It is tulip season in Mt. Vernon, and for me that brings to mind a book.
One of the classic investment books is Extraordinary Popular Delusions and Other Madness of the Crowd by Charles Mackay. Despite being first published in 1841, it is one of those books that I think has not only withstood the test of time, but is also, and unfortunately, relevant to modern investing every few years. The book begins in the 1600s and works its way through famous bubbles, such as the South Sea Bubble from 1719, John Law’s French Mississippi Scheme, and, perhaps most famously, Tulip Mania.
Tulip Mania swept through Europe in the 1630s. Tulips were a highly-desired luxury item from the Ottoman Empire and with so few making their way into Europe, the prices began to rise to the point where in 1634, speculators were investing in them – a perishable good! By 1635, 40 tulip bulbs were worth 100,000 florins, while the average yearly wage was only 150 florins. In 1636, with a booming futures market, two tulip bulbs could have purchased 12 acres of land. Many investors made very rich.
By February of 1637, the market dried up and prices crashed.
It’s not hard for the modern investor to jump from Tulips to the Dot Com bubble of the late 1990s/early 2000s. Hindsight being 20/20, we like to think we wouldn’t fall into another bubble so quickly, but as Mackay’s book proves, we all love the idea of a get-rich-quick scheme, and it is difficult not to imagine that the next is somehow going to be different.
I overheard a conversation in the grocery store back at the beginning of 1999; I overheard two twenty-something women talking and one said, “You’ve got to buy stocks! You know, you can borrow money on your Visa card, and you’ll only have to pay 18% interest!” To me, as an investor, that was another signal that the Dot Com bubble, that those good times, were coming to an end.
Something similar occurred a couple of months ago; I had a former sales associate call, and after some brief small-talk, she asked me for a loan of $10,000 to purchase Bitcoin. She has no investing experience and I wasn’t swayed to invest, but I got the same feeling I had the grocery store almost 20 years ago.
My concerns with Bitcoin stem from the same place as Tulip Mania. When I invest, my evaluations are based on measured value. I believe that if you cannot measure the value, it isn’t a good deal. I am also devoted to doing my own research because I know that TV personalities, the media, and so-called “experts” all have their own agendas. When I can’t rule out any of those concerns, there are too many red flags for me to invest in the product.
I’ve heard some people discussing the idea that Bitcoin could become a world currency, and perhaps it’s on that basis that the virtual currency has skyrocketed 1600%. The problem with that idea is that there are some very strict requirements for a currency to become the primary exchange currency. The reason the US dollar is so far-reaching – is, in fact, used in 85% of all foreign currency transactions and greater than 60% of all foreign countries hold their reserves in the US dollar – is because it is uniquely stable, large, and backed unconditionally by the United States government.
Prior to 1914, there were three primary currencies – the English Pound, French Franc, and the German Marc. Following WWII and the Great Depression, a number of countries met together and from that meeting came the rules that still define a world currency. At the time, the United States was the largest nation with both world-wide reach and the least damage following the war. The US had an enormous trade surplus, and other countries such as the UK found themselves deep in debt following the war. Any other currencies that were potentially stable enough were too small – specifically Switzerland’s Franc. In the end, the United States dominated and the dollar cemented its place as the world-wide industry.
Bitcoin is neither large nor stable enough to take the place of the dollar as a world currency. In fact, the dollar was considered a safe-haven even during the Great Recession.
In the end, much of the market is about perception – if the market believes 2+2=5, they’ll buy for 4 ¾ all day long. While the perception of Bitcoin is bringing speculators flocking, I don’t trust that the perception will hold, and like the Tulips, eventually someone will realize we’ve been paying more than they’re worth.
One of the things that I believe sets me apart from other talking heads commenting on the state of the markets is that I hold myself accountable for my predictions. 2017 is over now, and that means that most people are talking about 2018, and prepared to let bygones be bygones – whether they were right or wrong. I think it is important to take stock of what I said back in 2016 about the year just passed, and critique myself.
I said at the end of 2016 that I believed 2017 would see the stock market continue to grow, not from any short-term political ramifications, but because we are in the middle of a secular bull market. These bulls do not die of old age; in fact the last began in 1982 and went on until 2000 – more than eighteen years! It’s said that bulls are born on pessimism, grow on skepticism, mature on optimism, and die on euphemism, and while many investors seem to worry that this bull is getting too old, I think we are still in the second stage. This is something I’ve been saying since 2009, and that was the basis for my 2016 predictions. Tied into my prediction regarding the Super Cycle, we saw almost all countries showing positive GDP growth in 2017.
