China: more important than Greece

While most of the world was overly focused on Greece, bigger things were afoot in China.

First, the Chinese economy is the 2nd largest in the world. What happens in China matters for the world economy. In contrast, Greece’s economy is but 2% of the European economy. Although Greece’s problems are likely to become broader problems in Portugal, Spain, Italy and France, by itself Greece doesn’t have a big impact on the world economy.

Second, China’s economy is still essentially run by a communist central planning authority. They are giving some free market principles a try, but they have maintained a firm grip on the most important things. How they react to the inevitable ups and downs any economy faces is important for understanding how the world economy will do in coming years and decades.

Over the last year, the Chinese government has been showing they aren’t ready for prime time. First, they have reacted to economic slowing–inevitable in any economic system, whether capitalistic, communistic, socialistic, etc.–with attempts to prop things up. As usual, such attempts look good in the short term but fail over time. Governments just aren’t any good at allocating capital.

Second, they are misreading market reactions and have basically lost their cool. After trying to use free markets to boost their economy, they are now trying to prevent markets from clearing by forcing large stockholders to hold instead of selling. There is nothing that spooks markets more than a government’s attempts to force the outcome they want instead of the natural equilibrium that would otherwise exist.

This a classic reversal of cause and effect. Stock markets, like all markets, react to news by adjusting prices to make supply and demand match at market clearing prices. Any attempt to prevent that mechanism from operating in the short term leads to disastrous effects in the long run. Markets are effects, not causes, contrary to how many politicians and historians like to interpret the facts.

The more the Chinese government continues to overreact and try controlling outcomes, the more world markets will overreact as a result. Such impacts will be much worse than letting markets find equilibrium. Just witness commodity price swings in reaction to Chinese intervention and you can get a flavor for how nasty things can get. 

I think what is going on in China should be watched much more closely than what is happening in Greece. The stakes and consequences are much greater.

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.

China: more important than Greece

Optimism = poor returns

It’s easiest to invest when you feel good about a company or the economy. That feeling reflects good recent results, and a herd of other people who share your good impression. Good feelings cause people to push prices far above underlying value. When the future turns out to be not as rosy as people’s inflated expectations, prices move back to value and poor returns result.

Exhibit A is 1999, when almost everyone was so optimistic about technology stocks, right before they dropped 76%.

Exhibit B is 2006, when almost everyone was in love with the real estate market, right before it plunged over 30%.

It’s hardest to invest when you feel terrible about a company or the economy. That bad feeling is due to poor recent results, and a herd of other people who agree that prospects are lousy. Bad feelings cause people to sell or not buy, pushing prices far below underlying value. When the future turns out to be not as bleak as most expect, prices move back up to value and better than average returns ensue.

Exhibit C is 2003, after the stock market dropped 48% and the second Gulf War started, right as the market started to climb 95% over the next 4 1/2 years.

Exhibit D is 2009, after the stock market dropped 56% and there were rumors the government was going to nationalize the banks, right as the market started to climb 106% over the following 3 years.

My point: optimism leads to poor returns, and pessimism precedes great returns.

The above is easier to grasp than it is to follow. Most people know they should buy low and sell high, but they mistakenly believe that they should wait “until the coast is clear” to invest, and run for cover “when the future looks scary.” They know what they should do, but they succumb to optimism or pessimism and don’t act.

Warren Buffett is the most successful investor alive because he is “greedy when others are fearful and fearful when others are greedy.” Follow his lead:

  • If the coast is clear and it looks like everything is coming up roses, that’s not the time to double down–expect poor future returns
  • If some people are optimistic and others pessimistic, then you can expect average returns
  • If people are panicking and running for cover, that’s the time to double down–expect high future returns

In other words, don’t expect great results if everything looks safe, and don’t expect poor results just because everything looks gloomy. 

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.

Optimism = poor returns

Counter-intuition

To most people, good investing seems frustratingly counter-intuitive.

When the economy is on its back, looking like it will never recover, and the stock market is hitting new lows–that’s the best time to invest. When the economy is breaking growth records and the stock market is hitting new highs–that’s the absolute wrong time to pile in.

Or, as Warren Buffett more succinctly put it: “be greedy when others are fearful and fearful when others are greedy.” (He should know, you don’t become one of the richest people in the world and the most successful investor over the last 60 years if your approach is fundamentally flawed.)

But, most people can never really get their brain around this paradigm. They easily accept that they know nothing of particle physics, brain surgery and rocket science, but they just can’t accept the notion that investing and economics are similarly complex.

To most, investing is counter-intuitive.

But, to me, this counter-intuitiveness makes perfect sense. Investing is not like physics, surgery, rockets, home building, plumbing or most other things people do. In most fields, man is competing with nature.  

