An Even Better Trade of the Decade
From a speech given in Las Vegas on Saturday:
On my recent trip to India, the financial press was very eager to hear what I had to say.
They invited me on to their television shows. They interviewed me for magazines and newspapers. The local paper ran a full-page interview and sent out an artist to do a sketch of me.
I thought they might have had me mixed up with someone else. I’m not used to people taking me so seriously.
“Noted Western Economist Gloomy on World Recovery,” was the headline in the paper.
In all these interviews I had more or less the same message. I told them that there was no recovery…none at all…and that very soon it would be obvious that we were in a period of correction – the Great Correction, I called it.
Stock prices would fall, I said. The property market in the US and the UK would sink further. There would be some spectacular bankruptcies…including some bankruptcies by whole nations.
Whether the next move to the downside has begun or not, I don’t know. The Dow fell 158 points on Friday, after taking a jolt earlier in the week. Gold rose over 1,180.
The one thing that Indian investors seemed most interested in…and I assume you are interested in too…was my Trade of the Decade. But I’m not going to give you a typical investment analysis or a target for GDP growth or for the Dow this year. Instead, I’m going to talk to you about history and philosophy. I hope that’s okay.
I had great luck with my last trade of the decade. Ten years ago I suggested selling US stocks and buying gold. It worked out very well on both sides. So people wanted to know what my trade would be for the next decade. I gave it some thought and came up with something. I think this one will work out too… but I’ll give you an even better Trade of the Decade.
But first, let me explain how it works. Behind the Trade of the Decade is just a simple observation: that things that are very out-of-whack tend to get back into whack. Over a 10-year period you have a fair chance that they’ll return to normal.
This is another way of describing the phenomenon known as regression to the mean. One of the surest phenomena in the natural world is that things that are extraordinary will eventually become less extraordinary. And over a 10-year period, you have a decent chance that that’s what will happen.
So, what’s my Trade of the Decade now?
Right now, the US Treasury market is out of whack. It’s been going up since 1983. And now investors lend money to the world’s biggest debtor at what are historically very low interest rates. And they do this at a time when that debtor has begun the biggest borrowing and spending spree in history. This is not normal. It’s downright weird.
Sometime within the next 10 years, I figure that the Treasury market will get whacked hard. So on one side of the trade…I’m short US Treasuries.
On the other side of the trade I had more trouble. Because I was looking for something to buy. And nothing is really cheap. Even gold…which seems to be in a bull market…and which I expect to go up much higher…is not cheap. As near as I can tell, an ounce of gold buys about as much – in terms of consumer products – as it did 700 years ago…and maybe even as much as it bought 2,000 years ago.
Gold has already reverted to the mean, after being seriously undervalued in 1999. Now, most likely, it will become over-valued when the current monetary system begins to break up…but that’s a different phenomenon. It’s not reversion to the mean, at least, not for gold. It’s a reversion to the mean of the monetary system… I’ll get to that in a moment.
What I needed for the buy side of the trade was something that was historically undervalued. And the best I could come up with was Japanese small cap stocks, which have been going down since 1989. There are some that sell for less than the amount of net cash and current assets that they have in their own company accounts. That is extraordinary. Of course, it could become even more extraordinary. But that’s the risk we take. And over 10 years, we hope that that risk – such as it is – comes and goes.
So, that’s the new Trade of the Decade. Sell US Treasuries. Buy Japanese small caps.
But I’m going to give you an even better Trade of the Decade. The problem for non-Japanese investors is that the small caps may actually go up…but if the yen goes down you might lose your gains.
So, how about this? Instead of selling US Treasury bonds, sell Japanese government bonds. Japanese bonds are probably even more over-valued than US bonds. And with the Japanese borrowing more than ever…while the Japanese savings rate declines…it seems a fair bet that Japanese government debt will go down at least as much as US debt. Maybe more.
By buying Japanese small caps while selling Japanese bonds you take out the currency risk. You have an even better Trade of the Decade. The Japanese small caps stocks are extraordinarily under-appreciated. The Japanese government debt, on the other hand, is extraordinarily over-appreciated.
But the first point I want to make is that this is just an idea. It’s not a substitute for a serious investment strategy.
The second point I want to make is that you can only have a serious investment strategy if you’re willing and able to think deeply about ideas. And if you do think about them enough, you’ll have a decent chance of doing well…simply because most people – including most serious investment professionals – don’t think about them very much. That’s what I mean about philosophy…you have to think long and hard about how the world actually works. And history is about the only tool we have to work with.
I’m going to give you 2 examples of what I mean right away.
First, we celebrated an important anniversary in April. It was 2 years ago, in April 2008, that Countrywide Financial went broke. Countrywide was the second biggest subprime lender in the US. When it went down it set in motion a whole series of domino-like bankruptcies that eventually wiped out half the world’s capital.
But when Countrywide collapsed, reporters asked Henry Paulson what would happen next. Paulson would seem to be a good person to ask. He was Secretary of the Treasury and formerly the top man at Goldman Sachs. Nobody had more or better information than Paulson. So what did Paulson say?
He said that he could imagine ‘no scenario’ in which the taxpayer would be called upon to bail out the financial industry.
That was 2008. By the end of 2009, according to Bloomberg’s calculation, the federal government had committed more than $8 trillion in taxpayer support, supposedly to prevent the end of the world.
It must have worked. Here we are 2 years later, and the world still exists.
But there’s a gap of 8,000 billion numbers between Paulson’s estimate and the eventual federal commitment. Which, at the very least, makes you wonder about the people at the top of America’s financial intelligentsia…and the methods they use to figure out what is going on.
What does it mean when the best informed, most sophisticated, most knowledgeable financial authorities in the country are completely wrong about what is going on?
Continued tomorrow…
Regards,
Comments: