Beyond Fear and Greed

The Daily Reckoning PRESENTS: We aren’t going to sugarcoat it for you: economics can be boring. What makes it intriguing is the study of choice and human action. And who doesn’t find human action interesting? If it’s good enough for Shakespeare, it’s good enough for us. Dan Denning explores…


Economics is not physics. It does not obey the laws of physics. In truth, economics is not even a science – not yet, anyway. This is why Adam Smith was the chair of moral philosophy at Glasgow University and not, say, an actuary.

Smith’s moral philosophy was the study of choices people made with money. The money was a secondary phenomenon. The basis for choice – the rules that govern what we do and why we do it – were primary. Smith and other economists thought those rules were moral. Today, some economists tell us those rules are natural, but have benign moral consequences.

Human action is not based on cold, hard, rational economic calculation. It is based on fear, greed, hope, jealousy, kindness, pettiness, love, hate, and indifference. That is why any science of economics will always be somewhat philosophical. The discussion of what is moral is really a discussion of what is good. And who can pretend to know what is good without at least examining the issue a bit? And even then, who can presume to know what is good well enough to order other people around?

Still, there are general rules in life and in economics. These rules form the basis of an environment that even people who radically disagree can live in. In America, we call those general rules the Constitution and “the free market.” What you and I do behind closed doors might be completely different, but our Fourth Amendment and property rights allow us a wide degree of liberty upon which the government (or nosy neighbors) cannot constitutionally intrude. If the house is a-rockin’, don’t bother knockin’, unless I’m disturbing the peace.

With the law, the fewer the rules the better, and general rules work best. Everyone knows what they are, and the laws don’t favor any one group over another. That leaves people free to fail and succeed on their own merits.

The tendency to tinker with the law to make people “more free” or make things “more equal” is the same tendency economists have when they talk about maintaining equilibrium. They believe that the economy is not a dynamic and open system (like common law, for example), but a static thing that needs to be tinkered with and then frozen in time and kept in the same working order with the same fixed relationships, forever and ever, Amen.

In nature, static is dead. Closed systems don’t have access to energy inputs. Without them, nothing new is created. Resources are eventually exhausted.

Thankfully, despite the tinkering of the rationalists, the world remains a dynamic place, if not an entirely open system. Luckily, the enemies of an open system and a free market (governments) are not immune from the forces buffeting the world. They face the same threats that every institution faces in a world that demands adaptation. Guns can stave off those threats for a long time. So can taxes. But the more closed a system is, the more likely it is to die. It takes a lot of energy to hold a gun to the head of your population forever. Sooner or later, unless you’re Castro (who seems to get his energy from some ungodly place), you’ll tire and fail and your system will collapse. Sic semper tyrannus.

Outside places like North Korea and Cuba, the behavior of individuals is governed by simple rules, rules that each individual knows or learns without being told. Using those rules, people – or agents in an economic system, if you prefer – adapt. They adjust when the anthill is kicked over. An innate survival strategy kicks in. For those who fail to learn the rules or those who flout them, no survival strategy emerges. The individual dies, or in Darwinian terms, is selected against.

Adaptation is a crucial survival skill, then, especially in periods of volatile and violent change. When the environment around you is changing quickly, you have to Observe it, Orient yourself correctly to the changing conditions, Decide what to do about them, and then Act with effectiveness. That is, weary longtime readers will note, a short version of John Boyd’s OODA loop.

Boyd was the former U.S. Air Force fighter pilot turned strategist and theorist whose ideas on fighting fourth-generation warfare have found an application today. Why today?

The pace and scale of global commerce is shaking the postwar system to its foundations, not least the global monetary system that Mises referred to in his quotation on Page 1. In a world without a gold standard, all values seem relative. Without a solid point of reference – whether it’s gold, God, or the Constitution – the world is just a mishmash of things moving and colliding relative to one another.

But what if I told you that this seeming chaos really signaled the emergence of a new system? Call it the system of the world. This system will determine how money and commerce works and return us to how value is determined (through exchange of course, but through a stable medium of exchange that acts as reliable store of value).

This system will preserve the elements of some existing institutions. Other institutions like Fannie Mae and its culture of fraud – entire nations, even – will be demolished. And importantly for this month, this system that favors smaller, adaptive, innovative, and imitative firms and individuals will have a different kind of energy input. If the previous cycle of global growth favored size and centralization and flawless global logistics and distribution of raw materials and goods by virtue of cheap energy and cheap credit, the next cycle and system will favor independent and self-sufficient actors who have their own sources of energy, capital, and ideas.

