I took my own advice from last Thursday’s newsletter. Mrs. Draconian and I packed up the car — with mother-in-law and Mini-Dragon in tow — and drove up to Lassen Volcanic National Park. We enjoyed a nice stay and some beautiful drives. The trees are just starting to turn golden.
I realize that one of the things our slapdash little newsletter has lacked is an abundance of cuteness. There’s an obvious reason: this isn’t a personal blog, it’s an investing newsletter. Investing is a harsh slog through a cruel, ugly world. But sometimes we tell personal stories and share personal things and try and relate those stories to the world of finance. After all, you guys are my 1,000 closest friends.
Many of you have already met the Mini-Dragon but for those of you that haven’t, allow me to introduce the fire-breathing and poop-spewing cherub that has provided my wife and I with heretofore unknown pleasures and pains during the last six months.
I mention her because, as children do, she has changed my perspective on things. I have become acutely aware of the fact that the decisions I make will impact her life directly, a life that in theory will continue beyond my own. The decisions we make collectively will impact the world that she and her cohorts will inherit. I have always known these concepts but never felt them in a visceral sense until recently. This is one of the reasons why we tend to take a rather long-term view on things here at The Draconian. There are more important things to discuss than if the market will go up tomorrow or what words the Fed will use in its next statement.
Anyway, Lassen Volcanic National Park may lack the drama of Yosemite, California’s most famous national park, but it makes up for it with its honesty. While inside the park, visitors are never afforded a moment to forget the subtle undercurrent of danger. All of you local readers understand that the Sierras are a dangerous, powerful place. These mountains are not to be messed with. Around every hairpin bend up in Lassen are sheer cliff faces, jagged talus, and pools of boiling mud, bubbling up from deep inside the earth.
It’s a range of slumbering volcanoes, for heaven’s sake!
Another cool thing about Lassen is that it gets relatively little traffic. It sees only about 380,000 visitors per year compared to Yosemite’s 3.7 million. One of the reasons why I like to visit these national parks is to escape from it all, to spend some time away from the noise and the crowds and the anxiety.
National Park visitor centers are always really interesting because visitor centers are the highest-density locations you’ll encounter when travelling out to “the middle of nowhere.” They are the places in nature where people congregate if any congregation is to take place. And the thing about being in the middle of nowhere is that there is zero connectivity. No television, no wi-fi, no service on your cell phone. If you visit one of these glorious parks this fall, take a moment and revel in the marriage of those concepts. Here is a place where a large number of people have gathered, a location where nobody is talking on their cell phone. Not a single person is on their laptop checking e-mail or updating their Twitter status.
When was the last time you visited a place like that?
I realize that may qualify as a somewhat alien environment in today’s developed world. There truly are no other public locations like it. People were talking with one another, smiling at strangers and asking questions of the rangers. Kids were exploring the exhibits and running around outside. Everybody seemed so happy. And peaceful. It didn’t feel alien at all, but rather perfectly natural.
OK, what does this have to do with investing?
The new Kohm Yah-mah-nee visitor center is a sight to see. It rests in valley surrounded by four craggy, magisterial peaks. About a million years ago it was the middle of a gigantic volcano. Over the eons the super-volcano erupted and eroded and ultimately caved in on itself, leaving four pillars behind to retell its geologic history. Lassen Peak is just one of them.
When I stepped out on the observation deck, an eerie feeling of insignificance crept up through my legs and wrapped its tendrils about my torso. I was powerless. I was in the presence of something far greater, a force that cared nothing for a mortal like myself and my petty struggles from day-to-day. It was a refreshingly humble experience. Try it sometime.
In any case, it reminded me of two important and powerful principles that investors frequently forget.
- Things change, especially over long periods of time.
- The markets are fraught with danger and are also not to be messed with.
How many companies in the Dow today were in the Dow fifty years ago? How many of today’s dominant companies were dominant during the 1970′s or 80′s? Even over the last decade so many things have changed. In the midst of the tech-revolution we thought Microsoft, Intel, and Cisco had changed the world and would dominate forever. Instead, those stocks went nowhere, usurped by Google, Apple, and a paradigm-shifting rabble-rouser that hasn’t even gone public yet. Where will these three be in 2020? Who will usurp them? Gold was at $250/oz a decade ago. Today it’s at $1,300. Where will it be in another decade? Real estate went from boring to sexy to downright-depressing; I can’t wait to see what it’ll do next.
My point is that things change. This is the clear history of the world: epic cycles of change. So why do we always look to the recent past and assume that it will continue, if not forever then long enough to satisfy whatever needs we have of that moment’s forecast?
Look: predicting the future is tough. Some investors (and newsletter-writers) take it more seriously than others. As for me, if I could make predictions at a rate greater than 50/50 I’d change my name to Zoltar and start charging money for this thing. But I can’t do that. I can’t predict the future, and I certainly can’t do it by looking at the recent past. All I can do is make a list of things that might happen, assign some probabilities, and make sure my portfolio is built in such a way that I’ll be able to handle the majority of those outcomes.
That leads me into the second point, the notion that the markets are a dangerous place.
Last week I showed you a chart of the BlackRock High Yield Bond Fund. Investors are plowing money into that fund and others just like it. They’re doing it because it’s gone up over the last decade and has skyrocketed in the last year. Also, it’s a bond fund. Bonds are like, less risky. The fact that it had a 30% drawdown is completely erased from our minds simply because it recovered from it. But what happens when we get another economic freakout? (Don’t worry, there will be at least one in the coming decade.) Junk bonds are always the first things to fall apart if the economy slows down. Are people chasing funds like this because they think the economy won’t slow down? Or are they so desperate for yield that they’ll turn a blind eye to all the danger?
Most of you don’t need to be reminded of this. And what makes markets devious on top of being dangerous is that they lull you into a sense of false comfort before springing the trap. This is why we use the “booby trap” analogy. The market drifts higher, seemingly harmless and peaceful, and then shocks investors with fierce corrections. Like our beloved Sierras, we should respect the danger found within and we tread with justifiable caution.
So here we go. Today we get started on assembling a field guide for protecting wealth. It’s not a complete guide by any stretch of the imagination, but it covers some of the more effective things investors can do to keep their investments safe. Over time, maybe we’ll add more things to this guide. Hit me up at Feedback@TheDraconian.com if you want to share some of your favorite techniques and rules about how to preserve capital.
A Field Guide for Protecting Wealth
“In a bear market, everybody loses. The winner is he who loses least.” - Richard Russell
I love this quote. I love it because it gets straight to the heart of what makes bear markets so difficult to deal with. It speaks to the psychology that blocks making the right kind of decisions in tough markets. For most people it’s difficult to grasp the concept that simply not losing can be a huge win. In the NFL they call it “game management”, a fourth quarter playbook that is specifically designed to keep the offense from turning the ball over and the defense from allowing big plays. Running the ball up the middle over and over has a low probability of generating a touchdown on any single play, but it burns time off the clock and moves the leading team closer to final victory. It might be boring to watch, but when the game concludes there’s nothing boring about a win.
A good decision in a bull market is not necessarily a good decision in a bear market. A risky downfield pass may be a good way to try and get ahead in the first quarter, but it’s a bad call if you’re trying to protect a lead late in the game. Bull markets are about making money and being aggressive with capital allocations. In a sense, everybody wins in bull markets; the value of pretty much everything goes up. But the strategies that produce the biggest profits in rising markets are typically the ones that produce the biggest losses when the bears take over.
Everything changes in deflating markets and this is the reason why so few investors have relative success during both phases of the full market cycle. It requires a totally different playbook, and for some reason investors seem wired to perform better in one environment or the other. Just as truly balanced, dominant football teams are rare, so are investors who are successful outside their unique specialties.
