At War with the Obvious
Everyone has their opinion on what the U.S. economy is going to do…but as we like to point out in these pages, what the majority believes is very rarely correct. Chris Mayer explores…
"The world is full of obvious things which nobody by any chance ever observes."
– Sherlock Holmes, The Hound of the Baskervilles
After World War II, economists had an airtight case for another Great Depression. The argument went something like this…
The U.S. never really recovered from the Great Depression, they said. It was war-related hype that pulled the economy out of its doldrums. What would happen when all those orders for war materials dried up? Utter collapse.
The unemployment rate was 14.6% in 1940. During the war, it dropped to practically nothing. But when the war ended, what then? Well, you throw 12 million military personnel back into the work force and it would be a disaster.
Seymour Harris, a prominent economist of the day, called for unemployment rates of 20% in the U.S.! That was not at all an uncommon point of view. Paul Samuelson, a future Nobel Prize winner, said that "There would be ushered in the greatest period of unemployment and industrial dislocation which any economy has ever faced." Pretty much anybody of any standing thought the U.S. economy was ready to go into the tank after the war.
As it turns out, that was exactly wrong! The economy took off. In fact, the Truman years were great years economically. During his eight years, the economy grew 60%. Corporate profits nearly doubled. Unemployment by 1952 was practically nonexistent, at 3%. The Dow rose more than 80%, albeit from a very low base.
Just goes to show you that the consensus isn’t worth a pile of pigeon droppings. Great investors have always understood this. Bernard Baruch, the great wheeler-dealer of long ago, is an interesting case study in bucking a strong consensus.
Baruch made his first killing in 1897 going long American Sugar Refining Co. when everybody else thought it was a stupid thing to do. In fact, The Wall Street Journal reported on July 3 of that year:
"Washington correspondents of various newspapers are taking extremely bearish views and nearly all Washington houses are short the stock… The Street impression certainly is that the Sugar Co. has been defeated."
So there you go. Nearly unanimous opinion among the experts. But Baruch went long anyway. He turned $300 into $60,000 in the process – within in a year – and was on his way. (He bought the stock on margin. That is to say, he borrowed heavily. And he kept buying as the stock rose higher.)
The Journal, after a sharp rise in sugar, reported on July 24 – a mere 21 days after its first dispatch:
"Never in the history of Sugar manipulation have so few people been right on the stock."
I start with this anecdote to impress upon you that when the great mass of brains we call experts coalesce around an idea, that idea is far from being right. In fact, it doesn’t often pay to bet with the consensus, for the same reason it doesn’t pay to bet favorites in a horse race. The price you get won’t compensate you enough for taking the risk. You won’t make money over the long term.
Today, it seems analysts are competing with each other to see who can come up with the lowest prediction for the price of oil. Everybody is piling on. The Wall Street Journal reports: "Many oil industry insiders and traders now say prices could slump much lower, into the $30s, before supply cuts push prices back up, perhaps much later into next year." Merrill Lynch, as if to top that, now says that oil could get as low as $25 per barrel.
The commodity bull market is over, the consensus opines. You were an idiot not to see the bubble. You are an idiot today for continuing to invest in the names. That is what the mainstream consensus seems to be saying these days.
I don’t buy it.
Granted, I was wrong in thinking commodity prices would hold firm in 2008. I thought that the favorable supply and demand dynamics of these markets would prevail over a potential economic slowdown. And for a while, it looked like that’s what would happen. After all, let’s not forget that most of the destruction in commodity markets happened since July. Oil was $147 per barrel on July 11. Today, it’s $43. I certainly didn’t see that. In fairness, I don’t think anyone saw that steep of a drop. Other commodity prices fell in a similarly steep pattern.
And so we see our commodity names pummeled as well. But I’m hanging on because the market has gone too far in punishing these names. It will correct itself faster than I think most people expect. I still see good hard-to-replicate assets and smart management teams and cheap stocks, so I’ve stuck with them. If I thought otherwise, I would’ve blown out half the portfolio and started over. But I don’t think that’s the right course. I think we need to be patient. (I always remember the wise words of old Phil Carret, a great investor who at the age of 99 found himself on the Louis Rukeyser show. Asked what was the most important thing he learned about investing over the past three-quarters of a century, Carret gave a one-word reply: "Patience.")
