Gold is money, but that doesn’t make it a sound investment

“Gold is money.  Everything else is credit.” – John Pierpont Morgan

I must admit, I’m a bit of a gold bug. 

After studying economic and financial history for over 16 years, it’s quite clear to me that wealth is not pieces of paper, but economic goods.  And money–as a store of value or medium of exchange–is not pieces of paper, either, but an objective equivalent of wealth freely chosen by economic participants. 

Over thousands of years of human history, economic actors chose first rocks and cattle, then base metals like copper, and finally precious metals like silver and gold as mediums of exchange. 

Governments, starting with Croesus in Greece, started minting coins of precious metal not because they arbitrarily decided what money should be, but because market participants were already using it and they grabbed the market for themselves (not for the first or last time, I might add).

After seizing that market, every government has proceeded to debase money by reducing the amount of precious metal in coins, and every time economic participants have adjusted their actions accordingly, revealing the debasement for what it really is–inflation.

Every time, inflation got out of hand and led to price controls that, as always, caused shortages instead of reducing inflation.  And each and every time, this led to a slowing and contraction in economic growth that eventually led people to demand money backed by specie–metal or metal-backed currency.

Both the Chinese and French boldly tried paper currency only to find it yielded the same disastrous result as metal coin debasement–but faster.  Since the 1930’s, U.S. currency has not been redeemable in specie.  Since the early 1970’s, U.S. currency has not been backed by specie at all.  Want to guess why the 1970’s witnessed a huge spike in inflation?

Look at a dollar bill some time and you’ll see written across the top “Federal Reserve Note.”  A note, for those of you who don’t live on planet economica perpetua (I do!), is a debt instrument–in other words, credit.  As Mr. Morgan put it, gold is money and everything else is credit.

With that overlong introduction, you get an idea of why I believe gold is money.  But, let me be clear, that doesn’t necessarily make it a good investment.

I think Warren Buffett put things clearly when asked a question about inflation protected assets at his most recent annual meeting.  He noted that there were three types of assets: 1) assets backed by currency, like dollars, euros, bonds, savings accounts, 2) assets backed by something tangible, like gold, art, antique cars, diamonds, land, and 3) producing assets, like stocks, farm land, rental real estate. 

In an inflationary scenario, you can expect the first type to lose value (perhaps badly), you can expect the second to maintain value, and you can expect the third to grow in value.

I place gold firmly in the second category, which makes sense.  You expect gold to maintain value regardless of inflation, but you don’t expect it to grow in value relative to the value of other things.  Gold is money, so it is a store or protector of value, not a grower of value. 

You do, however, expect the third category to continue growing regardless of inflation, because it throws off economic value.  Instead of being debased, like currency denominated assets, or maintaining value, like tangible assets, you would expect producing assets to continue producing. 

A farm continues producing corn, regardless of how corn is priced.  Stocks are priced in terms of earnings, where revenues and costs adjust to changing prices over time.  Rental real estate rates adjust to underlying currency, whether dollars, dinars, or drachma.  You get the idea. 

I know gold is money, but that doesn’t make it a great investment.  Gold may preserve value, it may provide insurance against negative outcomes, but gold is not a producing asset.  You may speculate in gold prices, but that’s not investing.  For my money, I want growth, not standing still or speculation.

Gold is money, no doubt, but that doesn’t make it a sound investment.

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.

Gold is money, but that doesn’t make it a sound investment

Is the trend really your friend?

“Many shall be restored that now are fallen and many shall fall that now are in honor.”
Horace, Ars Poetica.

We humans have a tendency to extrapolate recent trends into the distant future.  This approach doesn’t work in the real world. 

Stocks that roared from 1996 to 2000 were expected to keep roaring.  They didn’t.

The national housing market that hadn’t declined since the 1930’s was expected never to decline.  It did.

Extrapolating recent trends into the distant future is foolhardy.  And yet, people do it over and over again.

Once dominant IBM became less so.  The same can be said for Apple and Google today, or even Facebook and LinkedIn.  But, try telling that to the raving supporters of such companies.  You’ll be angrily told you don’t get it.

China is on the upslope and Japan on the downslope.  These trends, too, are unlikely to continue.  Such is the nature of things. 

Regression to the mean–the tendency of economic series to drift back to average–is a well-founded phenomena.  And yet, people expect present trends to continue forever.  They won’t.

Corporate profit margins are at all-time highs.  They won’t continue higher for long, or even stay at today’s levels.

Commodities have been roaring.  That trend will not go in one direction.

Bond yields have been going down since the early 1980’s.  That cannot continue indefinitely.

The U.S. government has never significantly defaulted on its debt.  Just a matter of time.

Small capitalization companies have done exceedingly well over the last 10 years.  The future will not look the same.

Emerging markets have been on a decade-long tear.  Anyone want to bet that will go on forever?