We’ve been in the asset management business for a long time. We haven’t been around quite as long as that old grizzly, Richard Russell, but our firm has seen entire bull-bear cycles. And I can say that over the long-run, capital preservation trumps growth. Don’t get me wrong — growth is very important. But it’s not as important as capital preservation. I can’t tell you how many hedge funds I’ve seen over the years make a ton of money and then give it all back to Mr. Market at once. Sure, that’s anecdotal evidence, but my guess is that you’ve got plenty of your own anecdotes that reinforce the principle. Long Term Capital Management and their globe-shaking eruption is obviously one of the classic examples from our industry, but take a walk around your neighborhood. How many of those guys made a few bucks in the housing market only to eventually get crushed under the leverage? How many of your friends grew their investments at prodigious rates during the tech-boom only to lose most of it during the washout?
What good was all that growth?
Evolving one’s playbook can be difficult. But it’s possible if you pay attention to the game. The more profits you accumulate in the early quarters of the bull cycles, the more attention you should allocate towards protecting what you’ve earned. You’re not going to pick the top or bottom in any cycle, so use something of a sliding scale. As the bull market rolls on, gradually begin to establish defensive positions. That way you won’t have to worry about exactly when the bear is going to roar and when it does, your portfolio will immediately be better equipped to handle the threat. Your fourth-quarter defense will be ready to go.
Do the same thing in ugly markets. As things get worse and worse, gradually open yourself up to taking on new risk. Don’t plan on catching the exact bottom. Just know that when the bottom comes, you’ll already have a foundation to build on. If you don’t understand how to protect your capital, you won’t ever build much of anything. At least nothing long-lasting.
I’ll concede that the time for this newsletter was 2007. That’s when it truly would have done some good. But I think there’s still plenty of relevance today. Today the market is adrift in a secular cycle of abnormal volatility and uncertainty. We’ve come a long ways off the highs but capital preservation is still very important.
Guarding against disaster
When it comes to managing risk, the single best tactic that you can employ is something that protects you from catastrophic losses. It’s an idea with deep roots in human psychology, this desire to save ourselves from severe losses. It’s why we buy insurance for our homes or lives. It’s why fear always trumps greed and it’s why teams play the prevent defense to protect leads late in the game.
It applies to investing too, and limiting catastrophic loss is a surprisingly under-appreciated strategy. Nearly every great trader I’ve spoken with agrees that it’s more important for an investor’s long-term survival than any other factor.
There are a few tactics you can employ:
Diversify your portfolio. You never know when one of your holdings will miss its earnings forecast or may be suspected of shady dealings. Events like that can collapse your investment in a single day. If you own a bunch of different stocks, the impact of one company’s bad news won’t wreck your whole portfolio.
Trade sizing. If you’re an active trader, this is immensely important. One of the most common reasons that active traders blow up is because they size their trades far too large relative to the rest of their portfolio. Depending on your style, the “right” size for the trade will vary. Obviously, a global macro hedge fund trader will be concentrating on just a few major bets, but he’ll be sizing them in such a way that the effect on the portfolio will be both predictable and manageable if something really goes awry. A long/short equity hedge fund won’t typically be betting 150% of his portfolio’s capital in a single trade.
Odds are you’re probably not a hedge fund trader, so don’t make a single $75,000 bet at home with your $100,000 portfolio. If it’s a short term trade, you are exposed to significant loss. Even if that $75,000 trade is a low-volatility position, it may slowly move against you and you may find yourself locked into the position with too little capital elsewhere to take advantage of better trades. This is an insidious side effect of improperly sized trades that few investors, even professional ones, take into consideration. It’s the opportunity cost of over-sizing a trade.
Stop losses. This is a popular technique for limiting loss, but they’re a lot more difficult to implement than you might think. On the one hand, hard, mechanical stops can get run and knock you out of the trade before it’s had a chance to mature. But on the other hand, a soft, arbitrary stop adds risk of psychological bias and raises the chance of riding a bad trade for too long. In our trading, we’ve found that best stop loss system balances both of those aspects.
As a starting point, find the amount of loss you’re willing to tolerate. This too is surprisingly difficult, so look at the type of returns that your trading generates. A tolerable loss is one that your trading systems or investment strategy should be able to recover from in an appropriate length of time. If you’re a long-term investor gearing your portfolio to make 8% per year, a 20% loss is simply unacceptable. That’s a loss that will take you three years to recover from! Find a threshold based on the expected rate of return of your strategies. Then use that target as a midpoint for a flexible range. For example, if 10% is the type of loss that your portfolio can recover from in a sensible amount of time, begin to get worried if the trade is down around 8% and make sure you’re long gone from the trade before it gets much worse than a 12% loss.
Ask yourself some questions, too. What has changed in the market environment? What details have changed within the specific trade? Is your investment thesis even still good? Remember that the facts and the details will continue to evolve once you decide on your stop threshold. The best stop loss system is a dynamic system. If risk and volatility are increasing, tighten up your stop, especially if you have gains. If the climate is calm, be more willing to absorb a larger loss to give the trade time to play out.
Insurance in the form of options. The rule of thumb with insurance is that insurance is rarely cheap. Companies sell insurance because it’s in their interest to do so. Over the long run, insurance companies have a knack for generating profits. They’re able to do this because they understand the math and the statistics of the items they’re selling insurance for. With options, it works the same way. Roughly 70% of the options contracts that are written (sold) expire worthless. The odds are against the buyers.
The other important concept about insurance is that the worst time to buy it is during or after the crisis. Yet amazingly, this is when most insurance gets sold. We don’t have a lot of earthquakes here in Northern Nevada, but we do have some, and every time we get one local insurance companies break records for the amount of earthquake insurance they sell in the days immediately following.
The time to buy insurance in the form of options is before the crash, not after. Every option contract contains a premium and the value of that premium increases when volatility increases. So use low-volatility environments, periods where the market has run up or has slowly drifted around, to shop for portfolio insurance. This seems like a very intuitive concept, but mountains of data on consumer and investor behavior show that people have a remarkable tendency to always buy insurance at exactly the wrong time.
Finally…
Don’t borrow! Nearly every market disaster in history has had excessive leverage at or near ground zero. It’s one of the common denominators in every bubble and collapse, and one of the fatal mistakes that companies and economies make. Steering clear of leverage is the easiest, lowest cost, most effective way to lower the chance of catastrophic loss.
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That’ll do it for now.
We’ve got some good stuff planned for the weeks ahead. Today’s newsletter was kind of fun but next week’s is going to be hardcore. Buckle up. We’re going to talk correlation and really break down this whole “risk on / risk off” environment. Also, our own Kelsey Joyce has been working on a neat piece on socially conscious investing strategies. Stay tuned for that.
In the meantime, check out Kelsey’s new blog for this year’s Race for Research event. All you long-time readers know her mom was diagnosed with Multiple Myeloma and her family’s response has been to get proactive and raise money for research. It’s a really inspirational story. Click here to learn more, register for the race, or make a donation. Mrs. Draconian and Mini-Dragon will also be there, as will others from the Draco gang.
Stop by and say “Hi” on October 24th!
I got a flurry of text messages at about 5pm last night.
“It’s Trini! Turn on Channel 2!”
“Hey, is that Trini on the news?”
It was indeed. The folks at our local Channel 2 news asked Trini to go down to the studio last night to do a quick interview about hedge funds. It was part of their MoneyWATCH segment and he hung around for the whole broadcast and manned the phone as viewers called in with questions. News anchor Kristen Remington invited him back in a couple months, so next time he’s on TV we’ll give you all a heads-up.
Kyle will also be up at UNR today giving a lecture on alternative investments. He’ll be at the business school discussing a couple of strategies that can help investors large and small cope with the volatility in the markets and enhance their return. Keep your eyes peeled for that if you happen to be on campus later this afternoon.
It has been quiet couple of months since the midst of the European Debt Crisis. Barring any kind of global shakeup, summer is usually a quiet time in the markets. Investors are on vacation in both a literal and metaphorical sense. That doesn’t meant that the news flow stops and the world shuts down. It just means that certain stories receive a little less attention and there are fewer people in the industry overreacting to them.
But summer’s over. At least here in the Sierras. The trees are starting to turn yellow, we no longer have to run our air conditioners during the day, and it gets chilly at night, especially if we forget to close the window. The kids are back in school and the traders have returned to the markets.
