Full Spectrum Dumbbells
The Daily Reckoning PRESENTS: Every public spectacle makes the headlines at least twice: First, in pleasant expectation; later, in miserable regret. The war on Iraq is no exception. Bill Bonner explains…
FULL SPECTRUM DUMBBELLS
The Independent ran a photo of George W. Bush and Tony Blair on its front cover earlier this week. “Are these the only two people in the world who don’t think the war in Iraq is a disaster?” asked the headline.
Researchers recently tried to guess how much of a debacle the war really was. They focused on the number of people who had died since the government of Saddam Hussein was run out of Baghdad. Various estimates came in – between a low of 300,000 or so on the one side…and nearly a million on the other.
Estimates of the costs are similarly wide…from a couple hundred billion…to more than $1 trillion.
But it is a strange, strange world we live in. Can you really measure success or failure in terms of lives and treasure? The Bush team aims for “full spectrum dominance.” Who’s to say the occupation of Iraq didn’t help them get it? And who’s to say or know what fate has in store…or what purpose the heavens themselves may have for us…for the war…for the world?
An empire, being a rather grand and important public spectacle, makes many headlines. But all of them follow the same hiker’s trail – up the mountain on one side and down it on the other. The great historical achievement of the Bush team was to find a trail that got them over the hump quickly, and onto the path of self-destruction.
In politics or in markets, every fad and fashion follows a predictable pattern – from Dow 900 to Dow 12,000…from the beer hall putsch to the fall of Berlin. Like life itself, each one is destined not for eternal glory, but for the grave.
The housing bubble, like many other things, remains unfinished business. We have seen the headlines announcing its coming; we wait to see the headlines announcing its going. Its grave has been dug…but is still empty.
So too, in the 20th century, did we see extraordinary things. The human population began the century at just 1.6 billion. It ended it with the numbers reversed, at 6.1 billion.
The world’s output grew too, from $2 trillion to $39 trillion. Will we ever see the downsides of those trends, we wonder?
No one gets to read tomorrow’s newspaper headlines today. Still, after six centuries of moveable type – and countless centuries before that of longhand and oral traditions – you’d think the basic template for public spectacles would at least be vaguely understood.
Seeing one set of headlines…Germany Invades Poland…Union of Soviet Socialist Republics Declared…Dow Surges to All-time High…China is the New ‘Miracle Economy’…a reader might expect to see another, later, headed in the other direction. Looking ahead to long retreat…you’d think people would be tempted to stay home. ‘Why bother?’ they might ask themselves. The troops might stay in their barracks. Investors might put their money in the bank. Voters might avoid the polling stations. It is as if they could already know how the film ends; funny that they don’t get up and leave.
But they don’t. History continues. The old Sturm und Drang rattles and rumbles along. But why? We turn to logic – not for an answer, but for a culprit.
Any man who has had teenage children must be suspicious of logic. As soon as a teenager gets the hang of it, his sense of reason seems to leave him…and doesn’t return for at least five or six years. Or, if he takes up politics, law or economics, it may never return.
“If there really were a God,” says the teenager triumphantly, “he wouldn’t let people starve…he wouldn’t allow Bush to make war and kill people…and he wouldn’t make me do homework on Friday night.”
We don’t know whether God exists or not. But we’ve been around long enough to believe that God can do any damned thing he wants…even if it makes no sense to a 15-year-old.
Likewise, we’ve been around the investment markets long enough to know that they can do what they want too – even if it seems to defy our best thought-out theories and logic.
The logical mind wants to take the pieces apart…examine them…and figure out how they work. This is, of course, what separates man from the beasts. The poor creatures that walk on four legs can’t pick up a screwdriver, so they can’t take a clock apart to look at how the pieces go together.
Man, on the other hand, can’t seem to stop doing it. And so his knowledge of the material world advances, by fits and starts, and he’s gradually able to enjoy a kind of full spectrum dominance over the natural world. Except for tiny viruses, no living thing seriously challenges him.
Now, out in the penumbras and umbras on the spectrum of life…where the public spectacles occur…the light is either so white you are blinded by it…or so black you cannot see a thing. But the logical mind looks at politics, social order, economics, and finance as though it were a rudimentary cuckoo clock. He imagines that here, too, he can take the pieces apart and study them. Standing on two legs, with the entire natural world at his feet, he cannot help but think he can master this social world too…
It is here that he runs into trouble. He picks up the pieces, but he immediately sees that they are unlike the sprockets, wheels and gears of a clock. Instead, they are full of body fluids, bile, and air…hearts and guts…and “facts” as vague as a cloud and elusive as a bead of mercury.