More specifically, I expressed weariness over the new Administration providing an economic stimulus, which has never been done while the country wasn’t in a recession, and I didn’t know what ramifications we could see. In the end, what was passed was Tax Reform, which I don’t believe will have anything near the effect a full stimulus would have. This tax cut, from most of the math-based research I’ve seen, will largely benefit the wealthy and corporations, whereas a stimulus package is generally beneficial for lower income levels. The impact of the tax reform will in my opinion be positive for corporate earnings and thereby for stock market, at least for 2018.
I predicted that the economy would do well – not a 4% GDP rise, but no less than 3%. What we saw was that the economy did hit 3% in the last two quarters but did not hit 4%. I believe the Tax Cut was a gamble that the GDP would reach 5%, which I would like to believe will happen, but realistically doubt will happen.
I also stated that I believed that we would see record profits, and in that I was correct. I believe that we’ll see even more in 2018, too. Profits drive the market, that’s the reality. It is numbers and not administrations that make the market move. I’ll talk more about that in the coming weeks as I give my 2018 predictions.
We also saw record cash levels, consumer debt levels lower than the long-term average, and consumers benefiting from lower oil prices (and therefore having more money to spend driving up demand) – all things I predicted back in 2016. I predicted unemployment to be at 5% and was thrilled to see it even lower, at 4.1% as the low! I thought we would see housing not only recovering, but heating up as well. While the reality was regional and not country-wide, it is generally improving.
I said that I believed that 2017 would be a good year for the S&P 500 and when the final results were in, they proved to be even better than I expected. Back to math for a moment, we know that tax cuts for corporations are, fundamentally, very good for company profitability. When tax rates are going to be cut by up to 14% (as they will be in this tax bill), we will see increased profitability which will, in my opinion, in turn increase stock prices and the S&P 500. Again, that’s just math.
In the end, I believed – and continue to believe as I look forward into 2018 – that the economy would be good in 2017 and the years to come. I believe that the actions the government is taking will lead to a good today and good things in the next few years, but my concern is in the long-term.
I got my MBA at Carnegie Mellon University back when it was Carnegie Institute of Technology, and the MBA was called a Master of Science in Industrial Administration. Carnegie is located in Pittsburgh Pennsylvania, where the Monongahela and Allegheny Rivers meet to former the Ohio River. In those days, one of the most beautiful sites, in my opinion, was to take the tram up Mt. Washington and look down into the city. Mt Washington is not really a mountain, it’s only a hill, but the vista was so impressive. The smokestacks of Jones and Laughlin Steel spewed tongues of dancing fire streams in hundreds, if not thousands, of colors. It was so impressive.
In the 1960s and into the 1980s, the United States dominated the world steel markets. US Steel and Bethlehem Steel were part of the DOW. Allegheny Steel, J&L Steel, and Inland Steel were dominant in the industry. Many of Europe’s steel mills were either destroyed or not really functional following World War II. Japan and the far east were just beginning to build steel mills. As the mills were rebuilt in Europe and new mills came on-stream in Japan, they functioned with new technology and manufacturing methods. They were beginning to make steel cheaper than the mills in the United States could manage.
The foreign competitors were producing steel was so much more cost effective that it could be transported from overseas and still be priced less than the American companies’ product. America was losing market share with their out dated mills, but instead of updating and modernizing the US steel companies went to Washington DC and began to lobby congress to pass tariffs on foreign made steel.
In the beginning, those tariffs protected the US producers in America, but their world dominance was passing away. The foreign companies continued to work on reducing manufacturing costs, while the American companies hid behind the tariffs.
Today, US steel companies have lost most of their market share, and some have disappeared completely. Those smokestacks of Jones and Laughlin Steel are gone. The place where that steel mill stood now houses and redeveloped shopping and living area.
We live in a world where the law is global competition. Companies who do not innovate and improve will eventually die and disappear. There was an expression in the 1950s and’60s: “If it is good for General Motors it is good for the United States.” That same General Motors suffered its own failure to recognize the changes in the marketplace and filed for bankruptcy in 2008. Will they survive in the longer-term? It is not certain.