Today, as we head into fall, I’m going to talk about a few major items to keep at the forefront of your mind.
It’s official! The Great Recession is over!
On Monday the NBER came out and called an official end to the recession. It ended in June 2009 and lasted 18 months. It was the longest recession since World War II. It was not as severe as what we went through in the early 80′s.
Those of you who have been with us for a while know that we called that as early as last July. Not that that was a call that meant anything. Pretty much every economic indicator out there showed a trough last June and steady recovery since then. We talk about the Three Amigos here all the time. That’s the ISM Purchasing Manager’s Index, capacity utilization, and junk bond spreads. None of those Amigos are busting the doors down but they have showed consistent improvement in the last year and that means that the economy has been getting better. The data never lies.
Neither does Punxsutawney Phil:
I’ve also been repeating over and over that it doesn’t matter if the recession has ended or if the economy is technically recovering. It hasn’t felt like much of a recovery and won’t until median incomes start rising again and the unemployment rate drops a couple percent. Neither of those things will happen for quite some time and so it’s going to feel really “blah” for a while. It will make life in the markets very difficult, especially for the average investor.
Remember that people spend money in accordance with their expectations of future income, not their current income. This principle even has a name, the Permanent Income Hypothesis. That’s your sneaky economics lesson of the week. It was one of the great Milton Friedman’s many significant contributions to the field. Our economy is about 70% consumer-driven, so pay attention to the retail sector and things like consumer confidence. When that decisively starts trending upward, it will be because our expectations for the future have improved and only then will a real recovery grab hold.
It’s hard to believe, but in terms of GDP lost and the rate of unemployment, this recession was not as severe as the double-dip in the early 1980′s. This is because of the bailouts and the stimulus. Like ‘em or not, they had a profound effect on mitigating the damage. Mark Zandi and Alan Blinder — two highly respected economists — estimated in a controversial and wonkish paper that GDP would have been 11.5% worse without any government intervention. The economy would have lost an additional 8.5 million jobs.
We can debate the details of their conclusions and we can debate the true effect of the stimulus, but at this point we can all agree on a few items:
- Things would have been far worse without any government intervention.
- The scattershot stimulus efforts were neither as effective nor efficiently designed as they could have been.
- All this intervention had a cost and it will be significant and long-lasting.
It’s going to be a while before we can definitively say whether or not it was worth it. I believe this will be the debate that dominates modern economics. The decision for the government to step in and try and make it all better will be the action that turn-of-the-millennium USA will become known for. It will broadly define our approach to managing the economy and it will speak volumes about our culture, politics, and national psychology.
Chin up. It won’t be all bad. Japan made a strikingly similar set of choices about 20 years ago and even though they’ve been stuck in funk ever since, life has moved on. Millions of Japanese go to work every day; they earn money and spend it. They live happy, fulfilling lives. Every once in a while they loosen their neckties and sing karaoke.
A couple weeks ago we outlined a strategy for how to make the most of environments like this. Check it out if you missed it. We are living in abnormally volatile and uncertain times. All we need to do is adjust our expectations and our mindset a little bit and we’ll be able to cope with all this just fine. Humans are nothing if not adaptive.
Europe is still a gigantic problem
It’s amazing. If you just follow the headlines you might think that everything across the pond is hunky dory. You probably have some hazy memory about Greeks lighting people on fire in the streets or jittery German banks freaked out about a tidal wave of sovereign defaults. Maybe you even remember the economic slur “PIIGS” to highlight exactly which countries were the naughty ones. I always preferred the “Club Med” moniker, not because it’s less cruel but because it alludes to the massive difference in culture between Northern and Southern Europe. Seriously, what is it the Mediterranean sun that made those economies so lazy, irresponsible, and entitled? Is it the cold winters that make northern cultures industrious and forward-thinking? What’s with the correlation between budget deficits and distance from the equator? Except for Iceland, of course. We all know what happened to those guys.
Anyway: these crises are every bit crises of culture as they are of finance.
While EU debt story may no longer be at the forefront of the zeitgeist, the markets are telling a totally different story. In a moment I’ll show you a chart of European bond spreads.
What bond spreads measure is basically how skeptical bondholders are that they’ll get paid back. Remember, if you’re loaning money to your shifty brother-in-law you’re going to require a higher interest rate than if you were dealing with somebody like Warren Buffett. With the latter it’s a good bet you’ll get paid back. With the former, not so much. A spread is just the difference between how much you charge your shifty brother-in-law and Warren Buffett.
Raise your hand if you knew that bond spreads were back at the same levels we saw in the midst of the crisis, the scary day in May when Europe seemed to be on the cusp of unraveling.
I don’t see many hands in the air.
The markets are saying that the sovereign debt problem is as bad as it ever has been. So why does it seem like everybody has stopped caring about Europe? Back in May the IMF intervened and made bunch of short-term loans at below-market rates to help Greece roll over a mountain of debt. Once the immediate threat had been addressed everybody stopped worrying about the faulty foundation and long-term danger.
The Euro has even rallied something fierce:
I feel a little silly now having called for parity on the Euro, but something tells me that this story is nowhere close to being over. Go back and look at those widening bond spreads. The Euro is a risk currency and I think a lot of this recent move can be explained by a general increase in global risk appetite. All it’ll take is another booby trap to trigger the next leg down. If you think there are no more booby traps on the horizon then you really haven’t been paying attention for the last couple of years.
If you’re desperate to diversify some of your assets out of US Dollars right now, I’d look elsewhere. Park some money in Canada, Australia, or China instead. The guys over at Everbank offer CDs denominated in foreign currencies. I think that’s pretty cool and a great way to hedge US Dollar risk. Those seem like really attractive products to me and I’m a little surprised more banks don’t offer stuff like that. Maybe that will change during the next round of Dollar hatred. With rumors of more “quantitative easing” (aka Fed money printing) that could happen sooner than you think.
What about Bond(s)?
Like the European debt crisis, talk of The Great Bond Bubble has also slipped off everybody’s radar.
I’m not ready to climb on board with the “get short bonds” trade yet, but I do believe that this is not the time to mindlessly shift money from wherever into whatever looks most attractive in the bond space.
Junk yields are back to pre-crisis levels. Junk yields are one of the Three Amigos and they’re a terrific economic indicator, but I think this action speaks more to investors’ desperation for yield than it does about the improvement of the economy. The junk spread over AAAs is about 4%. In the 90′s or even the mid-aughts, that might have been sufficient compensation for that level of risk. But today? With all the booby traps and potholes up ahead, and with all of those “structural headwinds” that the brainy guys at Pimco are always talking about? I’m not convinced that the extra 4% is worth it. In fact, I’m pretty sure it’s not.
The rule of thumb in the bond market right now is easy to understand but requires discipline to practice: do not reach for yield! Stay near the front of the curve and favor higher quality offerings to lower. This is hard for a lot of people to hear because high-quality short-term yields are pretty miserable. It’s not the kind of thing that an investor can live off of.
Look, we’ve had basically a 30-year bull market in bonds. It’s been a great ride. The details in the bond market today are different, but the psychology should sound eerily familiar. Remember in the late 90′s when we all thought stocks would grow for 15%/year forever and ever? That stocks were the greatest long-term investment ever? Do you recall real estate circa 2005, when everybody thought that housing prices had never gone down and never could go down?
This is the psychology that’s present in the final stages of epic bull markets. I know that bond bears have been talking about this for years, but interest rates can only go so low and while it seems like they could definitely move lower still, the juice that’s left to be squeezed probably isn’t worth the risk of being exposed to another great unwind.
Today the retail bond investor just looks at the yield and says, “cool, I’ll take 5% from this basket of bonds” and assumes that that’ll be his rate of return for the next couple of years.
Here’s a chart of the BlackRock High Yield Bond fund. Unlike a lot of funds, this one actually made money over the last decade. The portfolio’s current yield is about 8.25%. It’s rated five stars on Morningstar. On the surface that sounds damn sexy.
