Clash of the Titans

To learn about the future of economics, you must be well aware of the past. Justice Litle shares some observations to help us get through, and possible even profit from these "interesting times" between the U.S and China.

"Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist."
-John Maynard Keynes

There is an old joke about economists barreling downs the road in a car with a blacked out windshield, driving by way of rear view mirror. The analogy has deep roots. These days we are always looking forward to the future, but the ancient Greeks had a different perspective: they saw themselves walking backwards through time. Keenly aware of where they had been, past terrain offered the best guess as to what might be coming next.

As investors and traders, we look forward as best we can; acting in the present, informed by the past, taking calculated risks in hope of getting it right. To some degree we walk backwards like the Greeks, yet with a significant advantage: the awesome depth and breadth of our past. As Mark Twain noted, history never repeats but often rhymes. Perhaps the skilled investor has a bit of poetry in his soul.

But what’s the point if Keynes was correct? Do our views really matter if we are just slaves to some dead economist? Fortunately, Keynes was not asserting some form of mind control beyond the grave. His point was to highlight the astonishing power of ideas and beliefs, especially the ones that act as building blocks for our assumptions, color our perceptions on matters of great importance, and are typically ignored as commonplace.

Idead and Beliefs: Foundations: Invisible, but Necessary

Many of these key concepts are invisible, woven expertly into the fabric of our assumptions. They hide in plain sight, like Poe’s purloined letter. Most of us do not consciously tend to our core beliefs. Like the foundation of a house, we place great weight on them sight unseen.

Yet without a solid foundation to build on, the house -or in this case, the investment portfolio- will not stand the test of time. A poor foundation is no good for building wealth, and a shaky framework invites collapse. The more volatile and dangerous things get, the more important the foundation becomes. When the sky is blue and the sun is shining, mistakes aren’t all that costly. But when the waters are churning and the winds gathering, structural integrity becomes paramount.

There is a tongue in cheek saying attributed to the Chinese (but potentially of Western origin): "May You Live in Interesting Times." That certainly applies today, as opportunity and danger roar forth like a pair of marauding lions. With two titans (China and the United States) facing off, neither at clear advantage and neither able to withdraw, the stakes have never been higher for the global economy. Not to mention booming commodities, inflation heading to the fore, crude oil on a long march to triple digits, the world’s reserve currency in doubt, nuclear confrontation, political turmoil on multiple continents, old strategic alliances cracking up, new alliances taking shape, and unprecedented financial leverage -from hedge funds to mortgage lenders to consumers to central bankers- straining the system to near breaking point.

So do we seize the day, or run and hide? Is this a doomsday forecast? Not at all. For some of us, the rapidly rising stakes are as much a call to action as a call to caution. The commodity bull, already an impressive beast, is still in very early days. The pace of development in Asia is bringing forth a sea change of incredible proportions, with incredible profit potential in tow. Skyrocketing energy prices are a driving force in the development of fossil fuel alternatives and innovative 21st century technologies, creating major investment opportunities. Precious metals have awoken from their long slumber. And so on.

This is where the value of core ideas and beliefs comes into play. Action and caution must strike a balance. We don’t want to turtle up and let a fortune pass us by… nor do we want to be reckless and rash. So how do we go about maximizing our advantage in these "interesting times," while successfully avoiding the tiger traps and the crocodile pits? Three key observations will assist. Here they are:

Ideas and Beliefs: Growth and Volatility Go Hand in Hand.

In markets and in life, rarely do you see progress in a straight line (except when massaged or artificially created). Corrections and setbacks are natural, and even desirable. As experienced trend followers are apt to say, the market has to breathe; a market that goes straight up without taking a breath is likely to burst. As we rack up massive gains in our energy and commodity positions, this principle is useful to keep in mind. Better to keep a clear head and a longer-term perspective than to panic at the first sign of a healthy correction.

The principle applies to countries and regions as well. If China’s growth path over the 21st century compares to America’s in the 20th, the potential returns will be astounding. But keep in mind that America still had its share of panics, crashes and setbacks over the years – and China will too. Here too, this is healthy and not necessarily a bad thing. Economic progress is largely based on creative destruction. Without occasional periods of cleansing, old ideas and methods would not be replaced by better ones. Without occasionally tearing down, structures would not be rebuilt stronger than before. China has a lot of work to do on its financial infrastructure, and some of that work will be painful.

Recognizing how markets work lends strength to our convictions. Anticipating volatility -and knowing how we will handle corrections and setbacks when they come- is a significant piece of the puzzle.

Ideas and Beliefs: Jack Be Nimble.

George Soros, the man who broke the Bank of England and made a billion dollars in less than 24 hours doing it, has a useful observation for investors and traders alike: "Volatility is greatest at turning points, and diminishes as a new trend is established."

