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Staying Alive
By Doug Wakefield w/ Ben Hill April 19, 2008
The
size and frequency of the government’s interventions into the
markets, especially over the last month, has generated little
coverage. Those articles that have addressed this seem to ignore its
implications, concluding that the markets will chug along
indefinitely. The only real surprise is that these comments have
more frequently come from individuals who have written extensively
of the morass in our financial system. How is it that so many take
such historically profound information in stride? Why does most of
the public not recognize the numerous warning signals the real
world is giving to prepare for significant changes? I
invite you to think with me and ask yourself the question I asked a
few professional traders recently: “What questions are we not
asking that we should be?” Historically
speaking, inflation is a cunning enemy, creating the greatest
societal illusion of power and success, only to dash dreams as debts
come crashing down. And, history and science show that there are no
easy solutions, for debt – created out of thin air to bail out
yesterday’s failing debts – is a sand pile that suddenly gives
way in an avalanche. Though science shows that earthquakes are often
preceded by increasingly frequent tremors, we are more prone to
extrapolate our current circumstances into the future than we are to
look for cluster patterns. So when the dramatic shift lower occurs,
the vast majority are not prepared. Whether it was pride or fear or
the pace of the race we call life that prevented us, we failed to
tear through the flimsy façade of the just-so story presented to us
and to look more deeply into difficult information. So, famous
people lose money; rich people lose money; politicians lose money;
and we can be sure that millions of couch potato investors and
advisors will lose money. If
our financial success has been built on inflation, or worse, runaway
inflation, and if we are told that our current credit expansion
–the largest in history – can continue, would it not make sense
that we would want to dismiss the rising fear and distrust around us
as individuals becoming too negative or too emotional? If given the
choice between fear and overconfidence, from which would we rather
operate? I
recently talked with Dr. Larry Parks, Director of the Foundation
for the Advancement of Monetary Education. While some may be
tempted to dismiss this institution as heady or academic, Dr.
Park’s passion to communicate his message
is nothing short of patriotic. I asked him to tell me what he
thought I might have missed in my research. In response, Dr. Parks
directed me to the
Bank of International Settlement’s most recent OTC Derivatives
Report, which states: “Notional
amounts outstanding of such instruments totaled $516 trillion at the
end of June 2007, 135% higher than the level recorded in the 2004
survey (Table A). This corresponds to an annualised compounded rate
of growth of 33%, which is higher than the roughly 20% average
annual rate of increase since positions in OTC derivatives were
first surveyed by the BIS in 1995. Notional amounts outstanding
provide useful information on the structure of the OTC derivatives
market but should not be interpreted as a measure of riskiness of
these positions. While a single comprehensive measure of risk does
not exist, a useful concept is the cost of replacing all open
contracts at the prevailing market prices.” [Triennial and
semiannual surveys on positions in global over-the-counter (OTC)
derivatives markets at the end of June-2007,
BIS, released Nov. ‘07]
The
first thing to note about this BIS chart is that it is measured in
trillions of US dollars, which makes one thing clear: we have
reached a point in financial history that we have never seen before.
That’s right, no one you are reading and no one commenting on our
current financial markets is an expert on where we are going. So,
successful navigation of these straits will require a great deal of
listening, frankness, and humility – things that have always been
in short supply within the financial system. I
am not the expert, and I have no problem with that. There is simply
too much to know to claim mastery of the subjects about which we
write. I do love to read brilliant thinkers, and I enjoy talking
with those whose experience is so vastly different from my own that
I am bound to gain a broader perspective. Mike Arnold’s experience
makes him keenly aware of the world of money and charts like the one
above. Mike is a professional trader.
He was a floor trader and an off-floor trader on the Chicago
and New York Exchanges. He managed a group of off-floor traders in
Chicago and New York and has taught
hundreds of people to trade stocks, futures, and options. Those at
the highest levels in the world of money will tell you that the best
way to gain an understanding of how the world of money works is to
become a floor-trader. When
I asked Mike to spend time thinking with me, he gave me some great
insights. In answering the same question I posed to Dr. Parks, Mike
commented: “We’ve
built this monstrosity of a machine, and there are tons of
architects always working on it. The problem is no one knows what is
going on in the entirety. Nothing this complex has ever existed in
history. I believe what we are watching is an exercise in the folly
of human ego.” What
is most frightening about the BIS’s chart and Mike’s comments is
that, whether we are bulls or bears, we do not want the system to
fail, and we do not want to see good people bear the increasing
weight of trying to bail out the system on their backs. And yet, we
all know that ultimately this is the decision we must make. The more
we ignore the human element in this giant quagmire, the worse it
will be when the major markets start reflecting the real
world problems that bailouts have only exacerbated. Whether
we’re hedge fund managers, with billions under management,
individual investors, with small IRAs, or somewhere in between, I
hope the following ideas will help each of us. Point
# 1 – Do not look to be accepted Surround
yourself with individuals whose business models have provided them
with a great deal of latitude in the world of money. If you respect
great contrarian stories like Templeton, buying heavily into Japan
in the 70s, and Buffet, loading up as the markets declined in 73 and
74, ask yourself, “As we headed into various equity markets’
tops last October and November, did my investments look like
everyone else’s? If I were to go to a conference with thousands of
people, would I feel comfortable because my story is the same as
theirs?” If
the answer is yes, the daily headlines are warning us to stop
looking for short-term emotional rewards and start looking at the
hard facts of science and human behavior throughout history. Because
it is most often a classic sign that everyone is wrong in the group
and no one wants to be rejected for a contrary view, we would all
probably agree that when everyone is agreeing with us, we should not
trust ourselves too much. If no one ever criticizes our opinion,
then this may be an indicator to rethink our position. To
drive this point home even more, consider the chart below. Remember,
at the end of a credit bubble, we should not look for the advice
that makes us feel comfortable. Rather, we should ask a ton of questions about the
real financial and social
issues before we are caught off guard. If you owned a large block of
Bear Stearns, did you take its decline in stride as just the
“natural” forces of the “free markets?”