I’ll admit, that’s a nice looking chart. This is probably as good as it gets in the higher yielding space. But this is a fund that has a 30% drawdown! This fund went nowhere for three whole years. Three years! Do its investors really understand what can happen to a fund like this if things get dicey in the debt markts? Do they rationalize that risk by anchoring themselves to that current yield and assuming that over the long run they’ll be just fine?
This is the kind of thing investors are chasing, something that they plan on living off of?
It’s crazy how much money retail investors have piled into bonds. $170 billion has flowed into junk bond funds this year, an all-time record and the year isn’t even 3/4 finished. It is charts like the one above that have been the justification for that record inflow.
Has anybody looked at a chart of (real) bond returns in the 1970s? They were terrible! I know all this stuff has done well during the last decade, but what does that have to do with performance in the decade to come? What happens if the interest rate cycle finally turns upward? I’d even make the paradoxical bet that many of these mindless bond chasers have also bought in to the inflation meme. That goes to show how little thought and planning the average investor gives to the decisions he makes. The only things that matter to him are current yields and past performance.
Here’s a chart of the 10-year Treasury, the grand-daddy interest rate benchmark of them all.
Seriously, there aren’t even that many folks alive that did much active investing during a secular cycle when interest rates were trending upward. All that most of us in this industry have known is an environment during which interest rates have slowly, consistently gone down. That’s awesome if you’re a bond investor — lower rates means that the value of the bonds you currently own goes up.
That being said, the 10-year has dipped below 2.5% before and it could definitely happen again. The yield on the 10-year Japanese Government Bond (JGB) is about 1% right now. This is exactly why I’m not ready to get on board with the “get short bonds” trade yet. Ugly demographics and karaoke aside, I think we are turning Japanese in this country and that means that there could still be some life left in bonds. A death rattle, if you will. If Japan is indeed the template for the US, then it’s far more likely that our bond market will follow theirs. Instead of rates bouncing like a tennis ball and trending back up again, I think they will instead go splat and stay there.
Here, take a look at the future of our bond market:
Anyway, we’re clearly in the later innings and the risk has increased. So be careful. Stay near the front end of the curve and stick with higher quality. Or play it tactically and wait for better entry points.
It would be a great irony indeed if the average investor, having been burned by three consecutive bubbles, leaping from lily pad to lily pad chasing stocks, real estate, and credit, sinking each one in succession after discovering that every other frog in the pond had leaped to the exact same places at the exact same times, now looks around and sees that once again all the frogs have gathered on one lily pad, the bond lily pad.
I don’t believe that this one will sink in disastrous fashion the way the others have. But I do believe it’ll be a disappointing place to hang out, and in the case of junkier bonds, the returns just won’t be worth the risk.
Fall is finally here
I love this time of year. It never seems to last very long, but it’s a wonderful couple of weeks. It’s easy to miss because we’re always so busy — coming back to work, getting the kids back in school and starting up soccer practice. Try and get out there during one of these next few weekends. Take a drive through the Sierras and enjoy the cool air and clear skies.
It’ll make these lowly market yields seem a whole lot less frustrating.
EDITOR’S NOTE: It’s been relatively peaceful in the markets this week. We’ll recap all the important bits next Thursday. Today we feature an interesting personal story from our own Trini Guillen. Trini’s been with the company since the early days and he’s seen a lot of change in the industry over the years. I think you’ll appreciate his longer-term perspective on this dynamic business and enjoy the touch of personal history that he adds.
A very close friend of mine often opens up with a single line whenever we meet: ”What’s your story?”
Most of the time I reply quickly, without hesitation, drumming up the day’s events for him and always rolling into great conversation. However, from time to time, I think about that question in depth and reflect on my story, which really is our story here. It’s a simple history that is complicated only by the confusion of defining exactly what we really do. But when it’s all broken down and laid out our story makes perfect sense and it’s coming full circle to be retold all over again.
I grew up in Fallon, Nevada, 63 miles east of Reno. My family moved there in 1981 and it was there I would learn to slow down and grow up. Coming from Southern California, even at a very young age I got the notion that you kept your eyes on the road and went about your business in a very rapid manner. That wasn’t the case in Fallon, because if you found yourself in a hurry there, you were sure to get nowhere fast! No sir, it was a very small town with small town etiquettes that everyone I knew adhered to religiously. You waived to friend and stranger alike when driving down the road and took the time to say hello and catch up at the store’s check-out line. Like it or not, everybody knew you, your business, and how to get a hold of your folks should something go awry. Sure, I tested that system out a few times, and boy was I surprised when the news had already hit mom’s ears before I even got home.
So very quickly I learned not to test the boundaries that would put my rear in a sling, or worse yet, shine poor light on family and friends. In Fallon as in the rest of Nevada, I would soon find out that in business and life, if you step out of line you either make it right or it will come back to you in spades.
It was a time that seemed to move at a snail’s pace, but apparently necessary to grind those lessons in to my head.
In 1993 I was offered a job to come to a little known trading firm called Jones Commodities. I remember my interview with Mike Abbott and Curt Breitfuss as if it were yesterday and wondering what in the world these guys did. They kept saying over and over that the models they deployed at the time could not be discussed outside of the office. Great, I thought. I’m interviewing for “The Firm”. That’s all I would need, especially after dumping my biology major (a family trend) for a degree in business. I could already hear my dad say, “I told you so”.
Jones Commodities, as most of you know, was founded by the late Deane S. Jones who started trading in 1965. Deane was a pioneer among the Commodity Trading Advisors and was among the best ever to have trend followed the markets. By 1993 Deane had a vision of where the markets and research were going and it was a far cry from receiving data via The Wall Street Journal or by charting as was the case for him. The winds of change were in the air and he sensed how research and trading were no longer going to exist in its current form. The firm needed to adapt.
Deane was also among the first to allocate assets out to other managers that were able to produce returns in a different style than his own. High Sierra Futures Fund was the vehicle that would allocate out to some of the most successful names the industry has ever known. Adjustments needed to be made in regards to trading, research, and who High Sierra would allocate its assets to in the near future.
Mike was the spearhead of the trading and research and Curt was overlooking High Sierra and the overall operations at JCI. The growing responsibilities moved Curt to hire me and fill the need to supervise the execution of the overseas trading models. As it happened, I would spend every night tracking the European and Asian financial markets. My first nights were spent with Mike or Curt who alternated evenings to make sure the orders were properly executed. What was supposed to be a 3 month training window quickly dissolved in two weeks. I was tossed amidst the wolves of the night.
Before I knew it, I learned why these guys didn’t want to stay up all night. Staying up all night is hard! But as the rookie, it was my job to forge through from this point forward. Great! I’m going to have to resort to becoming a vampire. Now, had I any real vision at the time I would changed literary history and introduced the world to my own Twilight series. I could have written a pretty entertaining book on the vampires within the financial industry. But destiny would have a different direction for me and besides, I could write that book anytime. The vampires weren’t going anywhere.
I spent 3 years manning the overnight desk executing trades and learning to program under Mike’s direction. The company operated and communicated with its limited partners with old school respect and class. I had somehow, by some accident, found myself again with a group that made my work feel like a home, being part of a family. It wasn’t all easy, but the satisfaction I got from doing something for those I truly felt a connection with was incredible. JCI was a great firm that was founded by a solid individual and would be the perfect place for me to grow in a rapidly changing industry.
It was the pre-internet age and the computer had just entered the trading environment; the research Mike would produce through back testing was really cutting edge. The steps we were taking on a much smaller level in regards to research would later be replicated by our industry on a much larger scale. We witnessed much larger firms invest heavily in their research departments in order to bring a new form of trading and a new breed of trader to the forefront.
High Sierra was positioned perfectly to embrace this new style and allocations were already in place to reap its benefits. The fund was seamlessly transitioning from the pioneers of trading to the new technical trader. The new traders were firms that employed numerous PhD’s and an army of machines forcing the industry’s best to adapt or die. The years that saw the birth of the internet all the way through the tech boom were fast and furious. The time we existed inside that whirlwind would be spent analyzing these technical powerhouses and their impact they would have.