Other types of firms will exist, of course, just as the crocodile remains at the top of the food chain in its ecosystem, despite few adaptations or innovations in the last few million years. People will still work for the crocodile firms and enjoy job security.

But the new growth in the world, the revolution in how wealth is accumulated and kept, will be led by the people and companies who adapt to the conditions of the new system best. That new system will be characterized by more expensive capital, more expensive energy, gradually more expensive labor, and more expensive raw materials. Nothing about it is getting cheaper. And competition is getting more intense. That’s a tough world to survive in. You’d better have a good organizational DNA.

The news from the housing market has been amusing, astounding, upsetting, and absurd, by turns. But has it presented us with any new chances to profit? The answer is yes, but it involves two different kinds of action and two different kinds of risk.

The first is the simplest: Favor real assets and “stuff” over financial assets and “paper.” That means mostly resources and energy stocks. Sound like a broken record? The risk of owning mostly precious metal, resource, and energy stocks is that your stocks get taken for a ride by hedge funds and the press. A mini-euphoria ensues and things get overheated.

Then you get a correction like we’ve had in May, where even a solid company can fall 15-20% in a skittish sell-off. This is the main risk with taking the “stuff” position and shunning the more popular sector rotation. You don’t shuffle your money around in the latest, greatest thing. You invest it in the strongest, most durable trends in the economy. And then you ride out the volatility.

It’s going to be volatile. Economist Hyman Minsky points out that “Stability breeds instability.” We’ve had a period of unusually low volatility for the last three years. If patterns hold, that means we’ll have unusually high volatility going forward. And because the resource sector is the dominant sector, the price swings will be nauseating. But there’s no need to lose your lunch.


Dan Denning
for The Daily Reckoning
June 22, 2006

Editor’s Note: Dan Denning is the editor of Strategic Investment, one of the most respected “big-picture” investment newsletters on the market. A former specialist in small-cap stocks, Dan has been at the helm of Strategic Investment since 1999 – where, drawing from his network of global contacts, he has designed an investment strategy that takes into account global political and economic trends.

“When you leave your hotel, the sights and sounds are so overpowering you can barely stand it. And when you get back, you’re exhausted and don’t want to go out again. We saw people who never left the calm and comfort of the lounge or the liquor bar.”

We have never been to India. Nor have we ever ridden in one of Tata’s automobiles. Perhaps it is better that way. Friends, recently returned from the subcontinent, report that it is a wild and wooly place.

Still, it is in wild and wooly places that businesses boom and fortunes are made. And India is booming. All the reports say so. The economy has been growing at more than 6% per year for the last 15 years. And it seems to be picking up speed. GDP growth over the last three years has averaged more than 8% per annum.

How did this happen? We will not venture our own opinion here. We merely note that many observers credit the new boom to reforms that eliminated the worst constraints of the “license raj” – as India’s painful system of government permits and regulations was called.

We admit we know little of India’s history. And what little we do know comes to us almost as oral history from Mohatma Gandhi’s grandson, a dear reader of The Daily Reckoning, who lives in retirement in Massachusetts and corresponds with us from time to time.

What we gather is that as with so many British colonies that became independent, India was left to start her new life with an enormous administrative bureaucracy, to which the Indians themselves added enthusiastically. Much of it soon outlived any use it once possessed and began strangling the newborn country. Unfortunately, the new Indian leaders were also attracted to the progressive economic ideas of the period – all of them: Fabianism, Marxism, Socialism, Nationalism, and Keynesianism. Rather than simply choosing one or the other, they took up a bit of each, overlaying hornswoggle over boondoggle, stirring it all up with a dash of ethnic flavoring and a generous helping of linguistic chauvinism, and finished off with a dollop of regional power-brokering. Then, they allowed the whole spicy curry to ferment in the hot climate. Is it any wonder that the result was a rancid mess?

But India is a large, diverse country with a lot of smart people. By the 1980s, , enough smart Indians were tired of the mess that they decided to get out the brooms and dustpans. Many of the worst regulations were swept away, in a clean-up effort led by Manmohan Singh. Then, he was finance minister. Now, he is prime minister.

Since then, the country has been booming. The economy is throwing up droves of new millionaires and expanding the size of its middle class at a furious pace. Huge office complexes spring up every day in the big cities and the roads are crowded with more and more new cars. Rich Indians are splashing out on luxury items; wages are rising.

