Ponzi finance, government style!

My wife is beginning to dread it when I talk about the economy (perhaps I’m being over-generous in saying “beginning”…).  This past week, I even dragged my dear sister down into the muck.  Now, poor reader, it’s your turn.

Government finances are looking more and more scary to me.  I was reminded of this recently when recalling much of what I read about housing finance in 2003-2005 (yes, I was that early…and no, I didn’t make any money betting against it…).

In particular, I remembered the intellectual framework of one Hyman Minsky, a great economist most people have never heard about.  His “Financial Instability Hypothesis” was frequently quoted with respect to subprime home loans.

In general, he said there are three types of lending, one following the other.  As lenders proceed from one financial crisis to the next, they walk farther and farther out on the risk limb until they fall off.  Then, they start all over again.  Silly, isn’t it?

The first type of lending he called “hedge finance.”  This is lending where the bank expects to be repaid both interest and principal.  Seems infinitely prudent, huh?  It is.  But, when it works well for some time, financiers move out the risk limb.

Next comes what Minsky called “speculative finance.”  This is where the lender expects to be paid interest, but not all the principal.  Does that sound imprudent to you?  It may, but it’s quite common.  If you’ve ever paid 20% interest on a loan or credit card, you’ve participated in speculative finance.  Banks charge that high interest rate because they don’t expect you (or someone else offered the same loan) to fully repay the principal.  The high interest rate allows them to still make money even without full principal payment.  This is very profitable business in good times, which leads lenders farther out the limb.

The final phase is called “Ponzi finance.”  This is where the lender expects neither full interest nor principal payment.  It only works as long as asset prices are rising, as was the case with the housing market, or as long as a “greater fool” can be found to buy the loan from the lender, also the case with housing.  This is the phase that ends in tears.

Which, brings me back to government debt.  A long time ago, the developed economies of the world went from hedge financing to speculative financing.  They did this when they decided never to repay their debts, but simply to roll them over (which means using a new loan to pay off the old one) each time they come due.

Because governments don’t die like people do, they can–in theory–keep rolling their debts over forever.  In practice, every government dies and every single one has defaulted at some point.  If they haven’t, yet, it’s only a matter of time.  If you don’t believe me, see the excellent work of Niall Ferguson, and Carmen Reinhart and Kenneth Rogoff.

Just like home loans progressed from speculative to Ponzi finance, I believe government debt is walking out the same limb, too.  This struck me most profoundly this week because of two data points.

The first was when I read that U.S. mutual fund investors were putting 6 times as much money into bond funds as they were putting into stock funds.  At the same time, any poll you read will tell you that the very same investors openly acknowledge that U.S. debt levels are a major problem and that they are skeptical the debt can be repaid.  If people are investing in debt they think is bad, they are not expecting principal and interest–they are expecting a greater fool to buy their bonds at a higher price!  That, my friends, is Ponzi finance.

The second data point comes from very smart, professional investors who support the deflation premise.  Most such investors openly acknowledge that U.S. debt problems are almost insurmountable, but that they are investing in U.S. debt because they believe deflation will happen and that they can make money as U.S. debt prices rise (in deflationary times, people seek the same safe havens, like U.S. debt, thus driving up the price).  Such investors aren’t saying they expect to hold that debt long term–they doubt that interest and principal will be repaid!  They are overtly expecting to offload such “investments” on other dumb investors.  Ponzi finance!

Like the housing market, this is likely to end in tears.  The problem is getting the timing right (as it was with the housing market).  With so many buying government debt they openly acknowledge is dodgy–at best–everyone will be looking for greater fools to sell to at the same time, and the race to the exits is likely to be ugly.

Although my wife hates to hear me say it, it’s getting scary out there.  We can still pull back from the precipice, but time is running out.  Our elected officials may suddenly become prudent (not in any democracy I know of).  We may experience a growth boom that saves the day–until the next crisis.  But, at some point over the next 5 to 10 years, we are going to live through the transition from Ponzi finance back to hedge finance, and that’s just plain scary. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Ponzi finance, government style!

Short term pain, long term happiness

With my daughter turning three in August, I know we’ll soon have a conversation or two about honesty. 

It’s a complicated subject, so I expect this conversation to occur off and on over the next…say…75 years (I plan to live to 115).

Most people think honesty is about lying or not lying, and therefore not very complicated.  I disagree.  I think honesty is about facing the facts.  If you frame honesty in such a way, you can live a moral life, and achieve and sustain happiness (which is what I think morality is all about).

