Monday, June 30, 2014

Investing is learning to deal with your inner-self

When stock markets crash we fear to lose it all and when we’re in a boom we think we’re so smart and we get addicted to buying more because we can only win. To know your emotions is critical for investors. So many of our decisions are based on fear:
  • The fear of losing it all
  • The fear of missing out
  • The fear of having unproductive assets
  • The fear of making mistakes
Fear, or better too much fear leads us to making poor decisions.  But the opposite can be true as well, especially during bull markets when we think we’re invincible.
I once felt that I had so much money, I impulsively bought a time share on my credit card.  "Who cares, in a week or two I’ll have made enough new profits to pay for it."  "Who cares, I have so much cash, I have to invest into something."
 I have made more expensive investment mistakes when buying into all kinds of follies during booms than by buying during a bust.  I have lost more money by selling during a bust than selling during a boom.  It is not for nothing that many successful investors are contrarians, because many good investment decisions are so contrarian to human nature.
Often we don’t even know that a particular investment transaction is nothing but the result of emotions. And it is very difficult to sticking to an earlier decision.  For example, after transferring cash savings to a brokerage account, I feel like buying stocks often in spite of earlier decisions that I shouldn't buy more in an expensive market.  It is as if that stuff is burning a hole in my pocket!
How do you deal with such emotions?  When the Russian armies were amassing on the border of the Ukraine this year; my guts shouted that Putin was a new incarnation of Hitler.  The same was true for Saddam Hussein’s phantom weapons of mass destruction. On that fateful 9-11 day, learning that Al Qaeda was based in Afghanistan triggered my initial reaction: ‘bomb the bastards’.   But looking back most of the time those responses were not correct.
Looking back on the Ukraine, I realize that Putin may have been lied to by the West; or at least that the West broke its promises.  You see, NATO has expanded since the days the Berlin Wall came down contrary to earlier assurances by George H.W. Bush (senior) that the West wouldn’t if Russia didn’t interfere in the German unification.  That promise was soon forgotten and NATO abused a weakened Russia (and allies) by assimilating many former East-Block countries into NATO.  I guess, the West’s manipulations in the Ukraine was the last straw for Putin and he responded the way he did.  Not that I think that Putin is a saint; but in the heat of the moment especially with a press more intend on sensationalized news sales if not on spreading outright nationalist propaganda, it is so difficult to see what reality is.
We are getting manipulated every day, whether it is with economic news and investment trends or whether it is in matters of war and peace.  We are subjected to a barrage of biased, poorly researched, opinions and we get caught up in a maelstrom of emotions that prevent us often from seeing the facts. It is hard to stay cool and make truly well thought out decisions. To make matters worse, we don’t even know for sure if our emotional decisions are really that wrong; after all technical stock market analysis is all about the psychology of markets; we’re studying investor behavioral patterns and what about momentum investing?  Are those not all emotion based investments?
If we truly want to be good investors we have to start with ourselves; know how we respond to events and examine if we should adjust our responses.  Many of our responses may have been build-in genetically; they may be instant reflexes that save us in daily life; but when dealing with investment they may have been the exact wrong responses. Good investing starts with good self-knowledge and with controlling our initial response to events so that we can truly make the right investment decision.
Strange, is it not that so much of our actions ultimately are a result of who we are rather than based on the world around us?

Sunday, June 29, 2014

By The Way: What about the next bear market?

I listened to an interview of David Stockman and it was sobering.  He was interviewed by Porter Stanberry famous for his ‘The End of America’ infomercial – these guys are two peas in a pot. Porter may say things in a more sensationalized way while David is more subdued. But the message is the same… and you have probably, like me, heard the story about government debt many times before. Yet, that does not mean that we should ignore it.

