Lahars

As in life, the greatest lessons of investing are often forged on the hot coals of great loss…

Imagine driving up to your house, walking around to your backyard, and looking into a hole that is so wide you can’t see the other side of it, five times as deep as the Empire State Building is tall.

That’s how visiting the Grand Canyon felt to me, when I first saw it 15 years ago. I got out of my car, walked over to the edge, and suddenly I was looking 500 stories down. It dwarfs us all right. It makes us realize how far down into the earth’s crust you can go before it starts getting hot.

Erosion did all this…amazing…or at least, I’d always heard that the Grand Canyon was the product of millions of years of erosion.

Turns out, it probably isn’t, though. The other day, I heard that geologists say the Grand Canyon wasn’t cut out of the desert floor by rivers eroding it for millions of years. Instead, they believe it happened very quickly. Hearing this immediately made sense to me, although I’m not exactly sure why. Maybe it was simply that I like it when the popular view is wrong.

The event that many geologists believe created the Grand Canyon is known as a "lahar." A "lahar" occurs when massive flash flooding sends tons of boulders rushing downward. One lahar can wreak more destruction than millions of years of erosion.

Lahars: Market Lahars

I’d forgotten about that odd sensation of staring down into a hole in the world’s floor that was one mile deep and miles and miles wide. Until I heard about lahars. I think we should use that word more. It applies to all kinds of things besides canyons.

What about market lahars? That’s what happened in 2000. The Nasdaq Canyon of 2000 – 2002 took that index from 5048 in March 2000, down to 1108 in September 2002.

People who held on to their Nasdaq stocks when it fell apart for three years still aren’t anywhere near where they were in March 2000. They’ll never get their money back. They’re living in the Grand Canyon. And they’re unlikely to return to the top again. The Nasdaq lahar cut through their brokerage accounts and its effects still overshadow anything that has happened since.

Terminal illnesses and injuries can be personal health lahars. My own personal health lahar happened in 2002, when I had my second back surgery. The pain in my right leg was absolutely intolerable. Morhphine barely took the edge off. So I felt I had no choice, as much as I loathed the idea of them cutting into me again.

Today, I live free of all that horrible pain. But I’ll never be the same. My right foot and areas on my right leg are still numb to this day. My leg muscles are as tight as piano wire, too. Lying flat on the floor, I can barely raise either leg 45 degrees off the ground. I can’t really run or do anything vertically jarring because I never know when another disc will give out on me. I used to run 10 miles every day when I was in my 20s. Now I walk the dog around the block and I’m done. I’m only 42.

Lahars: Changing Who You Are

The first time I injured my back several years ago, I’d just made a bunch of money on gold stocks. I quit my job, cashed out my gold stocks, and decided that I was going to compete in the Guitar Foundation of America’s International Guitar Competition. I started practicing several hours a day, seven days a week. My friends heard me play, and said, "Wow. You’ve really been practicing. You sound incredible." I felt light. I ran up and down the hills of Fell’s Point in Baltimore, traveling to and from various guitar gigs and parties.

The lightness lasted three weeks. Then, I herniated the L5/S1 disc in my lower back, and that was the end of my career as a classical guitarist. That’s how I came to write to the readers of Extreme Value, my investment advisory, every month. A lahar changed everything, and I had to change what I did and who I was. I couldn’t play guitar anymore, and I’d run out of money from my gold stock investing days.

I wasn’t sure what to do about my back. But I decided that no lahar was ever going to cut deeply into my wallet ever again. I believe that the only way to keep such grand events from destroying your wealth is to insist upon a margin of safety in every investment you make.

Money…health…only if you’re really lucky do you lose these things gradually and in small increments, over long periods of time. Being really smart helps, but is not required. What’s more usual, in my experience, is that you lose them in single, painful life-changing swoops. Lahars.

I remember the first thing I ever did as an investor. I had graduated from college with a music degree, so naturally I was waiting tables for a living. I worked constantly, always taking double shifts whenever they were available. I saved up $4,700 in cash. That was more money than I’d ever had in one place at one time.

I bought a brand new, handmade classical guitar from a guitar maker in Seattle, Washington named Mark Stanley. I still have it. He did quite a job on it. He even dyed the wood and made the rosette around the sound hole himself. No one ever does that. That cost me $2,700. With the remaining $2,000, I opened a commodity futures trading account.