Point being, when you are on the right side of the trend, you want to relax and let the market do its work, knowing that you are positioned for the duration. But… when the market starts flashing warning signals in the form of increased volatility and decreased directionality, thrashing around without gaining ground, it’s time to be wary. And in the current environment, it would signal a time to transition from a commodity/energy overweighting to a precious metals overweighting. Why? Because as John Mauldin notes, "Gold is seen by many as a neutral currency rather than just another commodity. Gold is a safe haven in periods of extreme financial instability, and there is enough leverage in the system at moment that if things go south; they will not go south quietly."

This makes gold (and to a lesser degree silver) ideal as a sort of backstop in the event of a China-driven commodity/energy correction. Precious metals as an asset class will be advantaged if/when any of the following events come to pass: a sharp (but temporary) drop-off in global economic growth; a hostile unraveling of the financial standoff between China and the United States; an act of terror or regional political crisis sending crude to $100 overnight; inflation breaking loose and triggering a USD freefall; or any combination of the above. It’s not necessarily time to move yet, but it is time to think clearly and observe keenly.

Ideas and Beliefs: Conviction Is Key.

If you are an active investor, you know the ride has been wild so far- and wildly profitable as well. It’s going to get wilder still. But as Jesse Livermore notes, the real money is made not in the trading, but in the sitting: letting the major move develop and having the patience to "be right and sit tight."

This doesn’t mean blind buy and hold, and it certainly doesn’t mean passive acceptance of whatever unfolds with no logical response. It does mean having the foresight and conviction to see the dominating trend and ride it to the fullest, not growing impatient or throwing in the towel. If we see a correction in commodities or energy over the next few months, it will be an invitation to book profits on marginal positions… but it will also be an opportunity to add to core positions, with an eye for the long term. Similarly, precious metals are already back on form, and they will accelerate dramatically in the event of an inflationary surge or a destabilizing political/financial event… but in terms of long run opportunity, the move has only just begun. We want to have tactical flexibility in the short to intermediate term, but maintain the strength of our convictions as the dominant cycles unfold.

Regards,

Justice Litle
for The Daily Reckoning

March 17, 2005

As Justice says above, the pace of development in China is not only bringing forth an incredible change, but an incredible opportunity to profit as well. China has made itself the "factory of the world," and their consumption of commodities and natural resources is increasing every day…with no end in sight!

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, 2004). In addition, Justice Litle has been quoted in the Wall Street Journal and by multiple financial newswires, such as Dow Jones and Future Source.

It is all beyond our ken, dear reader.

Flowers, buds, and blooming things are bursting out all over London. Yellow, white, pink…we admired them on the stroll to work. On another day, we might not have noticed them at all.

Some days we only see ourselves marching drearily to our own grave. Other days, we think how nice the funeral will be. The difference, according to scientists, is mostly chemical. The brain rations its serotonin. When it puts out a lot of it, we feel happy and content. When it puts out a little, we feel miserable – whether the crocuses are coming up or not.

But what causes the brain’s serotonin to rise and fall? More chemistry? Or the news?

Yesterday’s news seemed to depress investors’ serotonin levels. The Dow fell. "Exotic," bonds…junk bonds…and risky investments of all sorts fell. Almost everything fell – except the dollar, gold, and house prices.

The Dow is in retreat. Whether it is merely continuing to bounce around in its trading range or beginning the long-awaited next phase of the Great Bear Market of 2000- ? we will have to find out later. For the moment, we don’t know, but we also don’t really care. Because, here at The Daily Reckoning, we don’t invest according to our guess of what is going on. Instead, our investments are a matter of principle, not foresight. As a matter of principle, we do not buy expensive stocks.

Still, we try to figure out what is going on. For that, we need to screen out the noise – the useless headlines and vapid opinions – and focus on the essentials.

When things are expensive, as a matter of principle, we sell. When they are cheap, again…as a matter of principle, we buy. Houses are expensive. Yesterday came news that housing starts are running at a 21-year high. How do you make money in a housing boom? You sell houses…exactly what the housing industry is doing. But if you are an investor, and housing stocks have become expensive…you sell them too!

Specifically, the two news items that seemed to cut the serotonin output yesterday were the latest figures on the current account deficit, (the Commerce Department said it was $665 billion last year) and GM’s announcement that it had lost $1.50 per share last quarter. The two items made investors wonder if the world’s economy was really as healthy as people think. If it were, how come GM can’t sell more cars and trucks?

But the dollar rose on the news. Not because the United States needed to borrow so much money, but because there were so many people willing to lend it to them. Also in the news was January’s net capital inflows figure – $91.5 billion – an amount that easily covered the month’s deficit.

