"I have seen cases where something went down from $90 to 90 cents. It should never happen. Never, never, never. But it happens all the time."
-Benoit Mandelbrot, recently interviewed in Forbes
How is it possible that a stock can be worth $90 one day…and only 90 cents a few days later – the very same company? Maybe the CEO ran off with his secretary…and the company’s cash!
Sometimes stocks crash for no apparent reason. And whole markets can crash too – losing half of their value in just a few weeks. If Mr. Market is so smart, how can he be so wrong?
Returning to the subject that has fascinated us for the last few days, how is it possible for millions of people to get themselves into a war that almost no one actually wanted and from which practically no one actually benefited? How could they all be so wrong about so many things for so long?
Man, who is the smartest of all mammals…how could he do something far dumber than any mule or hedgehog would even contemplate – blowing himself up by the millions… for no good reason?
So many questions, but a single answer: Man is not what he thinks he is; he is what he is. He can be brilliant. But he can also be a beast.
This will come as no news to you, of course. But it will be a shock to anyone who believes that knowledge can be ricked up like hay bales and sorted out just as easily.
Alas, the things that are most interesting and most profitable about human life don’t work that way. Life is not regular, geometric or reasonable…it is fractal. Trees, clouds, coastlines – the patterns we see in nature…symmetry, spirals, cracks and turbulence – defy linear mathematics. Benoit Mandelbrot found ways to describe them using what is known as "fractal math"… which gives patterns that look a lot like a stock’s price chart.
The ups and downs look random. Maybe they are, but there may also be a deeper logic to them – a logic embedded in the human heart as tightly as a quarter wedged into a sewer grate.
At least, that is our operating hypothesis here at the Daily Reckoning. We believe that by looking more deeply into the folds of our critical organs…the heart, the brain, the entrails…we will see something both ghastly and revealing: how the beast actually works. The trick to this, we also believe, is to ignore the "wissen" and the "leicht denken" that you see in the newspapers and on CNBC. It is not just often wrong…it is mostly meaningless.
Take this simple matter "of fact": France and the rest of the Allies were victorious in WWII. Germany was the loser.
Everybody knows it is true. It is "wissen", as Nietzsche termed it. No one has ever actually seen or experienced it – because it is purely an abstraction – but it is nevertheless considered true.
And yet, if you were to tell a French woman – both of whose sons were killed in the war…and whose husband was blinded by a grenade – that she should celebrate the victory, she would take you for a fool. A third of France’s capital had been used up. Six million men had died. What kind of victory was this?
Ah…but France recovered its territories of Alsace and Lorraine! But for whom was this an advantage? Did the surviving men in Lorraine find their petite new femmes more beautiful than their hefty old fraus? Was their choucroute tastier than their sauerkraut had been? Could they drink more of their local hooch, now that it was called vin blanc and not weiss wein? Not likely. Instead, they toiled the soil as they had before the war…discovering, for years afterward, unexploded WWI- era bombs from time to time – which often blew up as they were scraped by a plow.
And in the years following, were the victors better off than the vanquished? Alas, no. By the 1930s, France, Britain and America were still in a slump – while Germany was booming. While the Allies seemed tired, worn-out and clueless…Germany entered a period of remarkable grit, pride and energy.
By the mid-’30s, socialist parties throughout Europe were imitating the German model. Uniforms were back in style. Everyone seemed to admire the achievements of the Third Reich, so much so that many thinkers predicted Germany would take over Europe because she deserved to do so; she represented the wave of the future!
Was France more secure, now that it had control over the west bank of the Rhine? Not at all. Germany quickly rearmed, and as subsequent events were to show, became a far bigger threat in ’34 than she had been 20 years earlier.
If France "won"…what had she won? You might just as well say she had "lost" the war as won it.
What kind of strange knowledge is this, dear reader? A "fact" is regarded as true; and yet, the exact opposite is also true. And what kind of thought process makes sense of it…what kind of reasoning can bring you to two conclusions at the same time, each one separated from the other as day is from night?
It’s a funny old world, as Margaret Thatcher once said. Things happen that should never, never, ever happen – all the time. And, trying to make sense of them, men lead themselves into the most extraordinary errors.
The same thought process that tells us that France won WWI also tells us that Americans got richer in the ’90s. Everyone knows it is true. If you want statistics to prove it, the Labor Department will beat up some numbers until they confess it to you. But might not the exact opposite be true, too? Or even more true?
Imagine a man who with a split-level house, $100,000 in savings and a wife as comely as a potato. Reaching a mid-life crisis, he goes on a spree. He dumps his old wife and gets a new one. He spends the $100,000 on a fancy new SUV, big screen TV and several luxury vacations to Paris.