Managing High Sierra’s allocations has put us in front of the most successful traders in history. The long and well established relationships led us through doors of trading floors and research departments that our counterparts have never even seen. The knowledge gained from these experiences has given us all a very unique insight as to what the key players are thinking and how they are positioning themselves moving forward. The information we’ve garnered from our experience managing High Sierra has helped shape and mold the research we would conduct in Draco today.
The advancement of processing speeds continues to reshape the market’s landscape and in my opinion, compresses time into smaller and smaller segments. This is a really important development. Trends that used to take weeks and months to setup now happen in moments, only to vanish in the few short weeks that follow. The information and execution speeds that today’s professionals operate with are so profound, the edge over the individual investor simply isn’t fair. So what are we to do and how does this reshape our future going forward?
The professional athlete — to a person — will tell you that to survive at their respective levels they have to slow time down. A football player that advances from the college ranks to the NFL experiences a huge change in speed. The NFL game at every position is exponentially faster than the game at the collegiate levels. The overall game, schemes, and patterns do not change, but the speeds at which they are executed most definitely do.
The game of trading has definitely sped up and we’ve adjusted quite well. High frequency trading has exacerbated what would otherwise be normal market conditions and created an illusion that resembles some sort of fire drill. Have the overall markets or patterns changed? No. They may look and react quite differently than in the past, but the patterns and trends that were once elongated out to months and years are now compressed into days and weeks. This is why “100 year events” seem to occur a whole lot more often! And that Black Swan you say? Good Lord! I’ve seen an entire flock during my career, most of which were spotted flying in formation this past decade alone.
The increase of speed in which the markets now operate will be in direct correlation to the number of these “unusual events” appearing in the future. Volatility, I suspect, will be with us for much longer than anyone ever anticipated and will make it much more difficult for the individual investor to withstand. Our research today in Draco is a result of what Deane impressed upon us early on and our relationships with so many of the elite professionals in the industry. We’ve been able to seize the knowledge gained and leverage our resources in order to “slow” the game down for ourselves and provide that much needed edge we’ve been seeking. By being able to identify and capitalize on the opportunities present in this seemingly chaotic environment, we have been able to provide a well structured investment vehicle for today’s market conditions and going forward.
One has the choice to accomplish this task themselves, by making that jump from the game of yesterday to today’s game all on one’s own, or you can move forward with what we’re doing and doing it in an old fashion manner. You see, Mike, Kyle, Jeff, and myself have all come from rather small and simple lifestyles. So we are quite comfortable growing our business the old fashion way: we’ll earn it. We take the time to get to know our investors and their needs and in turn work hard to earn their respect. That’s the way business was done when I was growing up, that’s the business Deane ran when I came in, and that’s the way our business will operate as we go forward.
Give us a call or drop us an email anyime.
We’d love to hear your story.
This week we’re talkin’ gold.
Our discussion will begin somewhat technically, but stick with it. Later on I’ll tell you my personal thoughts on gold and we’ll finish off with a quick story.
I know that some of you out there like to print out our newsletter and read The Draconian at your leisure. Thanks to the magic of WordPress we have a special little link above that will automatically format the newsletter in a way that will make your printer happy. If you’re printing this week’s newsletter, don’t panic. It’ll print a little longer than usual because this week we’re going to throw a lot of charts at you. I really like charts so that gets me excited. If you don’t like charts, now is a good time to change your mind.
Gold
Gold seems poised to make a new all time high in the next week or so. Yesterday it briefly traded over $1,260/oz.
I can hear you asking: is it expensive? Is it cheap?
To answer that question we’re going to play one of our favorite economist games. You guys like games, right? This game is called “Let’s Price One Thing in Terms of Another.” Don’t laugh! It’s actually much more fun than it sounds. It’s fun because it’s a game that can make you money.
See. You stopped laughing, didn’t you?
This kind of analysis — to try and clearly discern gold’s relative value — is really important right now. It’s amazing how divergent analyst views are at present. The gold bugs have been dancing in streets for what seems like forever and the most aggressive of their forecasts call for gold to get above $2,000 or $3,000 per ounce. On the other hand, it’s easy enough to find guys like MKM’s Mike Darda who believe gold should be down around $400-500 per ounce. How is it possible for two groups of people to have such a wildly different set of predictions?
It’s Draconian custom to look at things form a slightly different perspective, but we’ll begin with a relatively straightforward view.
In our first chart we have 110 years of gold prices. Any time we take this long a perspective of something, it’s imperative to adjust for inflation and we’ve done so here.
Pretty cool chart, huh? It’s amazing how such a simple graphic can be so eye-opening.
There was only one time in history when gold was more expensive than it is right now. It was during the midst of a speculative bubble. Is it in a bubble today? Depends which camp you bunk in.
Before we get too excited about this chart, know that it carries a gigantic disclaimer. Prior to 1968 the U.S. was on a gold standard. That is to say, the relationship between gold and the dollar was fixed. That’s why the line looks funny.
The greenback has a lot of baggage right now, so let’s take Dollars totally out of the picture. What if we priced gold in another currency like the Japanese Yen and then adjusted for inflation? In this next chart we have the number of Yen it takes to by one ounce of gold, again adjusted for inflation (Japan’s inflation).
It tells a similar story. If you are Japanese, you’re probably evaluating gold in the same way though you might be a little less worried about a bubble. Gold has traveled quite a ways off its lows but it clearly hasn’t been because of an increase in the general price level. If it were, the real price would be flat.
We can do similar charts for other currencies but the story will be basically the same in any language that employs a stable monetary policy. The price of gold has gone up and it’s gone up because of some reason other than a drop in value of the currencies it’s priced in.
This is worth mentioning because gold doesn’t grow, earn interest, or pay a dividend. A dollar on deposit in a bank will be worth a dollar ‘n change a year from now. A share of stock in a company naturally becomes more valuable as the company gets bigger or as the company increases the amount of dividends it pays to its shareholders. Gold doesn’t do anything like this. Its value, like that of any other currency, is based entirely on supply and demand in the capital markets. Unlike most commodities, the supply of gold is fairly easy to get a handle on and easy to forecast. Most of the price movement is thus driven by the demand side.
So why has the demand for gold gone up?
I’m sure each one of you has an answer. I have a few of my own but I’d like to submit that demand for gold might be increasing simply because the price is going up and demand is increasing. That logic might sound circular because it is! It’s a virtuous circle. If I know one thing about investors it is that they are slavish performance chasers. With something like gold, more chasing of the asset by definition translates to better performance for the asset. Virtuous circles are a lot of fun until they snap.
Again, I’ll chicken out and stop short of calling “bubble” right here. But know that virtuous circles and positive feedback loops play a major role in inflating bubbles. In both an economic and psychological sense.
I tell people over and over that the best way to look at gold is as a neutral currency. And in this framework, the demand for this neutral currency is driven primarily by a dislike of fiat currencies, particularly the US Dollar.
If you own gold simply because you hate the Dollar or because you’re sold on the hyperinflation meme, why not express that view a different way?
Seriously, think about it. Unless you have an intrinsic interest in gold, why not use some other asset to express your dislike of fiat currencies and fear about inflation?
Why not buy Yen or Euros? Or the Loonie? Canada’s fundamentals are pretty good. The New Zealand Dollar even pays you a decent rate of interest! Why not buy a house? Or farmland? If it’s the US Dollar that you’re really concerned about, why not exchange a few for something like energy stocks? Or TIPS?
Why gold?
I suppose that’s less of less of a technical question and more of a philosophical one.
The tip of your tongue
Back to that central question that I know everybody wants to have answered. I’ve dodged it twice so far.
Is gold in a bubble?
You tell me.
That chart plots gold’s current ascent against a few other famous bubbles in history. Something bubbly may indeed be forming, but if gold completely collapses tomorrow, I’m not convinced that we will label it the bursting of a bubble. On the other hand, if gold does make a run above $2,000 at some point in the next few years, I will absolutely start throwing around the “b word”.