Think of the DOW stocks from 1966, when the DOW first hit 1000: Bethlehem Steel, Union Carbide, Johns Manville, Anaconda Copper, American Can, Texas Corp, Swift and Co, Sears, Westinghouse Electric, and Woolworth all featured prominently.
There was a time when buying blue chip stocks, holding them, putting them in a drawer, would make a reasonable return. No more. The “blue chips” can become the “black-and-blue chips,” and even vanish entirely. That does not mean that holding stocks for 5 or 10 or 15+ years should be replaced by frequently trading. It does mean following the stocks and selling at the appropriate time.
In my opinion Modern Portfolio Theory is a Potemkin Village. What does that mean?
In the 1700s Catherine the Great, ruler of Russia, invited a number of foreign dignitaries to visit Russia. But in viewing the countryside she saw the villages of Russia were unimpressive to say the least. So, she commissioned Field Marshall Griorgi Potemkin to build all new villages to give the impression that the citizens of Russia lived a comparatively good life. It was completely illusionary. A “Potemkin Village” is something made to look elaborate and impressive but has no substance at all.
Modern Portfolio Theory sounds like it is new and rational and “modern.” In fact the concept goes back to Irving Fischer an economist who, in the 1920s, conceived the idea of a “rational market.” A rational market which should obey economic “laws.” Those laws, once discovered, would govern the world of economics just as the laws of physics and chemistry and biology governed their respective fields.
In the late 1950s, Harry Markowitz opined that the movement in the price of a stock was related to two factors – the relative value of the company itself and the movement of the stock market. Markowitz labeled the two by the Greek letters “alpha” and “beta.” Beta was the impact of stock market movements and alpha the impact of the company. We hear financial analyst, money managers, news commentators, and financial advisors use those terms frequently. According to the economists and the financial “experts,” those terms describe the price of a stock and even a stock portfolio at any given time or over a given time period.
Art Cashin modernized what Bernard Beruch said almost 100 years ago: “The stock market is a perception market. Any time it believes 2 + 2 = 5, it will pay 4 ¾ all day long.” My corollary is that any time the market believes 2 + 2 = 3, it will sell at 3 ¼ all day long. We have only to look back at 1999 during the dot-com days to see the rush to pay 4 ¾ for the market all day every day. At the same time, looking back to 2008-09, we see the rush to sell at 3 ¼ day after day. Neither case was rational.
Modern Portfolio Theory sounds rational and logical. In fact it sounds good. When talking to financial advisors who espouse that they follow Modern Portfolio Theory, it sounds like they are on the cutting edge, and those of us who do not believe must believe in the “Old Portfolio Theory,” if such exists. It is the classic Potemkin Village. It is elaborate with its “efficient frontier” explanation of risk and reward. It is impressive with “asset allocation” to reduce volatility (and thereby risk). It has that feel-good feeling a rational, reasonable, and logical market. History shows it is an illusion.
Eugene Fama, who shared the Nobel Prize in economics in 2013, is a strong believer in the Efficient Market of Modern Portfolio Theory. His studies of money managers showed fewer than 7% do as well or better than the market over the longer term (5-10+ years) when fees are considered. I am happy to be one of those who has done better (check my performance page on this website for my figures). Fama is not alone in his studies and findings of money managers. Charles Ellis (Winning the Loser’s Game) found less than 10% of money managers doing as well- or better than the market in the 1980s an d 1990s.
The premise of Ellis’ book was for investors to set their expectations lower. That was the way to “win at the loser’s game.” I disagree. Investors should take a lesson from professional sports – football, baseball, soccer, or basketball, take your pick. If the manager is a loser, fire him and go search for a winner. The Department of Labor reports that a 1% reduction in performance over 20 years will reduce a nestegg by 17%! Think of what 3% or 4% or 5% will do. Let me repeat, if the manager of your portfolio is not beating the benchmark over the longer-term, fire him and find a manager who does. If you are managing your own stock portfolio and not beating the S&P 500 over the longer-term, fire yourself and hire someone who is likely to beat the S&P 500 over the longer-term.