Fortunately, lower interest rates help cause a real estate boom, so his house doubles in price over the course of 5 years. He feels richer…so he "takes some of the equity" out of his home (why not, it’s like savings in the bank) in order to continue his spending spree. Home prices keep rising…and (not coincidentally) interest rates keep falling…so he is able to do it again.
After a few years, he has all the trappings of a richer man – he’s added a wing on his house, there’s a new SUV in the driveway…and a boat…and he’s still taking those expensive vacations. But instead of owning his home outright as he did a few years ago, now he owns only half of it – with a mortgage to pay. And instead of $100,000 in savings, he’s only got $25,000 in savings.
Looking carefully at the man’s balance sheet, rather than his driveway, might reveal that he is not richer at all – he is poorer.
Is the U.S. economy so different? Thinking lightly about it, consumers come to the conclusion they want: that new technology, better business management, and a cracker- jack job at the Fed are making the country richer. But a hard look at the nation’s balance sheet might yield an altogether different answer…as we shall see, tomorrow.
Your editor…doing his scwher uberleging at the Paradis…
April 11, 2002 — Paris, France
P.S. A few new entries for The Daily Reckoning’s Contrarians’ Glossary:
Wissen – Things you think you know – but usually have no direct experience of and couldn’t pick out of a police lineup if your life depended on it…Most ‘isms’ fall into this category – capitalism, communism, antidisestablishmentarianism….the kind of thing that is reported in the paper and discussed with pompous gravity on the editorial pages.
Erfahrung – Things you know from personal experience. For example, if you slam your fingers in the door of a Deux Cheveaux (the French answer to the Volkswagen… without the power or the comfort), the next time you close the door, you move your hand out of the way. Why? "Erfahrung."
Schwer uberlegen – Either the kind of reasoning one does based on first-hand experience or the winner of the Gold medal in the luge in Nagano ’98. We don’t speak German so we’re not sure.
Leicht denken – (Schwer uberlegen’s distant cousin)… the kind of superficial reasoning one does when he only has gross generalities or someone else’s money to work with. The source of much misguided action in government, politics, finance and romance.
"Spending of tax refunds drying up?" asks an MSNBC headline. Questions like that rarely get posed in the press unless the answer is probably "yes."
And so it is. The federal government sent out $117 billion in refunds, with an average amount of nearly $2,000. Curiously, the amounts of refunds have been getting bigger and bigger, despite advice from financial planners not to "give the government an interest free loan."
Nevertheless, taxpayers like paying too much. They may think it protects them from an audit…or maybe they just like being forced to save. Whatever the motivation, lending money to the government, even free of interest, is not always a bad move. For comparison, Investors’ Business Daily’s index of leading mutual funds is down more than 5%.
For the last 2 quarters of last year and the first quarter of this one, the U.S. economy has depended on the R’s: refunds, refinancing and really big new government spending.
"The Treasury has now borrowed, since the beginning of February," wrote the "angriest guy in economics," the Mogambo Guru, last week, "$73 billion. This is $63 billion more than the law allows, and the Total Public Debt is now comfortably over $6 trillion smackeroos."
"Sure enough," Mogambo continued, in 2001-02, "the GDP went up by $38 billion…the same report shows that the government spent $40 billion in the same period. Hmmm. The GDP expanded less than government spending."
Consumers, too, continue to do their duty. Only 28% of the people expecting refunds said they would save or invest the money. The others intended to spend it.
That’s part of the reason chain store sales rose 6.2% above their levels of a year ago in the most recent reporting week. But most of the refund checks have probably been spent by now. "The big impact has happened," said Sung Won Sohn, chief economist at Wells Fargo.
So what’s next? "Consumers may tighten belts as those IRS checks peter out," says MSNBC. Then what?
Eric, what’s new on Wall Street?
Eric Fry from New York…
– Stocks rallied yesterday…"just because." The kind of investor who insists upon a specific reason for every uptick would have been frustrated by yesterday’s action. Stocks went up because they went up. Isn’t that reason enough? The Dow soared 173 points to 10,381, while he Nasdaq bounced 1«% to 1,767.
– For whatever reason – or for no reason at all – investors viewed yesterday’s financial headlines "cup" as half-full, and placed their buy orders accordingly.
– Even stocks with no particular panache, like Honeywell International, Eastman Kodak and Sears jumped about 6% each.
– Sears’ shares in particular benefited from a benign reading of the headlines. Despite reporting an abysmal 4.7% same-store sales decline and lousy revenues, the stock soared. That’s because the giant retailer managed to slash enough costs to boost its profit forecast. Stock analysts disparagingly call this sort of profit performance "growth through shrinkage." Even so, investors loved the news.