If it’s still not clear whether or not gold is being artificially inflated based on speculative demand, let’s get back to that question of whether it is expensive or cheap.
I warned you there would be lots of charts. Here’s one that prices the Dow in ounces of gold. It measures the number of ounces of gold required to buy one share of the Dow.
I used the Dow here because it naturally adjusts for dividends, and since it’s also denominated in dollars, we can relate it to gold without adjusting for inflation. The chart covers the years post 1968 as we’ve been off the gold standard. It’s also log scale, so the rate of change (slope) has meaning.
Now, we can’t just think about this ratio in an absolute sense. Over the long run and in aggregate, we should expect the Dow to increase at a rate greater than gold because the Dow pays a dividend and participates in growing GDP. That’s why I included a trendline. That trendline isn’t an exact frame of reference, but it will help your brain interpret this chart the way it should be interpreted. The Dow/Gold ratio oscillates around an ascending trendline, not a flat average.
You shouldn’t use a chart like this to make a buy decision about either asset. I can’t conclude from this if gold or stocks are expensive or cheap on their own. But I can conclude — fairly confidently — that the further that ratio gets below the general trendline, the more stocks I want to own relative to gold. The further that ratio gets above the trend, the more gold I want to own relative to my stocks.
It’s a rather slow moving chart, but I like to bring it out and dust it off every so often because it does a really good job helping you identify the times when either gold or the stock market is obviously expensive or cheap. We didn’t know it at the time, but 1968 was a great point to own gold and pass on stocks. By the early 1980′s, the smart choice was swapping some of that gold for more stocks. That was a good strategy for a long time but by 2001 it was time sell those stocks and buy back some gold. This chart won’t time it perfectly, but it’s good enough if you have a long horizon.
If you work in the industry and spend a lot of time thinking about proper asset allocation, this kind of analysis can be particularly helpful.
Again, it’s tough to make the claim that gold is in a bubble right now. But it’s easy to point out that gold is getting expensive here and it’s easy to see that another 50-100% increase in the price of gold over the next few years should set off some alarm bells.
Let me repeat that another way with different emphasis: gold can only be considered cheap at these levels if the market is heading for another bubble or if the U.S. is heading for hyperinflation. There are clearly safer and possibly more effective ways than gold to hedge the risk of hyperinflation, so ultimately I think the belief that gold keeps going up comes down to a bet on a bubble or at the very least, continued speculative interest.
My two bits
As for my personal view, I don’t believe that fundamentals are playing much of a role in the day-to-day movement of gold. In fact, I’m not sure they’re playing any role.
I think most of the action is driven by speculative forces, not unlike what we saw push crude to record highs back in 2008. I use crude oil circa-2008 as the analogy because in both instances the market was tricking people into believing an incredibly convincing fundamental story. Back then the majority of the world bought into some variant of the “peak oil hypothesis”. Escalating demand + dwindling global supply painted a pretty clear picture. It was easy to see and the market tricked itself into thinking that the soaring prices were justified by these fundamentals.
As for gold, a similar story is being told. The most popular and convincing argument for owning gold is to protect oneself against future inflation (even if we’ve shown that it’s a rather poor hedge against typical inflation). Given the current state of the U.S.’s balance sheet, it seems like a no-brainer that inflation will be a problem for our country at some point in the next decade (even if the bond market doesn’t hold this view).
Here’s the thing: I think that the crude oil thesis is still good. I think the long term supply/demand fundamentals point in only one direction for oil prices. The tough part is that it’s going to take longer to play out than we all thought a few years go. Loading up on crude oil back then was a disastrous investment strategy even if the basic thesis may ultimately prove correct. And it’s the same deal with gold. Looking ahead into the next few decades it seems hard to avoid a serious bout against inflation. Isn’t that what Reinhart & Rogoff taught us? That these stories of debt gone awry end in one of two ways:
- Default
- Inflation (a sneaky way of defaulting)
For 800 years it has unfolded in the same way. Heck, even the ancient Romans figured that one out and slowly debased the denarius by minting them with less and less silver.
Anyway, the thesis for gold appears sound. But like crude oil a lot can happen between now and then and if I can make one guarantee, I’ll guarantee that the story won’t play out in the exact sequence that most are expecting. Always remember: investing doesn’t work like a wormhole. Do not fall victim to The Wormhole Fallacy. Don’t do it!
If you load up on gold at these levels, strap in for a bumpy ride. I wouldn’t be surprised at all if gold went to $800-900 before going to $2,000. And if you think that gold can’t get back down under $1,000/oz, you haven’t studied enough history of the gold market. The gold market is certifiably insane. I know Reinhart & Rogoff don’t have 800 years of data about gold traders, but I’m pretty sure all of those guys end up the same way:
- Going crazy
Thanks, but…
We’ve taken a twisty trail through a foggy forest today. Where exactly are we now? What conclusions should we take home with us?
For one, do not try and short gold at these levels. The trends in gold are immensely powerful right now and I’m not one to step in front of freight trains. If you want to ride the trend, go for it. Just understand what can happen if the Gold Train derails.
If you’ve owned gold, good for you. *HIGHFIVE* If more than 10% of your investment portfolio is gold, now is a good time to think about bringing that back in line with a more appropriate weighting. But my guess is that if more than 10% of your portfolio is in gold you’re either a gold bug, John Paulson, or someone who really knows what they’re doing. In the event that you are actually John Paulson, please contact me at Feedback@TheDraconian.com so I can tell you about our awesome investment products!
If less than 5% of your portfolio is in gold, you’re probably better served just hanging out for a pullback. Don’t worry, gold always pulls back. I think that 5-10% is a good weighting for the average investor to have in gold. Bullion is best. Coins are cool. And the GLD ETF is fine.
I think everybody needs to own gold at all times but not because I expect it to always perform well. I like gold for one reason and one reason only: it’s different.
I like things that are different and things that are different can be incredibly powerful tools when it comes to constructing a robust investment portfolio. Over the long-run, gold has exhibited little correlation with any other asset class. That is immensely desirable for professional asset managers like us.
My lovely wife, Mrs. Draconian, swears that gold has other “utility” but this is a debate that is still unfolding in our household. Her birthday is approaching. Currently, she has the upper hand in the argument. Perhaps some of you other men out there understand what a troublesome confluence of events this represents.
Yet again, the conclusion seems inevitable.
The Box
I feel like I’ve fallen a little short this week. Informative, perhaps. But this week I think I missed the mark on usefulness by raising more questions than I answered. So I’ll close with a personal story that I was reminded of as I wrote all this business about gold. If I can’t be useful then I’ll at least try to be entertaining.
I’ll never forget my first experience with gold.
You see, I am the son of a gold bug. Before founding an investment firm and launching his own fund, my dad was a local coin dealer. I’m sure that was a great business in the late 70′s when gold was going up, but now I see why he gave it up in the early 80′s and pursued a different line of work. I doubt people were buying much gold as the bubble was deflating.
Despite that, he was a guy with an undying love of precious metals. He wrote a newsletter about gold . He kept bags of silver in a vault downtown. He was a man that buried bags of pure-copper pennies in the backyard. I was told repeatedly as a youth to some day dig them up when the price of copper was higher than that of the penny. Are pennies even still made of copper? We had an honest-to-God treasure map for their location.
One day he came home and set a small box — maybe half the size of a shoe box — down on the kitchen counter. I picked it up. It was very heavy. Inside was a dozen or so plastic cylinders. They were sealed tightly and he would not permit me to open any of them. He did uncork one tube, however, and emptied out a single, radiant coin.
“Daddy,” I said. ”What’s that?”
“It’s your college education.”
There were probably two or three hundred one-ounce Canadian Gold Maple Leafs in the box.
It might have been $100,000 of gold sitting right there on the kitchen counter, where later that night I would eat my mac ‘n cheese. I wonder how much of his entire net worth was sitting there in front of us. My little mind couldn’t fathom that, of course. But the enormity of it left an impression nonetheless.
Who knows why we recall the specific experiences that we do from childhood. Whatever the reason, this one would impact me me in several profound ways through the rest of my life.