2016 has been off to a rough start – in fact it is the worst start in history and for many, 2016 is stirring up memories of 2008. I believe that this fear is unfounded and stemming from misinterpreting the oil and commodities drop. They are symptoms, I believe, of the credit bubble bursting and the overproduction which stemmed from futures contracts in the 1990s and 2000s. Despite this, I still think that we are in a super cycle, and as with previous super cycles, there will be some winners and some losers. We wouldn’t be in a super cycle if everything was going smoothly.
Where oil and other commodities are concerned, there is lots of supply and no demand. During the 1990s and 2000s, people believed that the price of oil would only continue to rise and so, many futures contracts were taken out. Airports and the like took them with the intention to collect on their contracts, but many – as much as 50% – were speculative, with no intention of ever taking possession. In addition, it became common for commodities to be treated as an asset class, and more investors joined the speculative boom that way. Futures contracts make sense if the prices continue to climb, but if the price drops, not only do you lose your investment, but you owe additional money as well. Often the money used to pay back the speculative contracts was pulled from other speculative contracts. In this way, I believe that the drop in oil prices was also the catalyst for other commodity prices to fall as well.
The speculation which caused prices to increase also saw trillions invested into factories, plants, and drilling to keep up with the nonexistent demand. $2 trillion was invested into factories in India and China alone, and $6 trillion was invested into oil drilling in Brazilian coast, Australia outback, and South Dakota. The additional investment helped create the oversupply and among others, China’s steel production quadrupled between 2000 and 2015. That is an excess of 600,000,000 tons, and across the globe in Scotland, steel factories are closing – and we are likely to see them closing here as well. A lot of money went into factories, as during the housing market when a great deal of building resulted in many empty homes. We saw banks and businesses close in 2008, and likewise in 2015, 25 energy companies defaulted on their loans and I suspect there are more to come. Despite the drop in oil, though, the S&P book value has continued to grow. I think this is because oil companies
saw the drop as very temporary and continue to carry reserves at full value ($100 to $110), and this spring auditors will force them to market value. I believe this will result in significant defaults and bankruptcies which will affect the market and earnings.
There is good news for the American companies and consumers looking to purchase steel, oil, and other commodities. The price drop will make raw materials cheaper to purchase. I also believe that outside of energy and commodities there will be real growth coming in the market. But as I have said before, to quote Richard Bernstein, it will be a tough year for investors, but perhaps not for investing.
As of January 14, the stock market had its worst start in history. Are we headed to another 2008? NO! In fact, I believe we will probably see a decent to very good market in 2016. But is that what you will hear during the presidential and congressional campaigns? No, you will be hearing doom and gloom. But how accurate is all the doom and gloom? Last December, Richard Bernstein published an article in Financial Advisor Magazine titled “Mute the TV,” in which he said “…2016 might be a difficult year for investors…not necessarily for investing.” Again, it could be a hard year for investors, but not for investing.
Why will it be so hard to be an investor, and why is the best advice you’ll get “mute the TV”? Because the Presidential and Congressional races are this November and everyone is campaigning hard. People are stirred up and there is a good chance we’re going to be seeing many negative ads, and their gloomy assessments of the economy. Their goal to be elected, the candidates are all saying the same thing: “Be scared – things are very bad – but trust ME. I’ll fix it.” Fact checkers have already found, though, that every single one of the candidates has at least exaggerated the truth, if not outright lied, and we can expect that to continue. Mute your TV, because we need to focus on the facts, on what’s actually going on, and not that we’re being told is going on.
The problems touted – the deficit, worker compensation, and commodity price drops – aren’t as catastrophic as it is implied. During the Great Recession, the total deficit was at 10% of the US GDP; expenses were high, particularly the safety net, and revenues decreased with more people out of work and paying fewer taxes. Today our deficit is at only 2.5% of GDP, better than historical average in the long-term. The National Federation of Independent Business released the results of a survey to US small businesses that found hiring intentions for 2016 were higher than normal as well. To accompany this, hourly wages have increased 2.3% in the last 12 months. Lower oil prices (and other commodities), higher wages, and low unemployment (5.0%!) has meant that consumer purchasing power is increasing, and the value of the dollar continues to rise. These are all very good signs for the overall health of the country – and for the American consumer.
It comes down to looking at the facts, and making your own decisions about the hard-and-fast numbers, not letting candidates or pundits talk you into “their” facts. One of my favorite sayings is Daniel Patrick Moynihan’s “You are entitled to your own opinions, but not to your own facts.” Stay educated and focused on fact, and 2016 might have a lot of potential.