What caught really my attention this time was the total disregard both man had for the Federal Reserve. Basically Stockman stated that the current printing of money is financing current government debt at an artificially low interest rate, costing around $250 billion per year. Once rates normalize though, these costs likely increase to $750 billion or a mere ¾ TRILLION dollars per year. That would be nearly 6% of the US GDP!
So when is interest returning to normal?  That may not be as far away as many of us think. The Federal Reserve itself is talking about a Feds Fund Rate of 1.25% in 2015 and 2.5% by 2016. Mind you, stock markets don’t necessarily crash; in fact these interest rates are still low and if anything they indicate stronger economic performance.  However, based on historical data, once interest rates exceed 4% or so the story changes rapidly and stock performance is likely to deteriorate with each further increase. Here is another way of looking at it: historical inflation rates are around 3.5 to 4% and short term interest rates are typically 0.5% or so higher than inflation. Since markets over the long term go more up than down you can expect under such conditions average stock market performance. But if inflation and thus associated interest rates, rise further stock market performance typically deteriorates.
If nothing is done about U.S. government debt and government debt in general, the interest payments by government will sooner or later become onerous and a major drag on the economy.  In the meantime, investors may wonder whether they want to keep on investing in those over-indebted governments and one day, possibly not that far in the future, they may stop lending to governments altogether.  If you think that governments don’t default on debt anymore, look no further than Argentina right now. Many governments, including China’s, have a house-of-cards type of national finance system. Gold, as a currency without strings attached, may better hold its value than any piece of national fiat money. With gold trading so far below its 2011 peak of $1900, here may be an opportunity to diversify you portfolio  and protect yourself against potential government debt and associated currency crises.
The problem in a major bear market is that you need ‘cash’ to buy assets when assets are cheap. But if the bear market is due to a confidence crisis in government debt, then what is your protection against a simultaneous loss of purchasing power of crashing currencies?  Right, gold is likely one hell of a hedge.  I am not saying to convert all your stocks into gold right now. In fact, owning assets such as stocks, real estate and commodities, including gold’ are often great hedges against inflation – but having a small portion of your portfolio, say 5 to 10% in gold may be a prudent hedge if the next bear market is caused by a collapsing bond market.  Oh… with interest rate spreads between government debt and corporate debt at a minimum, don’t think you’re safe in the corporate bond market either.
For the near future, I only see an improving economy in both North America and Europe.  China is not far behind.  So for now, let you profits run, but as discussed in earlier posts: use stop loss triggers, and consider selling call options or do collared options to force you to sell in case of a rapidly dropping stock market. Earlier this year, I expected a bull market peak in the first or second quarter of 2015. This may prove a bit early – I feel now confident enough to see this bull market last another year or maybe even another two years, which would make it one of the longest bull markets of the last 150 years. So, stay wary and don’t take anything for granted – let profits run, but also build cash up to at least 20% of your paper securities portfolio and when prices get even crazier, don’t be afraid to increase your cash holdings.

BTW right now looking in a crystal ball, government debt may be at the core of the next market crash, but don't forget that bear markets are often triggered by 'black swan' events such a major terrorist attack, a war in the Middle East or in the Ukraine or between China and Japan or... what the heck do I know? it is a black swan event after all!  J
BTW BTW During economic downturns a good investor looks for 'green sprouts'; during good times he/she looks for clouds at the horizon (things to worry about).

BTW BTW BTW I have a strange sense of humor!


Sunday, June 15, 2014

Don't go away in May!

Decent earnings growth with 70%plus of companies beating the earnings forecasts; decent macro-economic news; and the big reveal of my stop-loss sheet show that the bull market is in full swing.  The market may be somewhat expensive but boy, don’t stand in the way off a running train! 
We are obviously in entering the ninth inning of this bull market, the problem is we don’t know how long it lasts. When I updated my stop loss spreadsheet from just a couple of weeks ago it showed an amazing number of new highs.  This bull has definitely momentum.  Yes, you don’t want to be the guy or gal who misses the last musical chair but neither should we be afraid and sell your shares because we’re finally making good profits. We want to let our winners run in this stage of the stock market using our stop-loss sheet as an emergency break. 
Here is a portion from my stop loss sheet.  I got stopped out of Silver Wheaton some time ago and now I am eying the stock to go back-in. The unrest in the Middle East has temporarily pushed the stock back up from its low, but I don’t feel comfortable to dive back in. Remember from my last post, I think that automation has replaced the deflationary force of China’s cheap labor that kept inflation in check during the 1990s and early 2000s. Now it is automation that keeps inflation down and causes GDP to be too pessimistic.  I evaluate again purchasing it when it trades around $21 per share.
Click the figure to magnify
In the meantime my portfolio counts 58% of its holdings have new highs over the last number of weeks; a very broad portion of the markets that is in record territory.  On average my stocks trade 0.57% below their previous high while the median stock is 0.71% higher in the tops of the previous update.  In earlier posts we expected a sleepy market over the summer prior to a barn burner fall.  Well, the summer is a lot less sleepy than I anticipated; hold on to your hats for the rest of the year.  In the meantime, the Oil and Gas sector has been on a tear in spite a significant number of staff reductions (lay-offs); remember the canary in the coal mine?  We’re definitely in the ninth inning and thus let your profits run, but keep your finger on the sell button especially when prices go crazy!

