2015 Q1 Forecast

The latest forecast from my model of the S&P 500 index for the first quarter of 2015 indicates that the market continues to outrun corporate profits. The pattern is similar to that of the late 1990s. When the market turns, it will fall below the level that profits would indicate as investors become pessimistic and afraid. It's likely that any January effect this next quarter will be small as the market corrects for profits.

When the market gets ahead of the forecast it means that the P/E ratio is expanding because investors are willing to pay more for the same level of profits. Some of that optimism comes from chasing yields as more bond holders grow weary of earning about one percent in real terms on bonds. Other buying comes from speculation about what the Fed will do.

Abe Channels Hoover

Japanese Prime Minister Shinzo Abe recently vowed to press companies to raise wages. His vow should have set off alarms among economists. Instead it elicited applause. The irony is thick but only economic historians and Austrian economists can appreciate it. Even the financial press missed it.

The irony lies in the fact that the first thing US President Herbert Hoover did when he discerned the approaching disaster of the Great Depression was to employ the persuasive power of his office to convince employers to refrain from cutting wages and attempt to raise them. The Wall Street Journal of December 16, page A11, quoted Mr. Abe saying,

As I toured the nation during the election,  I heard the opinions of ordinary citizens who are suffering from price increases and small-business owners in difficulties due to price hikes in raw materials.”

Plucked Chickens, MMT and Investing

Plato once defined man to his followers as a featherless biped. Diogenes heard it, caught a chicken and plucked it then brought it to Plato saying, “Here is your man.”  I got that story from Jack Sparrow at the Mercenary Trader.

Was Plato wrong? No. Most men walk on two legs and most of us don’t have feathers, but that is a very simplistic model of what constitutes mankind and as a result has very limited application. The humor in the story comes from Diogenes stretching the model beyond its ability to describe the real world and drawing wrong conclusions.

Plucked chicken modeling happens in economics on a regular basis. Economics is about modeling complex events. If the model is too complex it becomes unwieldy and few can understand it. The trend in economics over the past century has been to create extremely simple models. The assumption of equilibrium that forms the foundation of mainstream economics is the most egregious example.

Tyranny of benchmarks

There has been a lot of press lately about institutional investors abandoning hedge funds. Conventional wisdom in finance tells us to compare fund performance with a benchmark, usually the S&P 500 index. That’s always a good idea, but the measure you use makes a lot of difference. The standard for decades has been rate of return. For example, the total return for the index in a given year might be 30% including price appreciation for the year plus dividends. Using that measure, few funds or investing strategies can beat benchmarks. That’s why conventional wisdom teaches us to buy a broad index and never sell until we retire. The assumption behind the philosophy is that earning a higher percentage means investors will have more money at the end of their investing life cycle.

Crude Economics

Central bankers in countries that have fallen into recession or are on the precipice have suffered seizures over the fall in oil prices. Most are mainstream economists or groupies who think that falling oil prices will deepen the plunge in prices, which they consider the ultimate evil, even while most consumers are cheering them.

Of course, mainstream economists will fall back on the old apologetic that says what is good for individuals can be bad for the nation as a whole. They claim it is a paradox and those types who love Eastern mystic nonsense like “the sound of one hand clapping” or “global warming will cause another ice age” love such inscrutable sayings.

The truth is that it’s not a paradox; it’s a contradiction. Mainstream macro contradicts a large part of the principles of microeconomics. And since micro has the firmer foundation that means a lot of macro is pure nonsense. Now mainstream macroeconomists aren’t dummies, so why do they love inflation when the rest of the sane world hates it? It’s because they know what inflation does: it transfers wealth from savers to borrowers (and they hate savers) and from workers to employers.

Abenomics' big fail and the sinking of the rising sun

Economists predicted a 2.25% gain in Japan’s GDP after the 7.3% fall in the second quarter. As usual, they missed it again. Japanese GDP fell 1.6% last quarter according to initial estimates. Mainstream economics’ theory of business cycles states that such downturns in the economy are random events, shocks to equilibrium. As the London School of Economics told the Queen, they had successfully predicted that no one can predict the onset of the worst recession since the great one. Still, they crank out GDP forecasts as if they could predict a recession. They irony is huge, but apparently unnoticed by most of the profession.

However, the most important part of the story was that Prime Minister Abe has been conducting a major monetary policy experiment. He promised to boost nominal GDP and achieve a minimum inflation of 2% by printing as much money as was necessary. No limits. Paleo-Keynesians like Paul Krugman were giddy. 