 Bernstein, Richard. “2016 – Mute the TV.” Financial Advisor Magazine. Dec. 17, 2015. retrieved from: http://www.fa-mag.com/news/2016-mute-the-tv-24293.html
Imagine you are invited to play a game. You are given $20,000, and can bet $1,000, you win based on the flip of a coin. Heads, you would win $1,500; tails, you lose your $1,000 bet. Imagine you agree to the game and bet $1,000. The coin comes up tails. You bet again and the coin comes up tails and you lose another $1,000. Would you continue to play? If you do and the next flip comes up tails, would you continue? You have lost three straight times. Would you stop and walk away with your $17,000? What if you tried one more time and again lost. Would you call it quits?
What if instead of losing the first time the coin was heads? And the second flip came heads. Now you have $23,000. But on the third flip you lose $1,000 as tails comes up. Continue to play? If you do, and for a second time a tails come up and you lose another $1,000, would you take your $21,000, now a profit and walk? Or would you play again? And if you did and again the coin produced a tails. You are even with what you started with. Would you stop and go? Or would you continue?
When would you stop? Or would you play all the way to the end? A good percentage of people would stop before playing the full 20 rounds. The reality is, to maximize the return – or profit – you have to play all the way to 20 rounds without missing a single coin toss.
This game has been played as an experiment a number of times. Participants did not start with $20,000 but with $20. Statistically, by playing every round, there is an 87% chance of breaking even or making money in the game. If half the time loses and half the time wins, the player will end with $25,000. Yet most people will quit when they see two or three tails in a row. 87% chance of breaking even or making money versus only a 13% chance of losing; those are great odds. Yet 40% of the participants in the study would stop after one loss and only 58% played all 20 times. You would think as people understood the game better they would want to bet more often. Actually just the opposite happened. The longer the game went they more people dropped out.
What this says is that people are more fearful of losing money than rational and logical evaluating the odds of making money. It hurts to lose.
The standard approach for many money managers and financial advisors is this: Do not lose your client’s money. Emotionally, that probably feels good for most clients and especially those who lived through the Great Recession of 2008, but is it really in your best interest?
RW Baird did a study of all mutual funds with a 10+ year track record. They found 370 mutual funds that had done better than their benchmark by an average of 1% per year. But it was not every year they did better. 100% of the funds did worse in at least one year. 85% did worse in at least 3 years. And 1 out of four, 25%, did not only worse in three years, but worse by 5% or more for those three years. Yet each and every one of the funds at the end of ten years had done significantly better over that ten year time period.
If you are holding one of those funds, do you continue to hold on when they are not doing well? How do you know they will not continue to do worse? Do you switch and try to find the winners? Some people and advisors do. After all, isn’t the safest way to keep clients by keeping them from losing money?
Suppose today you went to your bank and withdrew $10,000 in cash with the intent to make a purchase. On your way to the store you were held up and a robber took the $10,000. How would you feel? It is an immediate and hurtful loss, right? It deprives you of what you wanted to purchase.
In my opinion that is what happens when an investor chooses loss avoidance when the probability is in the investor’s favor to make money. A 1% reduction in return over 20 years will cut the value of a portfolio by 17% and 2% reduction by over 35%. That kind of reduction is the same as the stock market drop in 2008. But unlike the stock market drop, there is no recovery. That is opportunity money that is never going to be recovered. Underperformance is like the robber who comes and steals your money and is never caught. It is gone. That is why my emphasis is striving to do better than the market over the longer-term (5 to 10 years), and it is something I have done. While past performance is not a guarantee of future outcome, to accept mediocre performance in the name of safety really does usually lose opportunity money.
The outlook and predictions for 2016 are, frankly, awful. Between oil prices dropping, China’s repeated troubles, and the market opening only to drop 400 points, no one seems to have anything good to say about 2016. But how accurate is all the doom and gloom? Last December, Richard Bernstein published an article in Financial Advisor Magazine titled “Mute the TV,” in which he said “…2016 might be a difficult year for investors…not necessarily for investing.” Again, it could be a hard year for investors, but not for investing.