A physicist is trying to understand the rules of nature with mathematical precision such that it can be harnessed. The surgeon wants to understand disease and human physiology such that he can operate to restore health. A rocket scientist uses the rules discovered by physicists to harness nature’s power to propel and guide a payload into space. A home builder seeks to erect a structure that will keep out the elements and provide a comfortable and convenient abode for its dwellers. A plumber desires to harness water to serve man’s needs within buildings. All of these fields are concerned primarily with overcoming nature.

Investing is different. It’s more like sports or warfare in that it is inherently a competition of man against man. And that, I believe, is why it seems counter-intuitive to most.  

With investing, you are not just trying to figure out which company will survive and thrive, but how other people perceive that company. The price you pay is not based solely on a company’s underlying fundamentals, but on how investors in general understand and interpret those fundamentals (or just plain feel about a company).  

When people are excited about an investment, like Apple, they tend to bid the price up above underlying fundamentals. When they hate a company or think it is going the way of the dodo, they bid its price down below fundamentals.

When they think the economy will go ever higher, they want to be fully invested. When they think it will never improve, they want to pull all their money from the market–right now!

But, this herd-like behavior is almost always reflected in prices before such people buy and sell. The price they pay or receive is for the perception of a company or the economy, not just the underlying fundamentals.

In the long term, however, the fundamentals win out. As Benjamin Graham put it, “in the short run, the stock market is a voting machine, in the long run, it’s a weighing machine.” In other words, stock prices reflect human emotion in the short run and underlying fundamentals in the long run.

Which is why successful investing seems counter-intuitive. When everyone is selling and it seems like things can never get better (2009), you want to be buying. When everyone is buying and it seems like a new era of non-stop growth has dawned (2000), you probably want to be selling.

Because most people will never get their brain around this, counter-intuitive investing will continue to work for those who can harness other people’s short-term emotions. 

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.

Counter-intuition

Stick to the fundamentals

Although I tend to write here about the economy and markets in general, I must admit such opinions affect my investment process very little.

I don’t buy and sell based on what the market is doing or might do. I don’t buy and sell based on my assessment of the overall economy.

I buy when I find businesses selling significantly below assessed value and sell when the businesses I’ve bought are selling significantly above assessed value.

I pay attention to secular trends, such as energy prices and the expansion of cable into phone and broadband Internet, but I don’t use such trends as a starting point in my investment process.

I spend my days researching individual companies. I look for businesses with good economics–with sustainable competitive advantages. I look for businesses with great management, who are competent and rational, act as trustees for shareholders, and hold a significant stake in their company. Then, and only then, do I assess business value.

When the market is tanking or roaring ahead, it’s important to keep this in mind.

The best way to succeed in investing is to buy good businesses below their assessed business value and sell only if price exceeds valuation. To do this, you must stick to the fundamentals–you must primarily focus on business economics, management and valuation.

When the market is diving, it may be an opportunity to buy, but only if prices go below assessed value. When the market is rising, it may be an opportunity to sell, but only if prices go above assessed value.

The focus is always on the business fundamentals primarily, and only secondarily on prices. What the market and economy are doing should take a distant, and almost completely unimportant, third.

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.

Does the subprime meltdown indicate something bad for the economy?

Boy, oh boy, has the subprime market’s crash been making the news. I guess everyone loves a disaster movie, right?

But, a more important question to ponder is how the subprime meltdown may impact the broader economy. Some very smart people believe it’ll lead to the next recession. People like Merrill Lynch’s David Rosenberg and commodities investing great Jim Rodgers have made their predictions known.

I’d be a fool if I said I knew the answer, but I certainly have some thoughts of my own (you know what they say about opinions). I think a lot of the economy’s growth over the last 4 years has been due to the housing market. For example, much of the growth in jobs during this expansion has been due to housing (home building, mortgage finance, real estate brokers). And, mortgage equity withdrawals have certainly been fueling consumer expenditures.

So, if the a good chunk of the economy’s growth has been due to the housing market, what would happen if a few subprime loans defaulted? Those houses would come back on the market, and the bankers who ended up with them would be eager sellers. This could lower home prices at the margin. And, more homes on the market could lead to less home building. How might this impact all the jobs created over the last 4 years in home building, mortgage finance and real estate brokerage? Not for the better.

My fear is that this dynamic feeds on itself. More laid off builders, brokers and mortgage writers could lead to more defaults. Such defaults could lead to greater inventories, lower home prices, and more laid off workers related to the housing industry. Perhaps you can see the same spiral I do.

Added to this, Congress is worried that lenders have been taking advantage of consumers. Action on their part may restrict the mortgage market even further. This could be bad news, too, because folks with adjustable rate mortgages may need to refinance exactly when Congress restricts that market, further exacerbating the problem.

Betting against the US consumer any time since the depression has looked dumb, so I hesitate to spell out this worst case scenario. But, my fear about housing is exactly what kept me out of housing related investments even as they shot the lights out over the last 4 years.

People investing in the housing market now will end up looking brilliant if things don’t fall apart. But, because it’s almost impossible to forecast how bad things may get, I’ll wonder…were they lucky, or good.

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.