Abe also promised to reduce the deficit through tax increases and reform the structure of the economy. Partly as a result, the Japanese stock market climbed 55% and the value of the Yen fell 25% in 2013.

CAPE Fear

I recently finished Meban Faber's book, Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market, and found it to agree very well with the ABCT Investing philosophy. Faber is a co-founder and Chief Investment Office of Cambria Investment Management.

Faber aimed his book at the majority of individual investors who try to time the stock market on their own. Studies of the flow of money into and out of mutual funds prove that most individual investors wait to enter the stock market until it has reached the peak of a cycle and then sell when it is near the bottom of a collapse. In spite of this, most people think they are good investors. It's all part of the syndrome in which most people think they are better looking and more intelligent than average.

Burned by Bonds

Austrian economists can get forecasts wrong, occasionally. Many were wrong about inflation when the Fed stuffed its balance sheet with junk bonds. Inflation has remained asleep except in asset markets. That wrong forecast gave some of us a jaundiced outlook for bonds. The reasoning went that higher inflation and a greater demand for loans would force interest rates higher in 2014, and when interest rates rise the price of bonds fall. Also, the Fed was trying to go sober after multiple shots of QE. So I stayed away from bonds this year because the fall in value would erase all of the benefits from the interest earned. As a result I missed out on a great opportunity.

While most of the world was fixated on the choppy stock market, bonds were as stealthy as 007 while soaring. The October 20 Wall Street Journal (page C1) reported that the Wasatch-Hoisington U.S. Treasury Fund earned 28% for investors this year. Lacy Hunt, the fund’s chief economist, said, “I don’t think the Fed is going to raise rates. All they can do is hold rates here for longer and longer time periods.”

So where did Austrians go wrong? First, they didn’t take Hayek and Mises seriously when they warned against assuming the quantity theory of money works mechanically.  The monetarist Milton Friedman influenced too many Austrian economists. The quantity theory states that increases in the money supply will lead to consumer price inflation. That is always true, ceteris paribus, but things are never ceteris, let alone parabus. Many things can break the link between increases in the money supply and prices. Most importantly, we should temper our expectations of the quantity theory with the subjective theory of value. As Mises wrote, people may not always respond to increases in the money supply in the same way. That is the principle of subjectivism applied to money, something Mises is most famous for.

Aggregate Blindness

Peering at the economy through macroeconomics aggregates will blind economists. Gavyn Davies offers an example in a recent post in FT.com:

There have been downward revisions to GDP forecasts in the euro area, but these have been offset by slight upward revisions in the US and recently even in China. The latest nowcasts for global activity have remained firm, and data surprises in the world as a whole have been close to flat for several months.

 Maybe the slowdown in the euro area has increased the perceived risk of recessions returning to other parts of the world, but there has been no general downward revision to central projections for global GDP. In fact, J.P. Morgan’s team of economists, which tracks global activity data extremely carefully, said on Friday that signs of above trend global GDP growth were beginning to emerge. Markets have clearly been out of synch with the flow of information in this regard.

 I’m going to pick on Davies here not because he is a bad economist. He is one of the best mainstream economists I know and I read his columns regularly for his insights into mainstream monetary policy. I’m picking on him because his post well represents mainstream thinking on business cycles.

First, anyone who has tracked the accuracy of mainstream forecasts of GDP knows how inaccurate they are. They are very good at predicting the GDP for the next quarter, but forecasts farther out in time or when the next quarter shows a decline in GDP at the bottom of a recession, mainstream GDP forecasts are totally worthless. They’re worse than worthless because when people take them seriously, as Davies has, they become dangerous. How many predicted the major drop in GDP in the first quarter this year?

Mainstream economists have failed for a century to predict a single recession. So why would anyone expect them to be able to now?  In fact, the mainstream definition of recessions is that they are random events. So looking at GDP forecasts to try to see them coming is by definition futile.

Second, a decline in GDP is the mark of the end of the recession as defined by the National Bureau of Economic Research. Even if mainstream economists could correctly predict a decline in GDP in the next quarter, they would only be telling us that the recession is almost over.

Of course, Austrian economists can’t predict the quarter that recessions begin or end, either. The difference is that Austrians know that recessions aren’t random events but are caused by central bank manipulation of interest rates. So we look for omens that portend the end of expansions. And we have no confidence in the GDP forecasts.

Mainstream blindness to recessions happens because mainstream economists fixate on aggregate data, such as GDP, and high levels of aggregation hide important changes in the economy. Think about it. In recessions not every business in the nation fails. Actually only a few fail. If GDP contracts by say 3%, the economy is still 97% as good as it was the year before. Yet economists consider a 3% decline in GDP a really bad thing because of the damage it does through unemployment.