Trend extrapolation is a dangerous way to invest.  And yet, people keep doing it over and over again–and then losing their shirts.

A few trends last long, but they are the exception, not the rule.  Those who bet on a regression to the mean always look stupid in the short run, but then rich in the long run. 

So, why are so many suggesting, once again, that the trend is your friend?

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.

Is the trend really your friend?

The Foolishness of Forecasting

“Prediction is very difficult, especially about the future” – Niels Bohr, Danish physicist

“…the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.” – Benjamin Graham, value investing “Dean”

Warren Buffett, probably the most successful investor alive, doesn’t make earnings forecasts.  He doesn’t do what every MBA student is taught: build a model that forecasts future earnings over time.  That doesn’t mean the future isn’t important to him.  Quite the contrary.  He is obsessed about the future!

But, that doesn’t mean he makes forecasts.  Why?  Because forecasting is notoriously difficult.  The records of various forecasters, whether historians, economists, political scientists, financiers, social scientists, and, especially, government bureaucrats, are terrible!

My own record here is exhibit #1.  I like to forecast political and social outcomes, but my forecasting record is as dreadful as everyone else’s.

But, isn’t successful investing about forecasting the future?  Doesn’t one have to know what sector of the economy, which asset class, etc. will do best?  No.

In fact, the records of those who try to do the above are as poor as everyone’s.  Those selling such forecasts want you to believe the future can be forecast, but if they were any good at it, they’d be making a fortune doing it instead of selling forecasts. 

I can guarantee you, knowing the future would make you rich.  But, that makes the rather huge assumption that you can do it successfully.  I’ve never met or read about anyone who can.  Like ESP, tons of people seem to think it’s possible, but when submitted to scientific testing, proves lacking.

So what does Warren Buffett do?  He studies the historic record intensely so that he understands a company, its industry, its competition, its competitive advantages and threats, its management, etc., then he pays a cheap price relative to that historic record. 

He doesn’t forecast earnings growth explicitly, but he does buy businesses with a record of growth and with all the expectations of future growth behind them.  Its a qualitative rather than quantitative assessment. 

Most importantly, he doesn’t pay for future growth.  The price he pays has a margin of safety, rendering an accurate forecast of the future unnecessary.  If he pays a low enough price today, he’ll get an acceptable return no matter what.  If growth continues, and he spends gobs of time focusing on this qualitative aspect, his return will be better–perhaps much better. 

That’s it.  No magic flutes, no crystal balls, no whirling dervishes.  Just understand intimately a particular business (and no one understands what makes businesses tick like Buffett), pay a fair price for it, and let the qualitative tailwinds blow you on to wealth.

This is very contrary to what most investors, both professional and individual, do.  Most investors spend the vast majority of their time trying to figure out what the future holds instead of studying the past and present with the same intensity.  They make elaborate models with spreadsheets to forecast all the potential variables to the fourth decimal place.

The result isn’t just that they don’t understand the important variables of the past, the result is forecasts that are notoriously bad. 

The average Wall Street analyst over-estimates business growth by 50% (businesses they study with great intensity and with unique access to industry insiders). 

The average economist considers himself a hero if he gets the DIRECTION (not magnitude) of economic variables correct, and almost always miss major turning points (they have models of such mathematical complexity that physicists are intimidated by them). 

I could go on, but you get the point.  Forecasting is a dead end.

Contrary to all investing lore and conventional wisdom, this does not suggest broad diversification.  Don’t get me wrong, diversification is the right way to ride economic growth at minimum cost.  But, if you want to do better than that, you need to concentrate on the very few things you can understand better than others. 

As you may have guessed, that’s an understanding of the past and present, not a brilliant forecast of the future. 

If you study every cell phone company in great detail from quarter to quarter, and understand each of their technological, managerial, competitive, economic aspects, and you realize that one stands head and shoulders above the others, yet is selling at a very reasonable price, you may have a good investment.  If, on the other hand, you recognize that the technological or competitive dynamics are such that you can’t figure out who is and will stay on top, then you should move on to an industry where you can.

A tremendous amount of study and intellectual honesty is required to do this, but so few put in the effort that thar’s gold in them thar hills.

Don’t forecast.  Study intensively the past and present, and pay a low price.

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.

The Foolishness of Forecasting

The Fallacy of Too Big To Fail

I’ve tried to stay away from the Too Big to Fail discussion, but after doing research on the banking sector recently, I decided to put in my two cents.

First off, “too big” assumes some standard.  It assumes that something of a certain size is “good,” but when that size becomes “too” much, it becomes “bad.”  (What, like too much health, too much peace, too much prosperity, too much happiness, too much virtue?)  By what standard?  For what goal?  By whose judgment?  No data or references are provided by most of those who make this argument, which makes me suspicious right-off.