As a boy I remember being utterly transfixed by those coins, if not on the surface then subconsciously so. I wonder if there’s something deeper that attracts us to gold, something woven into our genetic code, something baked into the marrow of our bones. I think this might be why the history of the gold market is one of madness; it’s a corollary to our own history as humans. That knowledge and that feeling follows me everywhere.
By the time I went to college, those coins were worth half of what he paid. He always hoped I’d go to Stanford but I wound up at UCLA. Tuition was probably cheaper than what he originally budgeted, but I doubt that box of gold coins would have paid for all four years. When I graduated, I thought of those coins.
After graduation my first job was as a commodities broker. (Remind me to tell you that story sometime, the story of my first day at work — it was September 10th, 2001.) Gold was trading in the mid-$200′s. It had gone down for almost twenty straight years and was sitting at a generational low. Every single person I talked to about gold hated it. Everyone. No rational individual considered it a worthwhile investment. Even most of the old skool gold bugs had given up that ghost. I’m astonished at how dramatically sentiment has changed in just the last ten years. Don’t be surprised at how dramatically sentiment can change from here.
Today as I reflect on that box, I realize what he really was doing was making an investment in me. Even if that box wasn’t literally for my college education. There was something large and weighty sitting on the counter, and that put the hopes and expectations for me into perspective. Today that much gold might be worth close to half a million dollars. That’s a lot of money that was invested in me.
There’s not a day that goes by that I don’t wonder if that investment was worth it.
I can only speculate.
Once again, it’s been another volatile week.
We got the ISM Purchasing Mangers Index yesterday — it came in at 56.3. This is tremendous news. It’s an increase from the prior month and it’s a better number than was estimated, but it’s still below the high of 60.4 in April. The market rallied almost 3% yesterday and justifiably so. I’ve been in the “slow GDP but no double-dip” camp for most of 2010 and I think a number like this really closes the book that forecast. Unless things totally fall off a cliff in the next few months, we are not going to see a double dip recession this year.
The ISM-PMI might be my single favorite bit of economic data because it’s such a powerful leading indicator and it’s really easy to interpret. A reading above 50 means that the manufacturing sector is expanding and a reading below 50 means it’s contracting. Simple. It’s also one of the Three Amigos!
Tomorrow we’ll get the jobs report. As long as I can remember there has been a “data point du jour,” one particular piece of data that everyone in the media and the marketplace seems to fixate on. For a long time during the tech bubble it was Alan Greenspan and the Fed Funds rate. It seemed as though everything in the market depended on what Greenspan would do with short term interest rates. CNBC shot closeups of his briefcase to try and see if it was stuffed with papers or had nothing in it. Supposedly that meant something. I think it just meant that we were all insane back in 1999. Clearly.
Nowadays the focus is on the unemployment report and this disturbs me. It disturbs me because the monthly non-farm payrolls number is a ridiculously unreliable and shifty piece of data. As initially published, it simply isn’t an accurate reflection of reality. Typically the data point will be +/- a few hundred thousand workers. A month later they’ll revise that data point, sometimes as much as a few hundred thousand workers. Then they’ll revise it again, and keep revising it. The total revisions can be huge. I’ve seen gains of a couple hundred thousand turn into losses and vice versa. Then there are the birth/death adjustments; I won’t even go into those. That’s for seriously hardcore econ wonks. All the rest of us need to know is that a full year after the numbers are published they undergo — you guessed it — another gigantic revision.
On top of all that, the U.S. labor pool has about 150 million workers. The consensus estimate for tomorrow’s number is a loss of 120,000 jobs. With a labor pool of 150 million workers, that’s like, a rounding error. There is little economic relevance contained in that report. Right now it looks like the economy lost jobs in August. Probably. A year from now we’ll know for sure. Sort of.
Don’t ever read too much into the jobs number and certainly don’t try and trade off it. It doesn’t tell you anything about anything a normal person would care about. The only specific relevance of the monthly jobs report is as a political talking point. As I said, not the sort of thing that normal people care about.
The only thing about the jobs report that you need to know is that, on average, the economy needs to create about 150,000 jobs per month just to keep up with demographics and population growth. And don’t get me wrong, the level of unemployment is a really important factor in the economy, but focus on the longer-term trends of the data set. Ignore these monthly reports.
I’d rather look at the big picture. But that’s only because the details of the individual data points are less interesting to me than the broader story that they tell.
What I’ve been thinking about lately has nothing to do with data…
Our story so far
As always, it started with an idea.
It began with this notion that we could do nothing and get paid for it. Clever creatures, humans. Clever enough to immediately develop a corollary, a rationalization that if we were smart enough or had enough money, we should get paid really well for all the work we didn’t do. We deserved it.
Who were we to think otherwise? After nearly two decades phenomenal economic success and a stock market that went straight up year after year, why on earth wouldn’t we think that all we had to do was “invest” our money where it would “work for us” and create more money on our behalf. We dreamed about retirement, a magical kingdom where we could put our feet up, recline and indulge in the fruits of our labor and our Social Security. We could golf every morning. Or watch daytime television. This dream was more than a dream; it was a future that each and every one of us was entitled to. At least the clever ones.
The last thing we needed was the dot-com bubble, the kind of technological revolution that happens once in a lifetime. As Americans – as humans — we felt imbued with godlike power to reshape the world as we saw fit. Wealth was easy. All we had to do was buy NotYetBusted.com at 9:30am and sell it before the close. The Internet was changing the way all business would be done.
Why would we want to imagine a world any different?
But it was a fantasy, and maybe we knew it all along. Even still, fantasies are fun, funny things and it’s in our nature to cling to them. So we felt bad when it all went poof. We pointed fingers at the Pets.com puppet. And Congress.
But hallelujah, we got a second chance! We discovered a new idea, one in which it was possible to make money out of nothing. All we had to do was talk to our bank, borrow some cash, and buy the house next door. The less of our own money we used, the better! Maybe we weren’t really cut out to be day traders, but Real Estate Tycoons: now this was the life for us! It was silly to think that hollow tech stocks would be our ticket to retirement. Flipping McMansions with a view was a better way to do it. Maybe we’d even keep one for ourselves. One with a nice deck. Where we could put our feet up.
That went poof too, and we all know why.
We made some mistakes. But despite our deep reservoir of cleverness, we couldn’t wrap our minds around the notion that we were the problem.
So then came the bailouts and with them that other sparkling corollary, that rationalization that it wasn’t in our collective interest to let all these guys fail. Maybe. Maybe not. All we knew for certain was where Wall Street stood on the issue (saaave us!). Zandi & Blinder recently estimated that GDP would be a whopping 11.5% worse without all the bailouts and stimulus. Ouch — that’s a legitimate depression. Perhaps failure wasn’t in our collective interest after all. But the dodgy debt would be gone. Those who made bad loans would have paid the price. And taxpayers wouldn’t have been on the hook for a few extra trillion dollars. Was it a fair trade?
It was a really tough call. It was a defining moment in the history of our nation. We did what turn-of-the-millennium Americans will become known for. We exchanged acute, short-term pain for modest, long-term suffering. In other words, we became Japanese.
I’m not smart enough to know if that was the right decision. The existentialist in me says that it doesn’t even matter.
And that’s kind of where we’re at today. The economy, the stock market, Republicans vs. Democrats, the unemployment rate, the strong Yen, the homebuyer tax credit, Greece… does any of this stuff really matter?
If culture and psychology were the true causes of all that went wrong perhaps it is there where the solutions lie.
I’ve talked about this before, but everybody that writes an investment newsletter has answers. They tell you which stocks to buy, when to buy gold, or how much to pay for a house. We all like answers, but the real reason why we tune in to all these voices is to not feel so alone. We look for authoritative voices to validate our opinions and beliefs. If we feel like buying stocks, we go follow Jim Cramer. If we hate gay marriage we turn on Glenn Beck. If Republican Blockades make us angry we go read The Huffington Post.