For illustration, we turn to the investment world, but we might just as well turn to politics, war and other realms of collective imbecility.
The “naïve scientist” looks at the stock market and he figures it must follow some patterns. Prices go up…and then they go down. When? How? Why? He studies the situation and comes to his conclusions. He proposes a trading hypothesis: ‘I will only buy stocks that have gone up for the last 3 months.’ Or, ‘I will follow the them stochastically.’ Or “I will buy in the morning and sell in the evening.’ And so, he sets out…investing rationally…until his money is gone.
Experts say that 90% of traders eventually lose their money. We are amazed; we thought the number was closer to 100%. Why such losses in such a rational world? Aren’t markets fundamentally logical? Isn’t it all a matter of numbers?
Where have you been, dear reader?
As far as anyone knows, markets are unpredictable. And if anyone knows anything to the contrary, he is keeping quiet about it – because as soon as other investors caught on, the secret would be rendered useless. He might just as well give out the address of a bar that serves free drinks; the place would soon be mobbed and useless to him.
Unlike a cuckoo clock, markets are infinitely complex systems without discreet or even knowable components. The pieces of a clock…or a television…or a hamburger…are identifiable and limited. But how many different factors influence the stock market? An infinite number. Each stock has its own universe of influences…the cosmic dust surrounding even a single, small company is mind-boggling. That’s why even the insiders – top management and main shareholders – are often wrong about how well the company will do in any given period of time. Which is why a strategy of merely following the insiders is not likely to work much better than simply buying the index.
Markets are “chaotic systems,” say the mathematicians. As such, they are subject to feedback loops from their constituent parts. Imagine a cuckoo clock that ran slower because the cuckoo was feeling tired! Well, that’s what markets do…a subject of constant amusement at the Daily Reckoning. Investors drive markets in perverse ways and at inopportune moments. After prices have been pushed up by too much investor interest – leave it to investors to drive them up even further!
Chaotic systems are also subject to inputs that are largely invisible and whose impact is wholly unforeseeable. This is what is known as the “butterfly effect.” Something as remote and insignificant as a butterfly flapping its wings in China could set off a chain reaction that would lead to a hurricane in the Gulf of Mexico.
Henri Poincare described the effect in 1908:
“A very small cause which escapes our notice determines a considerable effect that we cannot fail to see, and then we say that the effect is due to chance…it may happen that small differences in the initial conditions produce very great ones in the final phenomena. A small error in the former will produce an enormous error in the latter. Prediction becomes impossible.”
So, even if you were somehow able to see the parts of the market system clearly…and even if your logic about how they interact were impeccable…you still wouldn’t know what was going to happen next, because you could never foresee the impact of every little winged insect in the financial world. It was the collapse of an unknown and unimportant Viennese bank – CreditAnstalt – that triggered the Great Depression in America. Right at this very moment, there is surely some butterfly of a hedge-fund manager sweating some multi-billion dollar trade, and praying it doesn’t go against him. Who knows what the consequences for the whole system would be if it does?
Likewise, in the world of politics, small things can have huge, unforeseeable consequences. When Americans pressured Chiang Kai-shek to let Mao’s army escape to Manchuria…or when the Germans put Lenin and sent him to Russia…or when Ho Chi Minh decided not to become a pastry chef…the results were enormous.
Our naïve scientists, of course, have no idea of all the various inputs, influences, and social forces that affect the flow of history. Examining the mechanism, they find the parts impossible to grasp…or even confine. Their only recourse is to simplify. Who knows how the Muslim world will react to American forces in Iraq? Who can say what would happen if Saddam were booted out of office? Who has any idea what a de-stabilized Iraq will mean for the future of the Middle East…or the world?
Out on the far edge of the spectrum, it is all darkness. Nobody knows anything. At least, a reasonable man would know what to do. He would go to a part of life where he could see what he was doing; he would focus on his work, his family and his private interests.