But let’s look at employment figures. In the latest recession unemployment climbed to 10%, but 90% of workers were still employed. And if job creation falls to say 100,000 per month, that is a net figure. The economy has created two million jobs that month while losing 900,000.

Recessions are similar. A few industries will do poorly while most will plug along. The recession happens mostly in capital goods industries and to a lesser degree among consumer goods makers.

Some mainstream economists who want to criticize the ABCT will attempt it using aggregate data. For example, they might look at all capital equipment makers together. But the ABCT never claims that all capital goods makers rise and fall together. It’s difficult to predict which capital goods industries will suffer the most. In the recession of 1991 the fiber optic cable industry had the most bad investments. In 2000 it was internet and software. In 2008 it was real estate and autos. If economists only look at aggregate data they will completely miss those features.

Mainstream economists are like house inspectors who drive by and if the house is still standing they declare it to be of sound construction. Austrian economists, taking a micro approach, inspect for termites.

So why is this important to investors? It’s important because long before mainstream economists recognize a recession the market will have crashed. A stock market crash is one of the better leading indicators of a looming recession. Mainstream economists will laugh and say the stock market has predicted 10 of the last 8 recessions. But they fail to see that the market has a better forecasting records than they do.

If investors want to protect their savings, they will ignore the sunny predictions of mainstream economists and look for termites in the economy.

The View Through Copper Colored Glasses

If you own a sailboat you know that copper infused paint protects the hull of your boat from barnacles. Plumbers like copper because it kills bacteria. Copper may also be good for your portfolio. To understand why, we need to keep in mind the method the National Bureau of Economic Research uses to define recessions.

The NBER waits until after GDP falls for two consecutive quarters. The lowest quarter becomes the bottom or end of the recession. The next quarter is the beginning of the recovery. Then the NBER gnomes crawl backwards through the data to find the most recent peak of GDP growth. The quarter after marks the beginning of the recession. So we don’t officially learn that we are in a recession until the recovery starts, sometimes 18 months after the recession has begun.

Pundits Practice Post Hoc

The mainstream media rounds up the usual suspects when trying to explain the latest stumble from the stock market. One expert had this to say:

Many factors have conspired to increase market volatility and push stocks lower over the last several weeks. Chief among them have been nervousness over the timing of Federal Reserve (Fed) interest rate increases, worries over the outlook for the Chinese and eurozone economies, the escalating Ebola epidemic in Africa, and rising geopolitical instability—particularly in the Middle East.

Others add the collapse in oil prices or commodities in general, global warming or just plain irrational fear. Technical analysts will cite the S&P 500 falling below the 200 day moving average or another favorite indicator, but that doesn’t explain why it fell through the glass barrier. Most of these are merely examples of the post hoc fallacy in which people notice that one event followed another and concluded that the earlier event must be the cause of the later one. An obvious example is attributing the rising of the sun to the crowing of a rooster.

Cover Your Assets

The market isn’t likely to go much higher the rest of this year because as the last post showed it has already out distanced profits by quite a bit. So unless profits improve dramatically, the best an investor can hope for is a flat market with the potential for a major drop. But what if the market does reach higher levels and sets new records as it has several times this year?

Covered calls are great tools for situations like this. A covered call is a strategy for an investor in which he sells or writes call options in the stocks he owns. By selling a call option, the investor is selling to another investor the right to purchase the stock the seller owns at the strike price. The strike price should be higher than the price of the stock at the time of the sale of the option, or what is known as an out-of-the-money (OTM) strike price.

The strategy produces a win/win situation for the seller of the option when the market has risen to nose bleed heights. If the market remains flat, the seller of the option keeps the premium. If the market falls, the premium replaces the lost value of the stocks and gives the investor time to sell.

Q4 2014 Forecast

Here is my latest forecast of the S&P 500 quarterly averages. The market is quite a bit above what profits would justify, which means the PE ratio is expanding, or to put it another way, people are so desperate for earnings that they're willing to take higher risks. The market is above the forecast as it was in the late 1990's bubble.

Swedes help with timing

Anyone not a mainstream economist has recognized the awesome blindness of the profession to the approach of the latest financial crisis and its impotent policies afterwards. I recently finished a book published last year that not only explains why mainstream economics failed but promotes good economics, the Austrian kind, and provides another tool for telling the future.