You can lie and be moral.  For example, if I’m served liver and Brussels sprout casserole I can tactifully lie by thanking the server.  I’m not denying the fact that I hate liver and Brussels sprouts, but the thanks is polite.  That white lie is not incompatible with honesty.

If the Nazis come to my door and ask where I’m hiding the Jews, I can’t say, “first door on the left,” and be moral.  Once again, the lie does not deny the facts, it simply acknowledges that I have no moral obligation to be truthful with monsters (actually, being truthful will definitely bring unhappiness).

It’s my stand that you have to be honest, to face the facts, in order to be happy.  But, happiness is not equal to instant gratification.  Sometimes, being honest with oneself or others is short term painful.

For example, think about making a mistake on the job and telling your boss.  Your boss is unlikely to be happy, but you have to face the the facts and let your boss know because she has the right to know.  If your boss is any good, she will reward that honesty over time even if she isn’t happy with the mistake.

In fact, I would go so far as to say that many (most?) moral things, like honesty, are short term painful in order to reach long term happiness.

I exercise 5 days a week.  I work out hard enough that it’s mildly painful.  But, the rewards pay for the effort.

I work hard to find investments.  I spent hours, day, months doing research on each investment idea.  This is rarely a fully pleasant experience.  And yet, I know it will work in the long run.  That’s why I do it.

Buying investments that will do better than average almost always includes short term pain.  The reason why it will do better than average is because something is wrong.  Most people will think you’re nuts for investing there–that’s why it’s cheap!

Over the long run, too, buying such short term pain provides long term happiness.

Do you think my three year old will understand why honesty or investing can bring short term pain and long term happiness?  No, me neither. 

But, over time she will, and then she’ll be long term happy, too.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Short term pain, long term happiness

Why I don’t work in a big city

A question I regularly get from clients, prospects, family and friends is: “if you’re so good at what you do, why don’t you work in a big city like New York, Boston, Chicago or San Francisco like all other investment managers worth their salt?”

It’s a great question, and highlights what most people think: a) people who are good at what they do need to go to the biggest stage to do it, b) those who don’t go to that stage probably aren’t as good as they say.

Fair point.  No truly great baseball player plays pick-up games on weekends.  No virtuoso pianist only plays in her basement. 

Investing, however, is different.  With investing, all you have to do to compete against the best is buy or sell securities directly.  Each time you buy, you may be buying from the best; when you sell, you may be selling to the best.  You never know who is on other side of your trade, but the best are all participating in the same markets.

So, it’s not necessary to go do New York, London or Hong Kong to compete with the best.  All you have to do is decide to buy securities directly.  I do. 

The reason why I’m not in a big city can be summed up in one word: independence.

To be a great baseball player, you have to compete against the best.  To become a virtuoso pianist, you have to play against the best.  Direct competition makes each individual better.

Investing, however, requires independence.  Groupthink is the source of poor performance.  So are marketing departments. 

If you’re pressured to sell products because you work on commission, you’re not independent and unlikely to beat the market.  If you’re boss is pressuring you to post good quarterly results to increase assets under management, you’ll lack the independence required to out-perform.

If you’re surrounded by people who represent the market, it’s very hard to resist being affected by their thinking.  If you meet and talk daily with people who disagree with you and think you should follow the herd, you’re almost certain to be worn down and comply. 

Or, as Benjamin Graham, Warren Buffett’s mentor, put it in the Intelligent Investor, “To enjoy a reasonable chance of continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) are not popular in Wall Street.”

Sound and promising means long term oriented.  Marketing departments hate that because short term results are what sell. Not popular on Wall Street means contrarian.  But, that’s difficult when you’re amidst the Wall Street herd day in and day out.

I believe I have and will beat the market over the long term because I’ve kept my independence.  Being in Colorado Springs and without a marketing department breathing down my neck is an asset, not a liability. 

Keep in mind that Warren Buffett spent his first 10 years operating out of the sun room in his Omaha home.  He, too, saw the benefit of independence.  Perhaps he was on to something.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Why I don’t work in a big city

Raging debate.

The investing world has divided itself into two camps: those fearing inflation and those fearing deflation. A debate is raging about what we’ll face going forward and the appropriate way to invest under each scenario.