Sunday, June 8, 2014

Macro economics are hiding true economic growth and underestimates our increased purchase power (deflation?)

This is 2014 and since 2008 we have nothing but depressing news about a slowly forward grinding economy with no way out.  Yet we have had a bull market in stocks and in real estate.  Yes, it took nearly five years to ‘recover’ from the trauma of 2007-2008.  Strange, everyone was worried over everything from a relapse of the economy to hyperinflation because of QE (Quantitative Easing).

Well guess what, we were climbing a big wall of worry which is the essential ingredient of every bull market.  Right now, most experts (and I don’t like ‘experts’) don’t foresee major economic problems and think that the sky is blue for the foreseeable future.  Most retail investors still feel theoretically concerned about losing money in the stock markets, but money market funds hold less and less money and where do these past money market funds go?  Right into the stock market.

Ladies and gentlemen we’re at the start of the ninth inning of the current bull market!  Right before euphoria and major crash.  This is the stage of musical chairs where prices go higher and higher; where ‘investors’ will pay stupid high prices and then? The big crash; the end of the world, yet again!  This is also the stage that people will make most money in the market but you have to be agile and cash in before everything goes to hell. It is literally a game of musical chairs and it is often the retail investor who can’t find a chair when the music stops and nobody has cash left to buy.
In the meantime, even the prophets of doom and gloom, the economists – scientists of the dismal science – noticed that things are getting better and are becoming more ‘normal’. But this time there is something truly different.  What happened to inflation that is so unavoidably connected to the printing of money by central banks?
What is happening to GDP growth that so stubbornly seems to stays below or around 3%? How come manufacturing is returning from emerging economies to North America in spite of low labor costs and lower employment taxes in those emerging markets?
We should have had a lot of inflation with rising commodity prices and real estate prices between 1998 and 2008. But really interest rates and inflation have been falling as  far back as 1982. First it was Paul Volcker who beat inflation back by pushing up interest rates to the absurd levels in 1981-1982 ; next it was China and India's large and cheap labor forces that reduced manufacturing costs and pushed inflation even lower.  In the growing economy of the late 1990s and early 2000’s, in spite of rising asset prices, inflation was still falling and so were interest rates.  Between 2008 and now we have had historically low interest rates. Last week the ECB introduced NEGATIVE interest rates.  GDP numbers don’t seem to budge much; although now the U.S. is growing at close to 3%. But after how many years of misery?  What lower labor prices created in the late 1990's is now replaced by manufacturing cost reductions due to automation and technological innovation.
Yes, the U.S. has now the same number of people working in the economy as at the previous peak in 2007. Yet, the total number of people available to work has increased due to population growth (babies) and immigration – both legal and illegal. We call that an increased work force.  When the work force is expressed as a percentage of the total population we call it the ‘participation rate’. The participation rate has not been this low since the early 1970s. More people competing for less jobs results in lower wages of the middle class. Wages have not increased and the overall cost of production has gone down.
I highly recommend reading ‘The Second Machine Age’ by Erik Brynjolfson and Andrew McFee, two academic types who review the impact of automation on society. Two things caught my attention:
1: with increasing automation what is going to happen with our jobs? We will no longer need workers to grow our food and make our cars. If there is no grunt work then how are younger people ever to compete with older experienced workers or workers with college education?  Will there be a new form of unemployment? Because of automation will we need less human workers? Technology unemployment - a new structural form of unemployment?
2: Are our economic assumptions and measurements such as Gross Domestic Product and Inflation obsolete? 