But we are talking about public spectacles. And in public spectacles, a man draws not on his powers of reason, but on the clunkiest kind of logic. He reduces complex ideas and contradictory information to simpler forms – childish and moronic political slogans – that the masses can understand as “reasons.” Then, he strings the reasons together with the artful finesse of a rail yard worker, putting together boxcars. One rusty simplification connected to the next…until they get him where he wants to go.
He becomes thoroughly logical…and completely unreasonable.
“The terrorists are out to get us,” he says, as if it were a fact. After that, his next fact sounds almost sensible. “We have to defend ourselves,” he says. “Better to do so in the streets of Baghdad than the streets of Baltimore,” comes the next heavy hulk. Does Baghdad have anything to do with terrorism? No, but it’s close enough for government work, as they say. And so, he eventually reaches Baghdad and gets himself into such a mess that the English papers are laughing at him.
Meanwhile, back in the financial markets, so great is the uncertainly and unpredictability of markets that professors of finance have come up with a short-hand simplification called the Efficient Market Hypothesis (EMH) to make sense of it. According to EMH, prices set by the market are so “perfect” you’re wasting your time trying to outsmart them. The market always has more information than an individual investor. Thus does the price reflect all known information and the collective judgment of all market participants. You’re better off buying an index fund, say the EMH experts.
The hypothesis is nonsense. Prices are not perfect at all…but wrong most of the time…and in shifting directions, from being too expensive to being too cheap. But EMH is a useful fraud; reminding investors how hard it is to beat the broad market and how unlikely it is that they will ever understand it.
Something similar should be developed for politics, in our opinion. The world is not perfect. But it is the reflection of the judgment of the world’s people – developed, elaborated, and evolved over thousands of years of experience. If a country like Iraq has a dictator of whom we do not approve, it may make sense to refer to the Perfect World Hypothesis, just to remind ourselves that “What Is” is for a reason…one we cannot necessarily know. We might what to replace What Is with What-Should-Be-In-Our-Opinion…but we ought to at least think twice about it.
for The Daily Reckoning
October 20, 2006
Editor’s Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).
In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions.
All we need are marshmallows.
Billions of dollars of American housing wealth are going up in smoke so fast, we feel as though we were watching the great Chicago fire.
You only have to read the headlines to get a good view of the blaze.
“More Homeowners Going Into Default,” says the LA Times:
“The number of Californians who are significantly behind on their mortgage payments and at risk of losing their homes to foreclosure more than doubled in the three months ended Sept. 30, providing the latest evidence of trouble in the housing market, figures released Wednesday show.
“Lenders sent out 26,705 default notices – the first step toward a foreclosure – during the July-to-September period, up from 12,606 during the same quarter in 2005, according to DataQuick Information Systems.
“‘We were putting buyers in homes with loans they could not afford to sustain over the long haul,’ said Bob Casagrand, a San Diego real estate agent. ‘If you’re a marginal buyer with an adjustable mortgage, you’re rolling the dice on the future.’
“‘Whereas a year ago, people could have put their house on the market and sold their way out of the problem, now they’re stuck with the house,’ said Richard Pittman, housing services coordinator for credit counselor ByDesign Financial Solutions in Los Angeles.”
Homeowners have been rolling the dice for the last ten years or so. Until then, they mostly counted on getting rich the old fashioned way – by making sure outgoing expenses were less than incoming revenue. The difference was compounded as savings.
But this is a new era, in the sense that, now everyone seems to think that every day is his lucky day.
“2007 home prices expected to fall,” comes from the Orange County Register:
“California’s 2006 sales slump is expected to last through 2007, resulting in a ‘modest’ drop in single-family home prices in the state next year, a top industry economist forecast Wednesday.
“Leslie Appleton-Young, chief economist for the California Association of Realtors, is projecting that home sales in the state will decline 23 percent this year, followed by an additional drop of 7 percent in 2007.
“That will result in a 2 percent drop in the median price of a single-family home – from $561,000 this year to $550,000 in 2007 – the first price decline in 11 years, she said.”
Well, there it is again – the 2% figure. Alan Greenspan opined recently that he thought the worst of the housing slump was over, with prices down less than 2% nationwide (the figures are still a little fuzzy.) Now, here is the Abby Joseph Cohen of the Golden State’s housing industry telling homeowners not to worry.
“‘It is relatively modest, a 2 percent decline,’ she said at the association’s annual conference at the Long Beach Convention Center. ‘You can’t have prices appreciating 15 to 20 percent forever.'”