That is not to say that India is a country on a smooth road to the future, mainly because in India, roads are one of the biggest problems. According to the Economist, it takes eight days for a truck to make the trip from Kolkata (Calcutta) to Mumbai (Bombay) – a trip that includes 32 hours of waiting at checkpoints and tollbooths. But the problem is so obvious and irritating that India is bound to build new highways. And Indians are bound to buy more cars. And India’s low-cost car manufacturers are bound to get much of the new business.

At our London office, we recently entertained two Indian businessmen who had raised about $3 million to start an auto business. In the Western world, the effort would have been laughably amateurish. But in India’s freewheeling world, the two are already making more money than General Motors!

Colleague Lila Rajiva fills us in on some details:

“Bill – on an Indian road, there is no room for fence-sitting, you are either one of the quick or the dead. The `road show´ in India is just that, a spectacular show – overcrowded buses with dashboards wreathed with jasmine garlands, compact Maruti cars, lorries (what you call trucks) painted pink and green, three-wheeled auto-rickshaws careening wildly from side to side, legions of scooters and cycles with saris or dhotis (the native dress most Indians wear) streaming behind them in the dust, oblivious pedestrians, bullock-carts, un-tethered donkeys, beggars, urchins, even a few random monkeys crossing the street. No observable lanes or rules. And all this on worn pot-holed roads that wash away or flood with every monsoon. The amazing thing is that people still get where they are going.

“But all that is changing rapidly.

“First, we now have the Golden Quadrilateral – an ambitious new highway project consisting of nearly 6000 kilometers of four to six lane expressways. It connects Delhi, Mumbai, and Kolkata (in the north) with Hyderabad, Bangalore, and Chennai (in the south) and costs about $12 billion. It’s due to be completed this December, and it’s going to be a major boon to drivers, car manufacturers, and businesses in India and abroad.

“Second, according to a BBC report in February 2006, the Indian car market is set to grow 10% this year

“That’s not only because of burgeoning middle-class salaries. It’s also the result of a change in habits: Indians have always been big savers, but they are now comfortable as big spenders as well. Last year, they proved it by buying more than one million cars.

“Third, manufacturers – domestic and foreign – are gearing up. The same report notes that Korean car maker Hyundai is planning to double its production in India and that Ford has become the fastest-growing car maker there this year, ahead of General Motors as well as the domestic giant, Maruti Udyog. Even Jim Cramer is betting on the Indian road, listing Tata Motors as one of his favorites in emerging markets. But I should tell you, Bill, that Tata´s growth is likely to be less about increased consumer demand than about increased commercial activity. Tata´s main business is making the lorries that carry things around.

“There is one more line of work that will boom, too. Hindu temples are going to be getting a lot of business going their way, too, because it’s traditional in Hindu culture to invoke the patron deity of any undertaking, and the patron god of new vehicles is Ganesh. You’ve probably seen him – the cheerful, pot-bellied, elephant-headed god who rides…a mouse.

“That makes him a good fit for the new rat-race on the Indian road.”

More below, but first, the news…


Chris Mayer, reporting from Gaithersburg, Maryland:

“Basically, a variety of top-performing investors offered up insights and ideas over two days to a packed audience…”

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening.


And back to the land of Ganesh…

*** We remarked last week that among the many departure points from which the “flight from risk” has taken on passengers has been India. The Bombay stock market has fallen around 25% from its peak, one of the biggest losses among all markets. Tata Motors, one of India’s top automakers, has seen its stock fall by almost as much.

As we pointed out, the flight from risk might be heading in the wrong direction. Are investors really wise to flee Mumbai and entrust their money to New York and London?

We think not.

In the case of automakers, an investor might hope to make money putting his money with General Motors. But it seems more and more unlikely. The company labors under such a burden of overhead, it is hard to see how it will ever make money. And how could it grow? Who doesn’t already have a car in America…or two?

Compare GM’s situation to that of Tata Motors. It is operating in a market with low labor costs, much less expensive management overhead, and virtually none of the health and retirement legacy costs that GM must wear around its neck. Nor does it have to go far to find new customers; it only has to look out the window. India is growing and so is its road system. So are its licensed drivers. Even modest growth is bound to bring millions of new drivers and millions of new cars onto the highways in the decade ahead.

In short, the difference between Tata Motors and General Motors is that with the latter you have to be a genius to make it prosper. With the former, you have to be an idiot not to.

A month ago, Tata stock looked like a bargain to us at $21. Today, it looks like an even better bargain at under $18. And if it goes lower with the summer, buy some more.