Thomas Aubrey, the author of Profiting from Monetary Policy and founder of Credit Capital Advisory in the U.K., consults businesses on how credit creation affects global asset prices. Aubrey begins by detailing the devastation of the crisis on pension funds. Not only did many funds lose money in the crisis, but the low interest rate monetary policies intended to restore the economy have inflicted more damage and will lead to many failing in the future. Aubrey doesn’t mention the life insurance industry, but it and millions of retired people are suffering for the same reasons.

Austrian Bull Riding

Earlier this year Doug French, a senior writer at Agora Financial wrote a nice review of my book, Financial Bull Riding. In case you haven't read the book, this might persuade you to take the ride:

How Austrians Ride the Financial Bull

By Doug French

The single most asked question I get at investment conferences is, “Do you have a list of money managers who invest guided by the Austrian School of economics?” The question is a good one. After all, the Austrian School stands alone in predicting the fall of the Soviet Union and the housing and financial crash.

Anyone with a retirement account has been whipsawed by the stock market over the past few decades. Fidelity’s Peter Lynch told everyone to buy stocks and hold. Everything would work out great. Diligent savers would even end up millionaires, courtesy of an ever-expanding stock market. The efficient-market hypothesis (EMH) provided intellectual support for the idea. The market reflects all information, so there’s no way to beat it, said the economists.

Another Omen - Price to Sales

The first indicator most investors check in order to begin to assess the value of the overall stock market is the price/earnings (PE) ratio, which is currently around 18 and just slightly higher than the 60-year average of 16.3. 

But the PE ratio can change a lot depending on the number of years one selects to calculate the average. For example, the Schiller ratio uses a 10-year moving average and calculates the ratio at 26.3. As the last post disclosed, corporations have been buying back their own stock and that alters the ratio by reducing the number of shares divided into profits. 

Who is buying?

The Dow is back over 17,000 and the S&P 500 topped 2,000 again this week. Who is buying at these nose bleed levels? According to Jeffrey Kleintop of LPL Financial the buyers are individual investors and corporations buying back their own stock (Hat tip to Christopher Rowe, Director of Investor Education at The Oxford Club). 

Currently, there are six notable trends in buying and selling in the stock market. U.S. stocks are being purchased by corporations and individuals; however, foreigners, hedge funds, institutions and insiders are net sellers.

According to data from FactSet, S&P 500 companies bought back about $160 billion in stock in the first quarter of 2014, and are on pace for an amount this quarter that is close to the all-time high of $172 billion set in the third quarter of 2007. Corporations have been decreasing the amount of shares in the market for 10 straight quarters. Over the past year, this has amounted to about 3% of shares outstanding in the S&P 500. 

Why does this matter? Individual investors tend to pile into the market near the top so that they buy high and sell low. Individuals are a small part of the market, so they function mainly as an indicator that the end is near.

Corporate buying is a much larger segment, large enough to overwhelm institutional selling and cause the market to rise. Corporations are borrowing to purchase their own stocks and pump up returns. This deflates the price/earnings ratio by inflating the earnings per share. So while I'm not a big fan of PE ratios as a guide to investing, corporate buy-backs make the ratio even less worthwhile.

But the main problem with corporate buy-backs is that the corporations are borrowing to buy. That pumps up the price of the stocks, makes management look better and in some cases triggers options and bonuses for them.

Kleintop expects institutional selling to continue. So what happens when profits go south and corporations have trouble making the payments on the loans? It will take out the largest group of buyers in the market this year. Most will have to sell the stocks they bought for a loss. That will accelerate any decline in the stock market that follows a bad earnings reporting season.

Entrepreneurs in the Big Short

Michael Lewis is the bestselling author of many books, but the first one I have read is The Big Short: Inside the Doomsday Machine, which is about the financial crisis of 2008. Lewis’ economics is terrible, but I still recommend the book.

First the terrible part: Lewis doesn't understand good economics, by which I mean Austrian. From the book I would guess he doesn't know much mainstream economics either. If readers really want to understand the mechanics of how the crises unfolded I would recommend Slapped by the Invisible Hand by Gary Gorton. In a nutshell, it was an old fashioned bank run in which depositors got scared that their deposits were in danger and pulled their money out of the bank. Only in this case the depositors were money market mutual funds, pension funds and insurance companies and the banks were the large investment banks like Lehman and Bear Stearns. But what even the Slapped authorGorton doesn't tell readers is that the run began because of the collapse in the price of housing. It wasn't lightening out of a blue sky.