Point
# 2 – In financial markets, all men are not created equal Realize
that at the highest levels, the true story of money is dirty. Think
about it. When Bear Stearns, one of the top five-brokerage houses in
the US, collapsed recently, did people start scrambling to get out
of their buy-and-hold strategies? Did they start to ask a lot of
tough questions? No. Why? JP Morgan, a firm with a long history of
“rescuing” other banks, was going to bail Bear out. Never
mind the meetings with Treasury officials over the previous weekend
to talk about things too sophisticated for the masses to understand
anyway. All we know is that JP Morgan initially announced that they
would only have to spend $236 million to buy out the entire
brokerage house. Of course, the Federal Reserve loaned JP Morgan $30
billion to “stabilize” the situation. Did most investors
understand that in so doing, we
were ultimately paying for the deal through a decrease in the value
of the US dollars currently in our pockets? When average Americans
fall behind on their debts, banks begin charging us 31 percent, and
we are hounded by bill collectors. When major banks fall behind and
lose billions, the banking cartel creates money out of thin air and
gives new loans at 2.25 percent to its favored members. Does this
sound sustainable to you? Does it build confidence in the system? Point
# 3 – Now is the time to do something different Listen
to people who have different opinions than your own. Have respect
for individuals whose experience in the world of trading and
managing money is vastly different from your own. Bob Lang, of Lang
Asset Management, is one such individual in the world of money.
He has managed money for nearly 5 decades. After 4 decades on the
long side of the markets and two years of practicing a short-selling
platform (without real money), in January of 2000, he went live with one of the few short-only
platforms in existence. I ask him yesterday, “What percentage of
people have you talked with over the last 8 years that you really
think understand the benefits of short selling in declining
markets?” Bob responded, “By
the time a prospect comes to us, they are usually very concerned
about the economy and the markets, but very few of those individuals
really understand the benefits of short selling. Due to the large
losses of the late 90s or the first few years out of the 2002
bottom, most consultants still do not believe in the concept of
shorting. So, the consultants would rather a manager make the asset
allocation decision between long and short ratios, so if the results
are disappointing, the consultants can blame the manager. Most money
managers don’t even like to short. For example, in the first
quarter of 2008, the typical long/short fund was down 6 percent.
Obviously, shorting was not a part of their long/short strategy.” And
in a way, when I think of the numerous conversations I’ve had with
individuals since the beginning of the credit crisis last July, I
completely understand. Sometimes it seems like every time I think
maybe the government intervention schemes have reached an
unsustainable level, and I am encouraging individuals to consider
managers or funds that use short selling tools or I am ready to move
some money out of the markets, the “exercise in the folly of human
ego” takes over in Washington and Wall Street, and the markets
don’t decline. Think about it; on Wednesday JP Morgan announced
that their profits
declined 50 percent in the first quarter on a $5.1 billion dollar
loss; its stock, and the markets, exploded up.
I
mean, we are reading the headlines and our world leaders even
comment on historic problems, and then we watch this happen. How
would we feel? Would we
think, “Maybe I just don’t get it? Maybe things really aren’t
as troubling as I was lead to believe.” General George S. Patton
once said, “Fatigue makes cowards of us all.” As government
makes more frequent forays into the markets, we should be careful to
guard against it. Point
# 4 – Don’t hammer nails with a screwdriver In
the charts below, I present the performance of two funds, with
diametrically opposed investment objectives, through a bull and a
bear market.