In fact, so easily was the deficit covered that many economists have come to believe that America’s overseas borrowing has no credit limit. The noise in the press on this point is so loud we must put wax in our ears to avoid going deaf. For example, David Malpass, writing in the Wall Street Journal, says the trade deficit merely reflects the fact that the U.S. economy is growing faster than its trading partners. Mark Tinker, writing in Britain’s "The Independent," argues, "America is providing the savers of the world with relatively high-yielding, low-risk assets to match their liabilities, and recycling that capital into higher-risk investments to allow the world to grow." What’s wrong with that, he wants to know.

Frank and Dan Newman, also writing in the Wall Street Journal, seem to misunderstand the whole problem. "Trade Deficit Trickery," they title their piece. The trade deficit doesn’t really matter, they claim, because "all dollars lead to home." Whether we spend our dollars at home or overseas, they believe, it amounts to the same thing. They don’t seem to notice that the dollars go out of the pockets of U.S. householders and come back in the hands of overseas investors. They go out from U.S. consumer earnings and consumer borrowings…and come back as capital investments by foreigners. They leave home as domestic spending…but return in the form of higher bond, real estate, and stock prices, thanks to foreign buying.

There is nothing "wrong" with it, cosmically speaking. What does God or Nature care if Americans sell the family farm to foreigners? All they care about is that people get what they deserve, and who can doubt that they will?

But people are ready to believe anything if it flatters them. They think the in-flowing capital merely shows how attractive we are. And so, serotonin flowed in the currency markets…and the dollar rose. At least, it did yesterday.

More news, from our team at The Rude Awakening…

————–

Eric Fry, reporting from Manhattan:

"One Budweiser and two ordinary glasses of wine should not cost $64…not even in Manhattan. But they did. And to hear most ‘experts’ tell the tale, crude oil shouldn’t cost $56 a barrel…but it does. Maybe these two phenomena are related…"

————–

Bill Bonner, with more gratuitous opinions…

*** Don’t do the crime, if you can’t do the time. Poor old Bernie! The Worldcom promoter rose from rags to riches. Now, the poor schmuck would be lucky to have rags.

It doesn’t seem fair to us. We were perfectly ready to believe he didn’t know what he was doing; we never thought he did. And investors who paid top dollar for Worldcom? Did they not deserve to lose their money? Did not Bernie – a former schoolteacher – help them learn a valuable lesson? Was it not worth the money they lost?

We don’t know. But we hate to see Ebbers go to prison while Greenspan remains at liberty. It just doesn’t seem fair. Who cost Americans more money? During Mr. Greenspan’s watch, the currency he was meant to be watching over lost 50% of its purchasing power. Mortgage debt more than tripled. Mr. Greenspan misled the entire nation…he endangered its finances…and its soul.

Our Pittsburgh correspondent, Byron King, has a few more thoughts:

"If you will permit me to kick a man while he is down, and make a larger point…

"’Guilty on all nine counts,’ said the jury. My dad, who practiced law for 52 years, used to say that when a jury finds a man ‘guilty on all counts’ in a criminal matter, then the jury probably did not understand the government’s case. Still, there is a sense of justice in seeing Bernie Ebbers, one of the architects of the late and much-lamented stock market disaster, brought low. ‘Guilty on three counts’ or ‘Guilty on five counts’ would have been quite enough for me, but I am not terribly bloodthirsty by nature.

"As with all economic booms, however, absent the excessive liquidity of an even more guilty Central Banker, in this case Herr Alan Greenspan, WorldCom would never have bubbled-up to so frothy a level, only to fall so hard. Nor would Bernie Ebbers have risen and moved so many long leagues beyond his own modest level of human competency. Whether Bernie understood it or not, the U.S. Federal Reserve’s excessive liquidity was instrumental in allowing him to affix his feet to the deck of that fateful bridge, to control the helm of a mighty economic vessel, and steer his $100 billion company right into the iceberg. Now Bernie Ebbers, too, can follow in the ancient and honorable tradition of going down with his ship. This tragic ending occurring, of course, with a bit of help from the many fine attorneys who are employees of the U.S. Department of Justice.

"Bernie Ebbers, we are told, started out his rise to fame by re-selling used phone equipment. I never met the man, but I would wager that he was probably a darn good phone equipment re-seller. He probably could, just as easily, have been selling any manner of patent medicine or snake oil, and people would have bought it from him by the gallon."

*** Our roving reporter, Greg Grillot, just off the plane from Delray…

"Last week, The Daily Reckoning sent me packing on down to balmy South Florida, to attend the 7th Annual Investment University conference.

"I saw Dan Denning speak of the nascent, emerging markets like Vietnam, Malaysia, and Singapore. I listened to Porter Stansberry detail his secret ‘No-Risk Investment’ strategy and I watched Dr. Steve Sjuggerud make presentations on some of his favorite real assets like timberland and gold coins. Finally, Dan Ferris spoke about buying the world’s most undervalued real estate for meager dollars on the acre.

"I could have ducked out right then to gawk at the bikini-clad valkyries on Delray Beach, but Alex Green hadn’t spoken about dynamic asset allocation yet…"