considers what she may gain. She sees the business, not the stock. ... So this morning, I sent her a recent letter from Third Avenue Management. ...
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