Let’s also not forget that 2008 was as bad a year for stocks as nearly anyone living has ever seen. The broad S&P 500 index will likely finish the year down more than 40%. There weren’t any places to hide, unless you were going to sit it out in cash.
As bad as it seems now, it won’t last forever. In 1932, in the absolute pit of the Great Depression, Bernard Baruch wrote a short foreword to Charles Mackay’s classic work Extraordinary Popular Delusions and the Madness of Crowds. This was a book Baruch said saved him millions. And it is a good history book that stands up even today. Anyway, Baruch wrote:
"I have always thought that if, in the lamentable era of the "New Economics," culminating in 1929, even in the very presence of dizzily spiraling prices, we had all continuously repeated, ‘Two plus two still make four,’ much of the evil might have been averted. Similarly, even in the general moment of gloom in which this foreword is written, when many begin to wonder if declines will never halt, the appropriate abracadabra may be: ‘They always did.’"
He was right. In fact, in 1932, when he wrote this, the worst was over.
I don’t know if the worst is over today. I wish I could say it was. But markets don’t work that way. No one knows where the bottom is. It is unknowable. I can only tell you that what my Mayer’s Special Situations readers own is cheap at these prices. And that I think all of what I’m recommending to them will be much more valuable in the years ahead.
for The Daily Reckoning
December 17, 2008
P.S. There are bound to be several 10-baggers lurking on our back page and out in the marketplace today. If we give up now, we may never have a chance to own these stocks at these prices ever again. Inevitably, some won’t make it – and we’ll trim them as we go – but the ones that do will more than make up for them.
Chris is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital & Crisis – formerly the Fleet Street Letter.
Chris also recently wrote a book: Invest Like a Dealmaker: Secrets from a Former Banking Insider.
As we suspected, the Fed went for broke yesterday. We predict it will work: we will go broke!
"Fed effectively cuts its key rate to zero," is how today’s International Herald Tribune brings the news.
This year has been a 1929 rerun. The feds don’t want to see the ’30s too.
Investors were buoyed up by the news. The Dow rose 360 points. Gold rose $6 too – to $842. If it can hold above $838, it will end the year in positive territory. Get your gold while the going is good…and the price is still reasonable.
"Going further than analysts anticipated, the central bank cut its target for federal funds rate to a range of zero to 0.25%, a record low, bringing the United States to the zero-rate policies that Japan used for six years in its own fight against deflation."
As predicted, the US follows the Japanese model…and its own model from the ’30s…the ’70s…’80s…’90s…and ’00s. Borrow it, lend it, spend it and print it. Money, that is.
It doesn’t seem to bother anyone that these policies don’t work. Last time we looked, Japan was still in the on-again, off-again deflation/recession it’s been in for the last 18 years. And more recently, Japan’s share market is at a 22-year low. A whole generation of Japanese investors have gotten nothing for their trouble. Stocks for the long run? It’s a good thing the Japanese have long life expectancies!
But we are all Japanese now. Sushi it is! ZIRP – the "zero interest rate policy" – was tested in Japan for many years. There is no evidence that it did any good. Zip! Nada! Now, it will be used here…again, for many years.
There are really only two ways out of this mess – up or down. People owe too much money…and they’ve invested in too many things that aren’t worth what they paid for them. There’s no easy way out. Mistakes are mistakes; somebody’s got to pay for them. Either the people who made the mistakes…or people who didn’t.
The feds can just butt out…and let the market take care of itself. That will mean HIGHER real returns on capital. Real money will be scarce. People will pay for their own mistakes – dearly. Savers will be rewarded with higher yields. They will save more. Prices will fall. The economy will go through a tough, but relatively quick, reorganization. Debts will be written off or paid off…or worked off. Investors will lose money…business and consumers too. It will be long and hard, but gradually balance sheets will be strengthened…and the economy will be re-capitalized with savings. Still, many people will go broke. And riots will break out …as the lumpen malcontents take to the streets demanding that their government ‘do something.’