Whether these voices steer us in the right or wrong direction is inconsequential. What matters is that they assuage that deep, dark fear of being alone.
A Formula for Success
Look, folks. I don’t have the answers.
I’ve spent most of my life as an outsider, from being an awkward geek in school to a forging career in the alternative asset industry, a niche reviled by Main Street and Wall Street alike. I’ve done a lot of introspection and self-discovery over the years and I’ve picked up a trick or two that helps me deal with who I am. What I’ve learned has helped me get more enjoyment out of life and it’s helped me be a better investor. Sadly, I cannot just give all these answers to you. They are my answers. This is the legwork you have to do on your own.
But there are some things I can pass along, some lessons of psychology and culture that have helped me in a personal and professional sense. I think these principals will help me get through the scary times in one piece. None of them will surprise you:
- I need to work hard. Harder than my parents, who were already hard workers. Harder than my Gen X cohorts and harder than the fiery Boomers before me. You Millennials are the new benchmark and I need to show up at the office every day with that same enthusiasm and hunger.
- I need to be smart. I need to be relentless in my quest for knowledge. I need to know more than the other guy, and I need to know more about more things.
- I need to be careful. There is more danger lurking around more corners than in a long time. I need to make prudent decisions with my money and the engines that generate it. I need to make prudent decisions with my family and in my personal life. There will someday come a better environment for taking risks. But today’s climate demands a focus on not screwing up.
- I need to be diversified. I happen to be in the business of investing and in environments where the reality is that of perpetual uncertainty, I cannot afford to be overexposed to specific areas. True diversification isn’t the quickest way to generate wealth, but it is the most reliable way to do it and it’s an absolutely critical discipline when it comes to protecting wealth.
- I need to surround myself with people that I trust and discard those not worthy of it. Trust is always an important asset, but in these environments where everything is getting restructured and re-aligned, it’s doubly important. I need to ensure that my businesses are also worthy of our clients’ trust.
- I need to have fun. Ideally, I need to find a way to do all these aforementioned things in a way that is intrinsically enjoyable. And then do all the other things in life that make me smile. Friends and family, for example. Or fishing. And beer.
- From that balance will come perspective, the final tactic that will help me survive without going totally nuts.
If you look at that list, it sounds full of common sense. Those are solid values that are cornerstones of success everywhere in business and life.
But we haven’t done a single one of things in the last decade! We loafed around, we made stupid decisions, we took a lot of risk and focused too much on specific areas. We welcomed those unworthy of trust and for some reason were surprised when they betrayed us. We watched and wondered as it all unwound. Why?
Did we at least have fun along the way?
I’ve written extensively that this is the dawn of an era of sacrifice. Everybody is going to sacrifice in different ways. My wife and I are fortunate to have jobs that pay enough to cover our costs and support some luxuries here and there. We’re going to sacrifice in the form of a higher tax burden in future years and more regulation and restrictions on the businesses we operate. If you don’t make a lot of money, your sacrifices will come under the form of smaller benefits and reduced entitlements. If you’re middle class, you’re being squeezed in a lot of areas right now, particularly in the form of competition for good jobs. That’s not going to get much better in the years to come, and your sacrifices will be those of stagnating incomes and delayed retirement.
If you think the Economic America we came to know in the 80′s and 90′s will return, you are deluding yourself.
If you think the market ahead will resemble the market we came to know in the 80′s and 90′s, you are deluding yourself.
If you think you can create profits with zero money down or if you think you can simply invest money, do nothing, and get paid handsomely, you are deluding yourself.
This is reality. It’s time to roll up our sleeves, shoulder our requisite burdens, and earn it for a change.
First, step back from the ledge…
Take a deep breath. This is nowhere near as bad as it sounds.
We’ve been through environments like this in the past and we’ll get through this one too. Don’t worry, your friends at The Draconian aren’t going anywhere. We will do it together.
Step one is a proper alignment of expectations. You and I aren’t getting anywhere unless we have a realistic idea of what we’re up against. The reality is tough, but it isn’t catastrophic. This isn’t Haiti or Zimbabwe. This is still America, dammit! There are a lot of really scary forecasts circulating now and many of these have lost touch with reality too.
All of this only going to be a problem if your expectations are improperly aligned. This era of sacrifice will only be really painful if you’re expecting a return to the crazy days. It might even be pleasurable if you were expecting economic apocalypse. So try not to take it too seriously. Relax!
This is an industry that takes itself very seriously, a little too seriously at times.
Sometimes, when I turn on CNBC I am reminded of that famous passage from Slaughterhouse Five. It’s the one where Vonnegut’s alter ego, the hack sci-fi writer Kilgore Trout, describes one of his fictitious books, “The Big Board”. For reasons that are both obvious and less so, these are some of my favorite paragraphs in all of modern literature:
It was about an Earthling man and a woman who were kidnapped by extra-terrestrials. They were put on display in a zoo on a planet called Zircon-212.
These fictitious people in the zoo had a big board supposedly showing stock market quotations and commodity prices along one wall of their habitat, and a news ticker, and a telephone that was supposedly connected to a brokerage on Earth. The creatures on Zircon-212 told their captives that they had invested a million dollars for them back on Earth, and that it was up to the captives to manage it so that they would be fabulously wealthy when they were returned to Earth.
The telephone and the big board and the ticker were all fakes, of course. They were simply stimulants to make the Earthlings perform vividly for the crowds at the zoo — to make them jump up and down and cheer, or gloat, or sulk, or tear their hair, to be scared shitless or to feel as contended as babies in their mothers’ arms.
The Earthlings did very well on paper. That was part of the rigging, of course. And religion got mixed up in it, too. The news ticker reminded them that the President of the United States had declared National Prayer Week, and that everybody should pray. The Earthlings had had a bad week on the market before that. They had lost a small fortune in olive oil futures. So they gave praying a whirl.
It worked. Olive oil went up.
Seriously, read that again. Did it make you smile?
In the grand scheme of things how important are things like yesterday’s ISM number and tomorrow’s jobs report? Yesterday we were in rapture, tomorrow we may be in despair. Are we just creatures in a zoo for the amusement of an alien race?
I’ve heard a lot of chatter lately about how “it’s all rigged.” The market is rigged, politics is rigged, the economy is rigged. Is it the Creatures of Zircon-212 who have done the rigging? Whoever “they” are, it’s a fascinating psychological and cultural milepost. Perhaps it’s a sign that we’re slowly becoming aware of the insignificance of it all, the existential realization that it doesn’t matter. Unfortunately, our reaction has tilted more towards anxiety than whimsy.
What to do about it
Despite this brief excursion into the land of existentialism, I’m not about to throw my hands in the air, grab my Nietzsche anthology, and hole up in my bedroom writing socio-political manifestos. That’s for someone else’s newsletter, some other guy spouting answers. I only bring up the subject to offer some perspective, to remind the world that a few ticks up or down in the markets don’t matter nearly as much as we think while watching them tick up and down in real-time. Your homework assignment is to hold that principle in mind when we get tomorrow’s jobs number.
I think we can derive some practical benefit from this existential perspective. I think we can use it to construct better portfolios. I know it’s a whole lot harder to make money as an investor in this kind of environment but the good news is that the benchmarks have reset. In these kinds of environments, these secular slowdowns, it isn’t about making a ton of money. It’s about protecting what you have and setting yourself up for the recovery.
I’ve noticed that those investors still trying to emulate the returns they grew accustomed to in years prior are the ones suffering the most frustration. The time to re-frame your perspective was 2008, but if you still haven’t done it, better late than never. 5% is the new 10. 10% is the new 20. Don’t worry, someday, 20% will be the new 10! Won’t that be awesome? Just make sure you’ve still got some money left at that point.
Today’s environment requires totally different strategy, tactics, and mindset. There’s a reason why so few individuals are adept at outperforming their peers in both bull and bear cycles. We, captives on the planet Zircon-212, seemed to be wired for one or the other. Or neither. And this is why we are so entertaining! This is why we respond in such amusing fashion to realities that push against our expectations.
If it fails, I suppose there’s always prayer.