Lately, this argument has been made with respect to banks.  “XYZ Bancorp is so large that it can take down the whole financial system” seems to be the implicit line of reasoning behind the Too Big to Fail discussion.  Does that mean breaking XYZ into 10 or 100 or 1000 small banks that all fail at once is better simply because they are each small?  Are lots of small failures good and one large failure bad?  Is smallness somehow an implicit good?  No. 

I guarantee that if you break XYZ into lots of pieces that all have the same debt to equity ratios and loan exposures as XYZ as a whole, they will all fail at the same time.  And, you’ll end up in an even worse situation than if an integrated XYZ bank had failed.  Too big or small isn’t the issue, the real issue is leverage and loan exposure. 

The Too Big to Fail argument assumes that somehow lots of smaller banks will not fail at the same time but one large one will.  Oh, like lots of small banks did so much better than large banks because the housing market can’t possibly crash nationally (note: I’m being sarcastic).  Oops, that argument didn’t float.

The housing sector crashed nationally and that almost took down our financial sector and the rest of the economy for reasons other than large banks.  The banks were a symptom, not a cause. 

If banks weren’t back-stopped by the FDIC and Federal Reserve and driven to hold low equity to capital, they wouldn’t have crashed due to too much leverage. 

If home ownership weren’t explicitly supported by Congress, the Executive branch, tax policy, FHA, GNMA, Fannie Mae and Freddie Mac (government supported enterprises), etc., then all kinds of mortgage derivative instruments would never have been created and crashed.

If the government hadn’t driven the creation of rating agencies and given three of them exclusive control of debt ratings that banks, insurance companies, etc. must use in the purchasing of securities, then risky securities would never have had a huge, captive markets in the first place.

If the Federal Reserve weren’t encouraging speculation with interest rates below free market equilibrium, there never would have been massive mis-allocation of capital to the housing sector all at once.

The only thing that seems too big here is government intervention in banking, housing, debt ratings, and interest rates.

Back when banking was more free (it’s always had lots of government interference), banks carried 40% equity against 60% in liabilities.  With government back-stopping and lots of regulation, that ratio is now 10% equity to 90% liabilities (it was 7%/93% right before the financial crisis).  Perhaps things were safer when banking was more free.

The history of bank failures in the U.S. has smallness written all over it.  Our regulatory structure has long encouraged lots of small banks.  But, a small bank in Iowa is very likely to crash and depositors to be wiped out when an inevitable bad corn crop occurs.  In contrast, a large bank with loans to corn farmers in Iowa, gold miners in Nevada, cotton growers in Mississippi, steel manufacturers in Indiana, orange growers in Florida, cheese producers in Wisconsin, etc. is unlikely to have all loans default at the same time, thus protecting depositors and borrowers.

Unless, of course, speculation is encouraged on a national level, or large banks are driven to hold 10% equity to 90% in liabilities.  That doesn’t happen, though, without national coordination–in other words: without a national regulatory structure that lines up the dominoes to fall at the same time and in the same direction. 

If leverage and loan exposures were the problem, wouldn’t greater regulation of those issues fix the problem?  No.  Not all banks are the same, and so no regulatory body can foresee all the potential business mix issues that might come up (only someone omniscient could).  JPMorgan, with international operations, investment banking services, and proprietary trading operations, has very different risk exposures than U.S. Bancorp’s community banks.  You can’t come up with one-size-fits all prescriptions for either debt ratios or loan exposures.

In addition, any attempt to prevent problems is more likely to create systemic risk, because a bunch of banks marching to the same music are much more likely to fall together than several separate banks marching to their own drummer (each might fall on their own, but not together systemically).  This is the same reason why periodic recessions and small fires that burn the underbrush prevent catastrophic problems.

The road to hell is literally paved with good intentions–which frequently take the form of national (or international) regulation.

I can’t help but point out one other blatant inconsistency of the Too Big to Fail argument.  If bigness is inherently bad, then why have a BIG, super-governmental body to oversee, break-up, regulate and control banks or any other sector of the economy?  Wouldn’t its bigness be an inherent threat? 

Please keep in mind, too, that no markets in the world are as highly regulated as housing and banking, the epi-center of our latest financial crisis.  Big regulation didn’t help there.  In fact, I strongly argue it created the problem. 

When looking at bigness, it’s useful to recognize that the regulatory bodies are already much bigger and more powerful than the regulated. The Federal Reserve made $80.9 billion in “profits” last year (by trashing our currency and punishing savers, no less) compared to the two most profitable non-governmental businesses: Nestle’s $37 billion and ExxonMobil’s $30 billion.  At least Nestle and ExxonMobil produced things people wanted to buy!  I won’t even mention the ridiculous spending power of other federal government branches. 

If bigness is the problem, then banks or any other non-governmental businesses are the wrong target for concern.  But, even there, the concern is not size, per se, but what an organization does.

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.

The Fallacy of Too Big To Fail