Lahars: Pulling Everything From Under You

Six months later, I closed the account. My broker sent me what was left: a check for $286 and change.

As with all lahars, I was never the same after that. For about a year afterward, anytime anyone talked to me about investing, I either clammed up or shouted him down. I wasn’t much fun, but I eventually got over it – and learned from it.

Lahars pull everything right out from under you. And it always feels like they take much more than you deserve to lose. Of course, as Clint Eastwood said in the film, Unforgiven, "Deserve’s got nuthin’ to do with it."

That’s how people felt in September 2002, when the stock market was in its third straight down year. That’s how I felt after my last back surgery. That’s how I felt when I lost 86% of my money trading futures.

My greatest fear for my neighbors, and for you and for anyone is that many, many people are going to have that feeling of sudden, severe loss, some time in the next couple of years. The stock market rally of the past year has them forgetting that they’re still more than 50% in the hole. I can understand that. I often forget that I have no sensation in my right foot.

Then I bang it on the end of a chair, and instead of feeling horrible pain, it just throbs lightly. Then I remember that I can’t really use it the way I used to. And that I probably never will be able to again.

Investors today are like losers at a craps table. They started with $10 grand. They were up $100 grand in early 2000. They lost $99 grand. Now they’ve got $2,000 and they’re feeling pretty good again. Hey, they’ve doubled their money. That’s good, isn’t it?

I don’t know what it is that’s going to cause most investors to lose and lose big, but I am confident that it will come. That’s what I’ve learned. That’s how life works. You either plan for such cataclysms, or you get run over by them, usually just when you’re feeling most confident.

That, at last, is what’s different about money and health, as opposed to geology. You can prepare for what lies ahead. You can ask yourself what you’ll do if the money in your pocket loses all its value, or if your house loses half its value – and you can take measures to protect yourself.

Those things might not happen, but something like them will.

Yours,
Dan Ferris

December 18, 2003

P.S. Today I do yoga and stretching for my back and practice Extreme Value Investing for my money. Those are the answers I’ve found. It took me years of pain and suffering to find them. I’ve often thought lately that I probably wouldn’t trust them as the answers to my two biggest life challenges if they hadn’t required years of pain to find them. But they did.

And it’s because they were the result of "life lahars," geologic events that changed the shape of my life’s landscape, that I have confidence in them. They were born of trials. They’re the result of the my greatest losses.

All you can do in this world is prepare for the worst and do your best. That’s what I try to do. That’s what I think you should do, too.

Dan Ferris is the editor of Extreme Value, an investment advisory service that uncovers the safest, cheapest shares in the market. Following the wisdom of original value investors Benjamin Graham and Warren Buffett, Ferris takes investors behind the numbers to learn the true value of a business – and to point out from a ‘bottom-up’ perspective which individual companies are trading at prices simply too cheap and safe to pass up.

Gold up, dollar down. Yesterday, gold rose $4.30. The dollar fell.

It was a GUDD day, as we used to say.

That is what seems to happen almost everyday, so we paid it no mind. What we found interesting was the bond market. In the face of record deficits…a falling dollar…and GDP growth that is supposed to be the fastest in 19 years…U.S. dollar bonds should be collapsing. Instead, they are remarkably strong.

Our colleague, Karim Rahemtulla, offers an explanation:

"It looks like deflation ahead – full steam! Consider this: We have had a loose money policy in the US for almost three years. Full-open on the spigot. Borrow for 0%, 12 months free financing. 60 months free on your car. 4% adjustable rate mortgage on your house. 5.5% fixed rate for 30 years. Buy now, pay in 2006. And people are buying…

"In any normal economic cycle, inflation would have already reared its head. But, if you look at the numbers so far this year, inflation is dead. The PPI just reported negative as did the CPI. So far this year neither has moved much at all…

"What does this mean? If the Fed is priming the pump like we have never seen before, and consumers are buying goods like they are going out of style, where is inflation? To the contrary, if the Fed ever stops priming the pump or the consumer cuts back, we will have deflation across the board. Prices today are falling in the face of huge demand…

"8.2% GDP and no inflation?? What if GDP was half that or "only" 3%? Prices would plunge and so would the market. This house of cards is going to fall hard. Interest rates will not rise until we see three or four months of sustained CPI and PPI increases. Barring that, the pump will be left open – just like it was in Japan. The country will be awash in cheap money, but the borrowers will not have capacity left to borrow…

"I guess the biggest difference between Americans and the rest of the world is our gluttonous appetite for everything, including debt. Shorting the market is becoming more and more appealing daily."