Why will it be so hard to be an investor, and why is the best advice you’ll get “mute the TV”? Because the Presidential and Congressional races are this November and everyone is campaigning hard. People are stirred up and there is a good change we’re going to be seeing negative ads, and their many gloomy predictions. Their goal to be elected, the candidates are all saying the same thing: “Be scared – things are very bad – but trust ME. I’ll fix it.” Fact checkers have already found, though, that every single one of the candidates has at least exaggerated the truth, if not outright lied, and we can expect that to continue. Mute your TV, because we need to focus on the facts, on what’s actually going on, and not that we’re being told is going on.
The problems touted – the deficit, worker compensation, and commodity price drops – aren’t as tragic or dangerous as it is implied. During the Great Recession, the total deficit was at 10% of the US GDP; expenses were high, particularly the safety net, and revenues decreased with more people out of work and paying fewer taxes. Today our deficit is at only 2.5% of GDP, better than average in the long-term. The National Federation of Independent Business released the results of a survey to US small businesses that found hiring intentions for 2016 were higher than normal as well. To accompany this, hourly wages have increased 2.3% in the last 12 months. Lower oil prices (and other commodities), higher wages, and low unemployment (5.0%!) has meant that consumer purchasing power is increasing, and the value of the dollar continues to rise. These are all very good signs for the overall health of the country – and for the American consumer.
It comes down to looking at the facts, and making your own decisions about the hard-and-fast numbers, not letting candidates or pundits talk you into “their” facts. My favorite saying is Daniel Patrick Moynihan’s “You are entitled to your own opinions, but not to your own facts.” Stay educated and focused on fact, and 2016 might have a lot of potential.
 Bernstein, Richard. “2016 – Mute the TV.” Financial Advisor Magazine. Dec. 17, 2015. retrieved from: http://www.fa-mag.com/news/2016-mute-the-tv-24293.html
Only 40 years ago, China was an agricultural nation, and yet in what seems like no time at all they have become the world’s second largest economy – second only to the US. How is this possible? I have drawn the comparison both on About Money and on my blog about the methods China has used to burst into heavy industry and those Louis XIV and John Baptist-Colbert employed in 17th century France. In fact, there are many, many parallels that help us understand why China is where it is today.
Like France in 1661, China’s economy was agricultural and found it difficult to compete on the world market. Both countries had the decision to change their economic focus by the government – for France, they focused on glass and textiles (both very lucrative industries at the time) and China’s Central Party focused in on heavy industries such as aluminum, steel and copper production, as well as building airplanes and ships. France and China both introduced factories and built dormitories, or in some cases entire cities, up around the factories to house workers. These factories also saw the implementation of a minimum wage for the first time. They worked to create a trade surplus by using foreign policy to limit imports and because the government implemented the work, they largely ignored supply and demand. Perhaps most infamously, both poached from foreign industry – France by attracting artisans and China by proposing joint ventures, and both offered attractive incentives. This economic method, in which the central government drives economic growth, is called mercantilism. China’s central government controls foreign policy, land, military, and banks – and they decide which industry is of major importance. In China’s case, heavy industry.
Yet the credit bubble bust and the commodities speculation may have hit China hardest of all. They invested billions into infrastructure and factories to meet the demands for copper, steel, and aluminum, but because only 50% of those contracts intended to collect on the product, they have found themselves up to their ears in overcapacity. To deal with the oversupply, there has been speculation that China is selling its steel at 10% under the cost to manufacture. To compensate, China has seen a devaluation of the yuan, but despite what we may be told by our presidential candidates, if allowed to float, China’s currency will decrease, not increase. In December of 2015, China spent $100 billion to support its currency, and spent another $3.4 trillion in foreign currency reserves – and yet history tells us that it is impossible to support a currency. I believe it will even take another devaluation. This is not a short-term problem, and we need only look across the Sea of Japan for an example. When Japan took an economic fall, they chose not to close banks and tried to work through the problem, but we find them 30 years later still struggling to recapture their former economic power. We can only watch and wait to see if China goes a similar way.
In the meantime, China’s misfortune does spell potential growth for the American investor. We have the opportunity to purchase raw commodities at or even below the price to manufacture. As I have said before, although 2016 will be a hard year for investors, it will not be a hard year for investing. I believe that you simply need to keep your eyes open and be in the right place at the right time to take advantage of what is out there.