One
of the funds is designed to mirror the daily movement of the NASDAQ
100, and the other aims to move exactly the opposite of the NASDAQ
100. Wouldn’t it make sense to try and use different tools in
different market environments, versus the same tool for all
market conditions? Point
# 5 – Wall Street’s warnings are often “a day late and a
dollar short” Those
who have studied the destruction of our nation’s money at the
hands of our Federal Reserve may have profited handsomely over the
last several years in commodities, oil, and metals. As we look back
over the last several weeks, I’d like to pose a few questions. Has
manmade inflation, through the destruction of a currency, ever been
sustainable? If not, will you know ahead of time when the day
arrives that the Federal Reserve’s inflation and the
government’s massive intervention fail – as they did in 1929? My
question is not what constitutes money. Rather, as credit continues
to contract throughout the system, what happens when the collective
groups of investors, who have made money investing in inflationary
strategies, are increasingly impacted by the desire to lock in
profits or the need for actual money that they can spend in their
daily lives? What would happen if these marginal transactions
flipped the switch on a number of quant models, causing an
inordinate number of them to exit the markets or short into the
decline? And
lest we think that our current, historic juncture is substantially
different from the generations that preceded us, let’s look at the
London Herald’s front page from October 25th of 1929.
That morning its headline read, “WALL STREET CRASH!” The
following excerpts are from two articles on the front page: “A crisis
meeting of New York’s leading bankers was held in the offices of
JP Morgan & Co and prices recovered slightly in the afternoon on
the assurance from the firm’s senior partner, Thomas W. Lamont,
that the problems were ‘technical rather than a fundamental’.
Mr. Lamont admitted that: ‘there has been a little distress
selling on the Stock Exchange’ but the most influential financiers
in New York concluded that the market was essentially safe and was
simply readjusting after four strong years of growth.” Next,
we read: “Massive sales
in the early morning created an extraordinary atmosphere of chaos
and panic. Brokers flooded the market with orders from their
investors to sell at any price. As the situation reached crisis
level, the market broke down entirely as the sea of brokers clamored
madly for non-existent buyers. Stocks were traded for any price and
the value of some companies halved during the course of the
morning.” Has
human tendency changed so much over the last 80 years that we would
take a 50 percent loss in stride? History records the plight of
those investors who trusted the financial leaders’ comforting
rhetoric that Friday in 1929. How did those who stayed put “for
the long term” do by 1932? What could these charts, of the two
largest municipal bond insurers in the United States – MBIA and
Ambac – be telling us regarding future risks?
Closing
Remarks I
can almost hear someone saying, “But certainly, with all the
people at the highest levels of government and finance working on
this, something will be done to change the course of yet one more
credit bust, which has already been stalled by the creation of new
ways to repackage and sell yesterday’s leveraged debt to someone
else.” After all, who am I to question the advice given every day
by thousands of advisors and newsletter writers? Who am I to
question the system’s sustainability? At the end of the day, I’m
just a person who keeps asking, “What is the question that we all
need to be asking that we aren’t?” A
couple years ago Gordon Graham, former Director of the Socionomics
Institute, suggested I read Dr. Jared Diamond’s book, Collapse:
How Societies Choose to Fail or Succeed. We included
the story below in our June 2006 newsletter. As you read it, ask
yourself if this information would be appropriate for investors,
advisors, traders, or for that matter, anyone. “Consider a
narrow river valley below a high dam, such that if the dam burst,
the resulting flood of water would drown people for a considerable
distance downstream. When attitude pollsters ask people downstream
of the dam how concerned they are about the dam’s bursting, it’s
not surprising that fear of a dam burst is lowest far downstream,
and increases among residents increasingly close to the dam.
Surprisingly, though, after you get to just a few miles below the
dam, where fear of the dam’s breaking is found to be the highest,
the concern then falls off to zero as you approach closer to the
dam! That is, the people living immediately under the dam, the ones
most certain to be drowned in a dam burst, profess unconcern.
That’s because of psychological denial: the only way of preserving
one’s sanity while looking up every day at the dam is to deny the
possibility that it could burst. If
something that you perceive arouses in you a painful emotion, you
may subconsciously suppress or deny your perception in order to
avoid the unbearable pain, even though the practical results of
ignoring your perception may prove ultimately disastrous. The
emotions most often responsible are terror, anxiety, and grief.”
[Page 435 & 436] If you are
growing more concerned by real world events, while finding emotional rest in the long sideways
movement in the US equity markets since January, I encourage you to
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here. Doug
Wakefield, 3010
LBJ Freeway doug@bestmindsinc.com Best
Minds, Inc is a registered investment advisor that looks to the best
minds in the world of finance and economics to seek a direction for
our clients. To be a true advocate to our clients, we have found it
necessary to go well beyond the norms in financial planning today.
We are avid readers. In our study of the markets, we research
general history, financial and economic history, fundamental and
technical analysis, and mass and individual psychology. Disclaimer:
Nothing in this communiqué should be construed as advice to buy,
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examination of how that "wisdom" has stood over time, is
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those individual's advice. Challenging one's thinking is the only
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