No, you can’t have prices going up 15% to 20% forever. But how can you have a correction of 2 measly percentage points? It’s as if Field Marshall von Kluge had warned the Fuhrer before the battle of Stalingrad: “Don’t worry, the worse that could happen is that some of our men will stub their toes.”
And here we have a little note that tells us just how good Ms. Appleton-Young is at foretelling the future.
“[She] conceded that last year’s forecast missed its mark in predicting a ‘soft landing’ for the state’s housing market. She had expected sales to decrease about 2.5 percent (not 23 percent) and price appreciation to settle at 10 percent…”
She was projecting 10% growth in property properties!
Meanwhile, from the other side of the continent, the New York Sun guesses, “Housing Correction Just Getting Started”:
“Don’t get relaxed about the housing industry,” writes Liz Peek, “because it’s going to get much, much worse. That’s the message from Gary Gordon at Annaly Capital Management, a firm [that] invests in mortgage-backed securities. Mr. Gordon is looking for substantial further declines in housing starts and sales, which will result in a recession beginning in 2007.
“The real issue is: How much consumer spending has been funded by rising home prices and how vulnerable is the economy to a fall-off in home values? Bears argue that the consumer has used his home ownership as a piggybank that is now ominously empty. They point out that mortgage equity withdrawals have climbed almost without pause since the early 1990s. Today, these borrowings are plummeting, a development that the folks at economics consultancy ISI call ‘unprecedented.'”
From the Economist comes a chart that shows how great those Mortgage Equity Withdrawals were. In 2004 and 2005, people “took out” amounts equal to 10% of personal disposable income – of which an estimated 50% was converted to consumer spending.
How was the American consumer able to continue spending more and more money even while his income went nowhere? Why did he not have to cut back when energy and housing costs soared? How come he didn’t collapse under the weight of so much debt? The answer is right there – the housing industry didn’t let him. Every time he was about to give in, they found a way to lend him more money.
But all that lending was founded on a swindle – that higher house prices meant homeowners were richer and could afford to borrow more. Now, the game is just about up, because homeowners can no longer “take out” any more money. So now they actually have to pay the debts they’ve contracted. Many are finding it hard to do, which is why default rates are going up…and smoke is pouring out of residential housing all over America.
And now the mortgage lenders are pulling fire alarms too. Poor Washington Mutual, the nation’s largest S&L said its income dropped 9% in the 3rd quarter – because of softening in the mortgage business.
Of course, Alan Greenspan, the Realtors, and Wall Street insist that the fire is under control. Maybe they’re right…and maybe they’re not. You can never be sure…for reasons we discuss, below.
James Boric, reporting from Baltimore…
“…There are 5,586 small-cap stocks that trade on a major exchange right now. But you should only consider investing in six of them. Two days ago, I ran my favorite screen looking for solid small-cap companies…”
And more views:
*** Yesterday, we told you about two ways to invest in Argentina: through property and electrical utilities. The third way to invest in Argentina, is to take advantage of its agricultural sector. Global demand for quality food is on the rise; the available land and water resources necessary to produce it, meanwhile, are declining. Currently, the world produces less wheat, corn and other agricultural commodities than the world wants to eat. The supply of wheat, for example, will come in at about 605 million metric tones this year. The demand for it is supposed to be on the order of 613 mmt. The story is similar for corn, with the gap for both grains being filled by drawing down inventories. If we read the chart correctly, inventories are now at historically low levels – close to the lows set more than 30 years ago, just before the last major bull market in soft commodities.
What has changed most dramatically is the demand side. While more and more farmland is taken out of production by encroaching suburbs and highways…the demand for food is soaring. Forty percent of the world’s population – mostly in Asia – is generating the financial means to buy food on the world market. The Chinese, for example, consume about 2,500 calories per day – the same as the Taiwanese. But on the island of Taiwan, the calories tend to be of the animal variety; the average Taiwanese person consumes nine times as much meat as his cousin on the mainland. The reds are trying to catch up…with meat consumption rising at a 20% annual rate.
What this means to the grain market is obvious, too. It takes about nine units of grain to produce one unit of meat. This is why both China and India, both of whom used to be self-sufficient in grains, now need to import the stuff. But from where?