If technology takes away the grunt and routine work, what is the future form of employment? For all of us it is nearly a life essential to do things we feel are worthwhile. A worthwhile job helps build self-discipline and makes us feel useful contributors to society and life in general. No matter how much we crave for vacation trips, working on a worthwhile project is a near wonder-drug.
We’re living in a low inflation era but is that due to cheap labor in China and other emerging economies who make products cheaper than us in the more developed world?  Then why have nearly 25% of factory jobs disappeared in China over the last decade in spite of its enormous economic growth?  And why are manufacturing jobs returning to especially North America?
Well, wages have not been falling in China; rather the opposite. On top of that, transporting products from their point of origin to the customer is becoming increasingly more expensive.  Manufacturing automation has reduced the number of manufacturing jobs and this combined with higher wages in emerging markets, lower or stable wages at home, and the increased price of transportation has brought manufacturing back to North America.
Whether you have a bunch of robots working in a factory in China, Vietnam or in North America, what is the difference? Machines costs as much to run in China as they do in the U.S. or in Canada. Also, energy prices and all manner of commodity prices are currently a lot cheaper in North America than in China or Europe. Energy replaces labor as well as that it reduces the cost of transportation.
Expensive machines require a better educated workforce with more high tech skills and a tendency to innovate rather than just a large number of muscles. This all explains the return of manufacturing to North America.  Just like cheap labor reduced inflation during the expansion of emerging markets in the 1990s, it is now the impact of technology and energy costs that has been driving down manufacturing costs and thus inflation.
Then there is demographics.  Yes the world population, in particular Europe, Japan, Russia and to a lesser degree in North America is growing greyer. Longevity increases combined with baby boomer’s reduced consumption needs have lowered consumer spending and increased the savings rate of the greying but still money earning generations. Schools get closed because of the lack of new students. House and household sizes are declining and also the need for debt so typical for young families is on the decline. This results in lower government deficits and an oversupply of private investment funds, in particular funds available for lending. This, in turn, contributes to cheap credit and again to less inflation.
Lots of products such as on-line news services; internet communication and on-line retail such as EBay, Amazon, Vacation by Owner, hotel bookings and air flight bookings have driven down prices and increased our quality of life. On-line Banking has reduced transaction costs to virtually nil. E-books have reduced the cost of book publishing to zilch.

Also, the costs of generating productivity enhancing software like Microsoft Office, Publisher, Quicken Books and other accounting software has fallen to only pennies per copy; even less now that traditional retail expenses can be bypassed and we download software from our home or office instead. These cost reductions are difficult to quantify in consumer price indexes that focus on daily food consumption and energy costs.
Software production and internet services are indeed very profitable to its creators.  Creating castes of wealthy entrepreneurs and executives that reap huge profits while the middle class disappears. Welcome to the one percent society.
We are living in an era of an extensive number of life improving services and products that costs less and less to produce. It requires less and less labor costs to output these new products while the profits go to innovators and executives who run the companies that through automation use less and less staff and more and more machines. The end result is excessive profits for the few and less jobs and reduced income for the middle class.
We’re also are living in an energy revolution that started out with horizontal well and multi-stage fracking technology. These innovations resulted in drilling of large volumes of rock that were considered not producible just 5 to 10 years ago. Now we have in North America enough energy to last us another century with the U.S. having the potential of becoming once again an energy exporter. Other continents have similar resources but population density and excessive concern regarding the environment as well as unfamiliarity with the energy industry stops them from benefitting from these 'new' resources.
With current land locked energy reserves, North Americans have a tremendous economic advantage. Especially when combined with technology, we can beat the foreign competition especially if we can drive down the exchange rates of our currencies versus the Yuan, Euro and Yen.
Compare how we, North Americans live today to a decade ago or 5 decades ago. It is hard to argue that our quality of life hasn’t improved and that our progress is accelerating at a near exponential rate. Measurements such as inflation and GDP provide only pre-second machine age yardsticks  showing us a depressing economic picture that often is far from reality. These deceptive numbers of inflation and GDP have dampened our spirits making us think that, contrary to reality, things are going from bad to worse.

GDP does not include products and services that can be produced virtually for free compared to just a few years ago as GDP is expressed in dollars.  Cost-of-living indexes that represent a measure of inflation do ignore the reduced costs of many innovations not traditionally included in cost-of- living items while the new technologies have dramatically reduced the cost of labor across the board. Inflation may be dead for the next decade or will stay at least largely muted for a long time.
 Underestimating the revolutionary times we’re living in results in many missed investment opportunities and in missing out on the benefits of real progress. By underestimating GDP and over-estimating inflation we will make adjusting to these revolutionary times and their effects even more difficult.