A Fool and His Money
The similarities between a certain card game and investing are undeniable – especially when you look at the players on both sides of the comparison. Justice Litle shows us what a poker player and a Passive Indexer have in common…
"Paradoxically, perfect market efficiency leads to markets becoming inefficient."
– Lee Thomas III, Pimco global bond strategist
"It’s immoral to let a sucker keep his money."
– Canada Bill Jones, 19th century poker player
Investing has many similarities to poker. For example: A small minority of professionals take the lion’s share of profits. The house takes its cut from all comers with ironclad regularity. Odds allow for confidence, but never certainty – there is no hand that can’t be beaten, no hand that cannot win. Both games are heavily influenced by luck in the short run, yet dominated by skill and consistency in the long run. And success is rarely the result of any one large decision; it is rather the result of countless small decisions, built into an accumulated edge over time.
The typical poker player reverts to the style he or she is most comfortable with in live play. This lack of variation gives the professional an edge, highlighting the best way to take the amateur’s money. Poker predators usually assign one of three classifications to their prey: Maniac, Rock, or Calling Station. Of these three, the Calling Station is prized as the most reliable source of funds. The Maniac is dangerously aggressive, and often too hot; the Rock is notoriously tight-fisted, and usually too cold; but the lukewarm Calling Station is just right.
A passive aggressive type, the Calling Station has no grasp of strategy, yet feels compelled to participate. He or she is happy to call the majority of bets, rarely raising or taking control of the hand. Analysis is minimal, actions robotic. The Calling Station’s attitude can be summed up as, "I don’t really know what I’m doing, but I’m just glad to be here." A streak of good cards will occasionally reward this hapless style of play, but odds inevitably prevail over time. The Calling Station thus provides a steady stream of revenue for those who understand the importance of strategy and put it to use.
The Passive Indexer: Mimicking the Dow Jones
On Wall Street, the investing equivalent of the Calling Station is the Passive Indexer – the individual who seeks to unthinkingly mimic the performance of the Dow Jones or the S&P 500. Like his poker equivalent, the Passive Indexer is either unaware that strategy exists or unconvinced of its necessity – just happy to be a part of the action, hoping that luck or providence will provide a decent retirement. (Of course, the Passive Indexer is frequently encouraged to believe that providence is all he needs. This is rather like wolves encouraging sheep to believe the forest is safe.)
By contrasting the modest returns of passive indexing with the subpar returns of mutual funds, index touts pull off a neat trick: they make the bad look good by comparing it to worse. Adding insult to injury, many large mutual funds are actually "closet" indexers, charging for active management yet hugging the benchmarks anyway. This is like starting at the bottom and digging a hole.
In essence, passive indexing is the equivalent of a dog chasing its own tail. Selected companies grow larger as sums of indexed money robotically swell their market caps. As valuations rise, the indexers are encouraged by the boost. The process repeats in round robin fashion, with little thought for the objective worth of the companies receiving these blind inflows. Few question this puzzling lack of logic, thanks to a triumph of circular reasoning: the Efficient Market Hypothesis assumes that all valuations are intrinsically self-justified. This academic diktat reinforces the torrent of not just dumb, but brain-dead money. Most of us know the crucial economic benefit of a stock exchange is rational and efficient capital allocation, but we forget that rationality presupposes intelligent thought. As passive indexing gains in popularity, the principle of rational capital allocation is turned on its head and thrown out the window.
Those who defend passive indexing invariably point to stocks’ historical uptrend. But like the Calling Station on a temporary winning streak, indexers overlook the cyclical tendencies of the market, putting too much emphasis on an extraordinary run of good cards.
As the Rydex chart shows, the market actually spends more time going nowhere than going up, with the typical bear cycle measured in decades. Whether things work out in the long run is a moot point for those with retirement needs close at hand. As Lord Keynes famously noted, in the long run we are all dead.