So, we are still headed to Japan, after all?

Eric, your thoughts please…

Eric Fry, our man on the scene in Manhattan:

– America is a land of economic marvels: No one saves money, but everyone spends it. Consumers buy things with money they don’t have…but never seem to run out. Home prices skyrocket…even though the majority of Americans can’t afford one. Bull markets flourish on Wall Street, even though the average stock sells for 35 times earnings. Commodity prices soar, yet the inflation rate barely budges. And most incredibly of all, the dollar’s value collapses, but foreigners still buy billions of dollars worth of Treasury bonds every month.

– Will America’s delicious economic fantasy ever end? Will our legendary privileges ever expire? A Day of Reckoning may yet arrive. But in the meantime, we Americans will busy ourselves buying overpriced stocks, denominated in an overvalued currency.

– Yesterday, the Dow gained a little and the dollar fell a lot. This regrettably familiar pattern is inflicting a great deal of pain on those foreign investors who – so reliably – keep plowing their hard-earned euros and yen into our financial markets. The dollar’s double-digit drop against the euro since the end of July has completely erased the Dow’s 10% gain since then.

– The staggering greenback stumbled again yesterday, to its 10th new record low against the euro since Thanksgiving! At the end of the New York trading session, one euro fetched $1.24…and European tourists, armed with fistfuls of muscle-bound euros, are flocking to Midtown Manhattan’s pricey emporiums. While strolling through Barney’s earlier this week, your New York editor overheard more French and German than English.

– Manhattan’s retailers and restaurateurs may be delighted by the boost their bottom lines receive from the dollar’s weakness. But we suspect their mirth will be short-lived. Receiving more of something that is continuously becoming worth less is hardly the sort of "prosperity" that produces wealth.

– The dollar’s continuing travails boosted the gold price by $4.30 yesterday, to a new seven-year high of $412.70 an ounce. Gold is not the only commodity to make a succession of multi-year highs. The slumping dollar, coupled with resurgent demand from China and elsewhere, is lighting a fire under almost all commodities.

– Within the last two days, copper prices touched a 6-year high, nickel reached a 14-year high, and platinum surged to a 23-year high. Hmmm…looks like a bull market. Incredibly, despite the surging price of many commodities and the plummeting value of the dollar, the U.S. inflation rate (as reported by the U.S. government, at least) remains miraculously contained.

– The U.S. consumer price index fell 0.2% in November. Excluding food and energy, prices fell 0.1% – the biggest drop in 21 years. As the Labor Department counts inflation, consumer prices for all goods and services rose 1.8% for the 12 months that ended last month. Core prices rose 1.1% from a year earlier, the smallest gain since 1966.

– Either the government doesn’t know how to measure inflation in the real world, or U.S. consumers no longer consume items that contain natural resources. You decide…but here’s a hint: Even in our highly productive, Internet-powered economy, the average single-family home in America contains about 400 pounds of copper.

– "Now we’re faced with the odd world," observes CNN/Money’s Justin Lahart, "where the prices of raw materials have risen sharply for two years, pushing the Commodity Research Bureau’s index of commodity prices a smidgen short of its all time highs, and yet inflation, as measured by the consumer price index, is remarkably muted."

– "You can come up with all sorts of reasons for this odd divergence," says Lahart; "however, the final effect is the same: Between rising commodity costs and consumer prices that are barely budging, many U.S. companies risk seeing their profit margins ground to a fine powder."

– "Take the auto industry as an example," offers Lahart. "New car prices fell 2.1 percent over the past year, according to the most recent CPI report. But the base cost of many of the things that go into a car has risen, as has the cost of the energy it takes to build it."