Of course, there is nothing the government can do…but cause more mischief. That’s the low road – the road the feds have taken…by cutting interest rates to zero and spending trillions of dollars they don’t have. It’s the low road they’ve been on for many years…it’s where they feel most comfortable…and where they can do most damage. Instead of recapitalizing the economy by favoring savers, the feds are continuing the process of de-capitalizing it. Yields go down, not up. Savers get discouraged…and ripped off. Money becomes cheaper and cheaper…eventually reducing the debt load via inflation. Reckless spenders’ debts are erased. Mortgages are wiped away. Speculators make money on wild bets. Debtors come out way ahead – including the biggest debtor of all – the US federal government,
Meanwhile innocent savers, ordinary householders, taxpayers, foreign creditors, unborn children – all pay the price.
We’re not arguing with it. Nobody asked our advice anyway. (Nevertheless, we give some advice…below.)
The feds are on the low road, no doubt about it. But so far, they’ve haven’t gotten very far. Instead of inflation, they’re getting deflation. Yesterday’s news reports tell us that consumer prices are headed down. Sales are down too – with luxury goods off 33% since Thanksgiving.
And, of course, housing starts are down…states are cutting back spending for the first time in 25 years (they don’t have printing presses…poor things)…and even the mighty Goldman Sachs has had to report its first quarterly loss since it has been a public company.
If the Japanese example were the only thing we had to look at, we’d think the feds couldn’t win this fight. Mr. Market is bound and determined to lower prices. So far, he’s clearly winning.
But there are other examples that boost our confidence in the feds. They’ll get the hang of it eventually.
The rate cut "means the Federal Reserve will have to reach for new and untested tools in fighting both the recession and downward pressure on consumer prices," says the IHT report. Untested? We bet Gideon Gono can show them how to use these new tools.
*** If our sage counsel had been courted, we would have told the feds to take the high road. Don’t cut rates, raise them. Get it over with. Reward savers, not spenders. Give people a bonus for doing the right thing, not for doing the wrong thing.
We’re not above a little showmanship either. If Obama wants to keep the masses at home watching TV rather than marching on the White House, he should offer a real stimulus:
Give people back their tax money. Declare a Tax Jubilee. No taxes in ’09. No income taxes. No capital gains taxes. No federal taxes of any sort…not even any inheritance taxes. If we had our druthers, you could die in ’09 and rest in peace…with no tax consequences…leaving your money to whomever you wanted.
But we know what you’re thinking…how could the federal government operate without tax revenue? Ah…that’s the other part of the plan. We would shut it down. Take a holiday from government. Send everyone home for a year. Tell them to make do with what they’ve got.
*** One thing is sure; we’d get along fine without the SEC on the job. It does more harm than good. It merely helps perpetrate a fraud – misleading investors into believing that their money is safe on Wall Street. As we’ve seen, donuts were safer on a fat farm.
Christopher Cox, chairman of the SEC, assured investors nine months ago that their investments in Bear Stearns were perfectly safe. The firm collapsed three days later.
"You are dealing with a commission whose effectiveness in fraud deterrence is open to serious question," said Professor Joel Seligman, an expert on the subject. Open to question? We would say the question is settled. The SEC does not fight fraud; it aids and abets it. In the largest heist in Wall Street history, Bernard Madoff was able to tell investors that their funds were safe: the SEC had examined the company carefully twice in the last 3 years…and given it a clean bill of health.
*** "Don’t you know there’s a worldwide financial meltdown?" we asked Elizabeth last night. "This is no time to be buying new furniture."
"Well, I needed a new desk. But I’m not buying anything else."
"Aren’t you picking up a new horse trailer tomorrow?"
"Yes, but I ordered that before the crisis hit. When I thought you had some money…before you started worrying about going broke."
The phone rang.
"Who was that?" we asked a few minutes later.
"That was the curtain man. I need to get new drapes for the living room."
"What’s wrong with the old drapes?"
"They’re just not right."
"They’ve been okay for the last 13 years…what’s suddenly not right about them?"
"They’ve never been right…and I’ve finally realized what it is…so I’m going to change them."
"Don’t you realize that there’s a global financial crisis? This is no time to be spending money."
"Yes, but the crisis is likely to go on for 10 years…and I don’t want to live with drapes that aren’t right for a whole decade…and then buy them after we’re too old to enjoy them."
"You’re not one of those ‘toxic wives,’ are you? You know, those women who leave their husbands after they lose their money."
"Don’t be silly. You didn’t have any money when I married you. And I’ll stick with you even if you go broke. We may not have any money. But at least we’ll have nice curtains to look at. That’s why I’m getting them now…while you’ve still got some money left."
The Daily Reckoning