The Passive Indexer: "Past Performance Does Not Guarantee Future Results"
Alternative asset managers – who pursue absolute returns rather than relative ones – are required to post the prominent disclaimer "PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS," or some variation of such, on their investment materials. Ironically, the Passive Index claque relies on just such an outlawed guarantee to make their case. They want you to believe that buy and hold is safe as milk. (In the current real estate climate, "safe as houses" has lost all meaning.) Worse still, the indexers lean on history for support without actually consulting it. By ignoring the ramifications of market cycles, massaged data like the Ibbotson study (the most famous bit of agitprop supporting "stocks for the long run") proves fundamentally dishonest. A more rational assessment, assisted by the chart above, would go something like this:
If historical market patterns offer guidance, we are probably heading into a period of sideways to down markets that could easily be ten years or more in duration – hardly the time to be passive.
On the other hand, if historical patterns do not offer guidance – that is to say, if "this time it’s different" and/or past performance does not guarantee future results – then the case for passive indexing no longer exists.
Is there ever a time to seek general exposure to stocks? Certainly. When valuations are low, pessimism is high, and interest rates and inflation have hit cyclical peaks, it’s probably a good time to be a broad market bull. In the stagflated seventies, the PE Ratio for the S&P 500 flirted with single digits, inflation ran rampant, and a determined fed chairman took interest rates to sky-high levels. Volcker’s victory over inflation, and the long march towards price stability that followed, set the stage for the great bull of 1982-2000.
Here in 2005, we are at the opposite end of the spectrum. Price stability is crumbling. The twin specters of inflation and deflation lurk. Government expenditures are skyrocketing. The reckless expansion of credit has been unprecedented. Liquidity-driven stock valuations cling to stubbornly inflated levels. All these excesses need to be worked off before general conditions can be considered truly bullish once again. A long-term sideways to down cycle is required.
But the news is not all bad. There will be plenty of opportunity afoot, even with the broad markets going nowhere. Savvy investors made good money in the thirties and the seventies, and they will have similar opportunities in the coming cycle. Some sectors will shine even as others languish. There will always be a handful of companies making money hand over fist. Volatility will provide ample trading opportunities on the short and long side alike. It will be a stock picker’s market, and very much a trader’s market… but not a passive indexer’s one.
for The Daily Reckoning
September 20, 2005
P.S. I do know of one asset that will never be affected by stock prices, bond prices or currency fluctuations – and it’s available to a small percentage of savvy investors at a 98% discount. There is really no way to lose with this – when there is a surge in natural resources – you will already be positioned to profit. When there is a bull market in the small-cap market – you will already be invested. Want to know more?
Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall)
Gold seems to have entered a new and more exciting stage of its bull market.
You’ll remember, dear reader, we began urging readers to buy gold six years ago when the price was under $300 an ounce. Since then it has gone up in stages, as if climbing a staircase. We followed along, raising our "target buying price" in $25 increments. Our most recent target for buying was $425. But the price of gold, December contracts, rose another $7 yesterday…to $470.40. Today, we raise our buying target to $450 and hope the metal falls below that level once again so we have a chance to buy more.
Why is gold going up? Well, the very big picture is that the Empire of the Anglo-Saxons, led by Britain until 1917 and since then by America, is probably peaking out. It is an empire built on debt. All empires are self-limiting. An empire of debt corrects when the bills come due.
We put this in a long perspective: In 1913, the Federal Reserve was set up, giving the central government control over America’s money. In 1917, Woodrow Wilson took the United States into a war in which it had no business. Germany was challenging Britain; it aimed to become the leading imperial power in Europe. America sided with Britain and gratefully picked up the imperial mantle in the process. In 1951, Harry Truman launched American forces into a major war, in Korea, with no declaration of war from Congress. Henceforth, the imperial president could make war wherever and whenever he wanted. In 1971, the last link between the U.S. currency and gold was cut by Richard Nixon; henceforth, the United States could print and distribute as many paper dollars as it could get away with.
This year, 1971, is significant in another way…it marked the beginning of the space shuttle program. Since then, about $150 billion has been lost in space. Readers will remark that valuable inventions have come from the space program. For example, NASA spent hundreds of thousands of dollars on one of them: the "space pen." It’s a remarkable writing device designed for weightless conditions. It will write on any surface from any position. The Russians used pencils.