On the supply side, the big producers are North America…the Ukraine…or Argentina. Each has its own unique problems, but one problem dogging the entire agricultural sector worldwide, is water. Just as the planet seems ready to reach peak oil production – the point at which future production is likely to be lower than past production – so too, does it appear to be reaching for a kind of peak water limit. India and China both have their well-known problems with water, but so does the United States. The great lake under the American prairie – the Ogallala Acquifer – is the world’s fastest disappearing water supply. The water under the Klamath Basin in Northern California is also dropping fast – down 20 feet in the last three years.
Energy companies, hustlers, and hallucinators are trying to replace oil with grain. But it takes huge amounts of land and water to produce enough grain to make a significant impact on energy supplies. And just as it took millions of years to lay down the world’s supply of oil, so too, did it take millions of years to stock its underground water supplies. Switching from oil to ethanol will merely suck the earth dry of water faster…and send food prices soaring.
Argentina’s big advantages are that it has a huge underground water supply – the Guarani Aquifer – and that the land on top of it is cheap. In terms of productive capacity, an acre in Argentina costs only about one sixth as much as an acre in the United States. Over the long pull, investors in Argentine farmland will probably do well.
[Ed. Note: Our friend at Agora Travel, Barb Pierello is taking a small group of investors to Argentina and Uruguay November 4-16, o explore some of the best opportunities available in this region. If you’re serious about diversifying your portfolio with solid, long-term, high-return investments about as far away from Wall Street as you can get, you will be pleased with what you find on this trip.
*** The effect of EZ credit was to turn ordinary people into housing speculators; in its next phase, we wager, it will turn speculators into homeowners – when lending institutions are stuck with the foreclosed houses!
Which brings us back to the very same Steve Cohen, mentioned in these pages yesterday. Mr. Cohen runs a hedge fund business…makes a fortune…and invests money in works of art – which is what got him a headline yesterday…he was going to pay $139 million for a Picasso before Steve Wynn put his elbow through it.
But what got him in the news a few weeks earlier was an interview, in which he said:
“It’s hard to find ideas that aren’t picked over and harder to get real returns and differentiate yourself. We are entering a new environment. The days of big returns are gone.”
Cohen thinks the big returns are gone because there are so many new hedge funds muscling into his territory. With 7,000 hedge funds, there’s bound to be competition for good ideas. And behind each hedge fund is a pool of capital…ready to go into any good idea that comes along.
The laws of supply and demand, and declining marginal utility tell us that returns on incremental units of investment are likely to go down. That is the phenomenon we discussed yesterday. Initial investors can get a good return on their money. But as the supply of investment cash increases, the rate of return to each dollar is bound to go down. The best ideas are quickly taken up. Additional investment doesn’t make them better, because each additional dollar is less useful.
Another way to look at the same phenomenon is to notice that, as you invest more in any given sector, prices rise. But the real return from the sector – as from any business – doesn’t go up. Google doesn’t become more profitable just because people bid up its stock. Eventually, you reach a point where the price is too high for what you get; returns suffer.
Jeremy Grantham, looking at stock prices over time, came to the conclusion that the big return in stocks is over. At today’s prices, an investor cannot expect even 1% per year for the next 10 years.
But this doesn’t mean the big returns necessarily disappear for everyone, everywhere. Investors…especially hedge fund managers…all read the same papers. They’ve learned the same theories; they use the same models, more or less; they go to the same bars; they attend the same conferences.
Wherever they go, they take their investment cash with them – billions of it. Not surprisingly, one area booms…another busts. Trillions are invested in U.S. stocks. Billions have gone into the Chinese market. Trillions (notionally) have gone into derivatives. And think how much “wealth” is said to be in the housing market.
So you see, dear reader, there is still a lot of money at stake…and big money to be made in the years ahead, too. But you are not likely to make it by following the crowd of investors into sectors that are already too popular. The big money in the years ahead is likely to be on the short side.
*** How do you go broke in style? You buy an apartment…and then fix it up.
“I had a designer over today to look at the closets,” said Elizabeth last night.
“What’s the matter with the closets?”
“Oh…you know perfectly well. They’re just not well designed. We need places to put things. Look at our stage in life. We might as well live the way we want, rather than make do just because that’s the way things are…”
“I’m perfectly happy with the closets…”
“Well, you’ll be even more happy when we have them redone. Let’s not talk about it any more…”