This debate is not between dummies. I’m not referring to the talking heads on TV or the perma-bulls of Wall Street who perpetually advise buying stocks NOW! Nor am a talking about the perma-bears and gold bugs that advise canned food and fall-out shelters.

I’m talking about the smart investors who saw the 2000 tech bubble and the 2008 housing bubble popping years in advance. They made money when almost everyone else lost it.

They were in complete agreement back in 2000 and 2008, but now they aren’t. Now, they hold diametrically opposed views about the economy and where to invest.

If we face deflation, you should hold cash and buy high quality fixed income instruments. If we face inflation, you should buy commodities and stocks that will thrive in a rising price environment.

They are in total disagreement about which one we face and are ripping each other to shreds in articles and interviews. I’ve never seen such strong disagreement between the smartest in the field.

The outcome really matters. If you invest in cash and bonds and inflation occurs, you’ll get killed; if you invest in commodities and stocks and deflation occurs, you’ll get killed. This is no mere academic debate. This will impact the lives of millions of investors.

Like many, I don’t know how this story ends. It’s my opinion we’ll experience deflation until bad debt is squeezed from the system and then inflation from there. The problem is getting the timing right of when we go from deflation to inflation (and correctly guessing ahead of the herd when the crowd will recognize that shift).

And, to further confuse things, the outcome depends more on the decisions of government officials than economic analysis. If they print lots of money, we’ll get inflation. If they don’t, we’ll have deflation. We’re in an uncomfortable position.

I don’t think it’s possible to get the timing right, so I’m not trying. Instead, I want to own instruments that can do well in either inflation or deflation. For me, that’s investing in businesses with pricing power and competitive advantages that can cut costs in deflation or raise prices in inflation.

I prefer businesses with cash on hand and that pay a meaningful dividend. That’s the same as owning cash and a fixed income instrument, but it has the benefit of adapting to inflationary conditions in ways that cash and bonds can’t.

I’m also favoring strong management teams that own a significant chunk of the business and are focused on building shareholder wealth. A smart management team can adapt and exploit a changing environment in ways that cash, fixed income, canned goods and commodities can’t.

In other words, I’m looking for the best of both worlds. I don’t want to guess whether we’ll experience inflation or deflation or when one or the other will kick in. Instead, I’m investing for either environment.

Such investments are likely to feel short term pain if either strong inflation or deflation occurs. But, in the long run they will survive and grow in ways the other alternatives can’t.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Rolling over?

The S&P 500 is down 16.2% since April 23. Commentators all over are trying to peer into their crystal balls to figure out if the market is tanking, or just taking a breather before resuming its climb.

Data point in both directions.

The Chinese stock market is down much more than U.S. markets, but state manipulation makes that data point suspect.

Railroad figures continue to look good. They haven’t recovered summer 2008 highs, but they’ve been steadily heading in that direction.

Commodity prices have pulled back but haven’t broken down to levels that would suggest all hope is lost. Copper is below $3, but has paused around that level. Oil prices are over $70, just where Saudi Arabia wants it (suggesting demand is still strong). U.S. natural gas prices have been climbing since late February and are hitting new highs. Asian steel prices have declined since March, but have leveled off above prices of last summer. Dry bulk shipping prices have tanked, but that could be as much due to on-coming supply of ships as lower demand.

The Economic Cycle Research Institute’s (ECRI) Weekly Leading Index has declined to the point of many past recessions, but hasn’t crossed the threshold or time period to make recession certain.

Weekly unemployment claims are below 500,000, but not below the significant 400,000 level that frequently signals the sustained end of recessions.

What’s an investor to do in such situations?

First, remain calm. No one predicts recessions with precision, except in hindsight.

Second, stick to your discipline. If some of your investments look cheap, buy more. If others look expensive, sell some or all. Don’t try to time the market, evaluate prices relative to potential returns and buy when returns look good. You won’t catch the bottom, but no one but the lucky do anyway.

Third, plan to react to up or down side. It’s handy to have a plan instead of reacting emotionally. Feelings are an investor’s worst enemy. Decide what you’d do if prices took off (probably selling) and what you’d do if prices decline (probably buying), and then have the courage of your conviction when the time comes. Don’t change your plans based on how you feel, but on what you rationally think.

Investing is a game where cooler minds prevail. Don’t get emotional and don’t abandon your soberly made plans. In the long run, the next few months will probably look like an unmemorable blip on the computer screen. Invest wisely and you won’t care.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.