Today’s paper announces a new spending program: $104 billion for further exploration of the moon.
"This development will open new worlds; and its consequences will go a long way toward cleaning up and vastly enriching the old one. It will not be merely revolutionary; it will be Promethean," wrote Rod Martin when the program was first announced.
We don’t doubt it. We recall that poor Prometheus was chained to a rock on Mt. Olympus where crows ate out his liver for all eternity.
President Bush announced that nothing would stand in the way of spending on New Orleans. We’ll spend "whatever it takes," said the president. No, we will not raise taxes to pay for it, he added. Then where will the money come from? Oh you silly, silly dear reader! Do you have to ask? The national debt is nearly $8 trillion. Every day for the last year, it has gone up by $1.54 billion.
Every day in America – in both public and private sectors – it’s spend, spend, spend ’til your daddy takes the T-bird away, which is why gold is rising. Gold is protection against vanity, foolishness, absurdity and ambition. It resists revolution, war, inflation, and debt.
Wars…space programs…social security and health…reinforcing the dikes…rebuilding the cities – all of these things cost money. As a consequence of all these Promethean efforts, we Americans are chained to a mountain of debt. In addition to the official national debt is another $35 to $40 trillion that has been promised by various federal programs. And that doesn’t count the private debt of $25 trillion or so. And every day that passes, the granite gets harder; as Americans add more mortgage debt, more credit card debt, more debt from hurricane clean-ups, foreign wars, and spacey programs.
We just wonder when the crows will show up. That’s when gold will really fly.
More news from our friends at The Rude Awakening:
Eric Fry, reporting from Wall Street…
"Fare thee well, Dennis Kozlowski. We will miss you. We will miss you each and every day of your 8 1/3 to 25 year sentence…We only regret that we will not have the opportunity to miss you for longer."
Bill Bonner, back in London:
*** Over the years, home prices have proved the old adage: what goes up, must come down. An example a CNN Money report gives is of Los Angeles in the early 1990’s. When you figure in inflation, the average house price dropped 34 percent from 1990 to 1996.
"History seems to dictate that the current price boom is at risk," the report tells us.
Hmmm…do you think the public is finally getting the picture, dear reader? Could the mania really be coming to an end?
"Bubbles do tend to last longer than most people expect," says Ingo Winzer, president of Local Market Monitor, which sells real-estate market analysis to corporate and consumer clients, "and end quicker."
*** Don’t worry about Alan Greenspan’s departure from the Fed, says a Wall Street Journal article, "central banking itself has been elevated." Oh yeah? That is what we are about to find out…
*** "It’s interesting that few in the media have considered the implications of Greenspan’s paper boom… not just the tendency of easy money policies to drive artificial appreciation in paper assets, but the repercussions of such," says Justice Litle.
"The idea is decades old – I forget who originally thought of it – but consider the notion of a government directly taxing its citizens through inflation, by way of the printing press. There wouldn’t be a need for the IRS under this scheme. By simply printing more dollars to pay his debts, Uncle Sam could eat into your purchasing power directly if he chose.
"The big problem would be the obviousness of the method. Right now, inflation is a ‘stealth’ tax; by removing the IRS, the taxing nature of inflation would be out in the open. Better to keep it under wraps.
"It would also be possible to pay zero under an inflation-only scheme, by getting a return on assets greater than the erosion of your purchasing power. If the inflation tax in a given year caused purchasing power erosion of ten percent, for example, and your return on paper-inflated assets was twenty percent, you would be a net winner from the system. The government’s pound of flesh would still be extracted, of course–just not from you. It would be taken from those who saw a net loss of purchasing power, unable to offset it with sufficient capital gains."
[More on this topic tomorrow, and more from Justice below.]
*** We are leaving this afternoon for the pampas. Friends have organized an investment tour of Argentina’s northwest area. We will write as often as we can, but perhaps not every day.