– Meanwhile, many long-suffering stocks continued to suffer yesterday. The shares of WorldCom that once changed hands at $64 tumbled to less than $5. EMC, a stock that traded north of $100 two years ago, fell below $10 during the session. And AOL Time Warner, which sold for more than $90 a share when AOL and Time Warner consummated their promising corporate marriage two years ago, kissed $20 before closing at $20.70.
– Lynn Carpenter’s Contrarian Speculator capitalized on AOL’s latest decline with a well-timed recommendation to buy put options on the stock. Since Lynn’s call last week, AOL shares have tumbled almost three points, which means that the options she recommended have soared about 50%.
– The low estate to which so many former New Economy icons have fallen recalls a theme from yesterday’s Daily Reckoning: "past performance is no guarantee of future results. Or, to state it differently, chasing past performance is a near-guarantee of abysmal future results."
– The list of mutual fund winners and losers over the last 12 months graphically illustrates this phenomenon. The Matthews Korea Fund topped the list of the best- performing mutual funds over the last 12 months with an impressive 109.5% gain. Despite the spectacular performance however, the Korea Fund’s investors might not be ready just yet to crown the portfolio managers with laurel wreaths.
– Here’s why: In 1997, the fund lost 64.7%. In 1998 it gained 96%, and jumped another 108% in 1999, before tumbling 52% in 2000. All that volatility adds up to about a 20% loss over the last five years.
– But more to the point of our little morality tale, the Matthews Korea Fund has tended to perform well after very poor years and to perform poorly after very strong years. This tendency is the rule, not the exception.
– Therefore, investors could have avoided some pain by avoiding the Korea fund after its strong years and by buying it only after its large losing years. Such an approach to investing is hardly foolproof. On the other hand, it does not require 20-20 hindsight to know that buying an asset that has already been rising in price for a long time is generally a bad idea. Conversely, value and opportunity tend to dwell among the dispossessed – the stocks that have been falling for a while.
– Another prominent entrant in the losers-to-winners category is the gold sector, which had spent so many years in the doghouse that it needed a flea collar. Over the last 12 months, however, gold stock mutual funds captured seven of the top ten slots.
– Does this mean that gold shares are destined to underperform over the next 12 months? Not, necessarily, but neither are they likely to grab top honors this time next year.
– The biggest losers of the past 12 months, you ask? Telecom funds, what else. All ten of the worst performing funds over the last 12 months were devoted to telecom and technology stocks. Should the value investor be scrounging around in that sector? Hard to say, But an objective investor wouldn’t rule it out.
– Yesterday, I asked a friend of mine who has been a stockbroker for more than 30 years how his clients are responding to the recent volatility and financial scandals on Wall Street. He said, "It’s making people much more cautious. They’re really stepping back. In fact, a lot of them are saying, ‘To hell with it, I’ll go into fixed income, where I can get a certain 6% or 7% without the grief.’"
– There is something to be said for a grief-free 6%.
Back in Paris…
*** "JDS Uniphase wrote off $50.1 billion," says Mogambo. "They were already on track to lose $6 billion…it is the biggest, all-time record write-off in history. But records were made to be broken, and AOL Time Warner is getting ready to write off $54 billion… [these two] just wrote off a combined $400 for every human being in the U.S.A."
*** Verizon’s earnings came in short of expectations yesterday. What’s more, the company said it did not "expect to report an improvement in revenue growth due to the continuing effects of economic downturn."
*** The recession is over, at least…temporarily. What’s wrong in techland? Perhaps attitudes have changed. People no longer believe they will be more productive, cooler or faster if they buy new tech gadgets. Instead, they treat technology like radial tires…replacing them only when they become dangerous.
*** Apparently, I’m one of the "World’s Foremost Experts"…at least according to an announcement for the upcoming Foundation For Economic Education (FEE) National Convention to be held in Las Vegas May 3-5.
*** "Expert on what?" I asked Addison. He couldn’t think of anything…except Bordeaux reds. But that’s not my topic at the FEE convention. Instead, I’m speaking on the subject of my new book: "The Idea of America", my attempt to bring together many of the threads we’ve discussed here in the Daily Reckoning.
*** "Have a nice day, Dad," said Edward as I left for the office this morning. Edward, 8, is the latest convert to our Daily Reckoning insight; that you get what you deserve from life, not what you expect.
*** "I hope you have a bad day!" he had said to me, cross, a few days ago. But that same evening, the poor boy was practically in tears. He had had a very bad day. His teacher had scolded him. He had not finished his homework. And he did badly on a test.
"Have a very good day, Dad," he offered the next morning.