– But who cares if GM earns a few pennies less per share because the steel price is rising? This sort of inflation is invisible to most Americans. The only inflation most of us care about is the "good" kind – stock price inflation and home price inflation.

– Wall Street knows all about the good kind of inflation. New York City’s securities firms will pay out about $11 billion in bonuses in 2003, compared to $8.6 billion in 2002. The average bonus for the industry’s 161,000 workers in New York City will be about $69,000 in 2003, up from last year’s average $52,400 – that’s a 31% inflation rate.

– But here’s a thought: Wall Street’s average bonus may be 31% higher in dollar terms…but it’s only 10% higher in euro terms. Now that’s inflation!

Bill Bonner, back in Paris…

*** Amazon offers us another great opportunity. The stock is up 160% this year. Thank you. Thank you. Thank you. We get a second opportunity to sell the great "River of No Returns" stock…

*** $146,000 is the average baby boomer’s net worth, according to the Wall Street Journal. About half of that is in real estate equity. How will the boomer ever retire? Sell his house? Rent? And hope to drop dead before reaching 70…?

*** Humility, dear reader. Humility. Whatever happens, remain humble.

Why? Because it is the only way to keep from making a fool of yourself.

The thought crossed our minds the other day when our book made it to the Number One spot on the NY Times bestseller list. For a nanosecond, we felt the warm flush of fame…fortune…success…

And then we came to our senses, and realized that we were still the same pathetic scribbler we had always been…with no more of a clue about stock prices, the war in Iraq, church attendance, or the subjunctive mood than we had yesterday.

The advantage we have over our fellow scribblers – if we have any at all – is that we glory in our ignorance. We’re proud of it to the point of arrogance.

We know we know nothing. The other poor schlep thinks he knows not only what will happen – but what is best for everybody. It makes no sense, generally, to buy an expensive stock. But this fellow is sure they’re going up – so why not? He thinks there is some federal agency in charge of making stocks go up. And if there isn’t, he’s ready to vote to establish one. He’s ready to send troops to Iraq because he’s sure he can do a better job of running the place than the local incompetents…and he knows good and well what will happen if he doesn’t.

And now he’s sure that the economy is looking up. It is improving because his fellow meddlers at the Fed have twisted the right knobs. And if the economy fails to response, they’ll jerk on some other lever. One way or another, they’ll get it right, he thinks.

*** The know-it-alls got a boost in the New York Times recently – the leading rag of know-it-all-ism – in a column by David Brooks, whom we have mentioned in these pages before. Mr. Brooks cites "two long economic booms" as evidence that government works. "They are a ‘howling refutation’" says he, of "those anti-political cynics." He did not mention your editor by name.

We are a "well-governed nation," concludes the Times man.

A little humility would have helped Mr. Brooks. The poor schmuck seems to have fallen into a special kind of absurdity…both ridiculous and menacing at the same time. He seems to want to prove that government is not incompetent. His example serves him poorly; it shows government not as a fool, but as a knave.

A boom in a heavily indebted, consumer-led economy is no virtue. It is nothing more than a reckless shopping spree. He sees the boxes and bags – full of gadgets and geegaws. He notices the retail clerks ringing up the charges. He spots the trucks pulling up to the loading docks…and the ships unloading their vulgar cargo in Long Beach or Newark. But he is as blind to what is really going on as a squirrel to a park mugging. He watches the transaction from his tree limb, but has no idea what is really going on.

But how will we pay for this stuff? How does this spending make us better off? The questions never seem to occur to him.

He is right, of course, that the booms had government to thank. The Feds set interest rates too low…and piled up paper money too high. People took the bait; they borrowed too much, spent too much, and saved too little. Now, it takes $45 billion per month in overseas capital – most of the world’s savings, in fact – just to make ends meet. All the assets in America put together are only worth about $50 trillion. Each year, the nation effectively sells off another 1% of its net worth – just to continue living beyond its means.

Instead of fostering a "positive trend," government not only allowed Americans to ruin themselves in an orgy of debt, it rented the hall and served drinks!

There is the trouble with thinking you know something: the range of error is much broader than the pinprick point of truth. You might even get as confused and misguided as Mr. Brooks. Be humble, dear reader; you’ll make fewer mistakes. Besides, it will make you feel soooo superior.