A Viennese Waltz vs a Stumbling Drunk

Mark Skousen is one of my favorite living economists because of my bias for the practical. Skousen has a PhD in economics, but he chose to pursue a career in the private sector as an investment adviser rather than one in academia or government. We need more great economists like Skousen. Their impact will be much greater than that of academics because those of us who need practical advice are much greater than the number of people who will major in economics in college. Also, if you wander through the blogs of Austrian academics you’ll find that academics spend a great deal of time on Quixotic efforts like trying to change Fed policy or reform mainstream economics.

Laissez Faire Books has released a collection of essays by Skousen with the clever title A Viennese Waltz Down Wall Street: Austrian Economics for Investors. It answers the classic book A Random Walk down Wall Street, by Burt Malkiel that promotes the mainstream vision of the Efficient Market Hypothesis.

Ghost of Ricardo Haunts Europe and Japan

The ghost of David Ricardo must be sending chills up the spines of the economists of Europe and Japan. They may not understand what causes those chills because of the poverty of their education. The US may soon experience a similar visit. Here is how the Wall Street Journal put it in email newsletter:

Can the U.S. go it alone? All of a sudden, economic data from around the world is looking decidedly worrisome. China on Thursday showed stark, sudden slowdown in lending and home buying in July, while Europe’s second-quarter results confirmed everyone’s worst fears, with Germany registering a contraction for the quarter and the euro zone as a whole failing to grow. This comes after a very big slowdown in the same quarter for Japan, the world’s second-biggest economy.

Omens of the fall

In the ancient world outside of Israel pagan priests discerned the will of the gods through omens in the sky and on earth.  Israelis didn’t need omens because they had revelation straight from God in the Torah. Omens came from the movement of planets and from the structure of kidneys in goats sacrificed to idols. Pagan gods would never have considered humiliating themselves by speaking directly to insignificant humans. The more omens a priest collected the more certain he could be of the will of the gods.

Investors today don’t have a revelation about the future. We have the Austrian business-cycle theory that tells us to expect a crash after years of artificially stimulating the economy with near-zero short term interest rates and massive buying of junk bonds by the Fed. But we can’t know the exact date, or even the quarter, when the crash will come. So like ancient pagans we have to rely on omens that suggest we are near the end of the expansion. These omens are what mainstream economists consider good news about the economy. Here are some gleaned from the kidneys of the Wall Street Journal.

BIS Pushes ABCT Draws Fire

ABCT investing offers financial advise derived from the Austrian business-cycle theory, so to be confident in that advise investors need to be confident in the theory. The most visible institution promoting the theory today is the Bank for International Settlements (BIS). The BIS is the central bank for central banks based in Basel, Switzerland. Just as the Fed in the US coordinates the exchange of funds for commercial banks, the BIS acts as a clearinghouse that coordinates the international transfer of funds between the central banks of nations. 

Claudio Borio and William White of the BIS have used the ABCT for years to analyze events and create policy. Recently, the bank created a minor storm in the world of economics and central bank policy with the release of its 84th annual report. The report asserts that the loose monetary policies of the world's central banks as well as fiscal policies of governments have failed and continuation of those policies will prove harmful. Mainstream economists trashed the report. Martin Wolf of the Financial Times descended to juvenile language. Gavyn Davies, also of the FT,  wrote of the report,

The Bank for International Settlements (BIS) caused a splash last weekend with an annual report that spelled out in detail why it disagrees with central elements of the strategy currently being adopted by its members, the major national central banks. On Wednesday, Fed Chair Janet Yellen mounted a strident defence of that strategy in her speech on “Monetary Policy and Financial Stability”. She could have been speaking for any of the major four central banks, all of which are adopting basically the same approach.

Dow 17000!

The Dow Jones Industrial Average crossed the 17,000 mark for the first time this year. What does it mean?

The market is somewhere in the Excitement stage of the Overstone cycle of trade.  Overstone described business cycles in the mid-19^th century. Starting at the six o’clock position in the graphic, the cycle begins with Stagnation, the depths of the depression with high unemployment. Stage two is Improvement, followed by Confidence, then Prosperity, Excitement, and last, Convulsion.

If you enlarge the graphic you’ll notice Overstone’s sense of humor. In the Excitement phase, crowds fight to get into the building with the sign “South Pole Warming Company” while a machine lifted by four hot air balloons flies over the building. In the Convulsion stage the Royal Bubble Bank explodes and sends people flying.

George Soros describes the Excitement stage as one in which the stock market becomes disconnected from the real economy, but Soros is thinking like a mainstream economist and assumes that the market has an intrinsic value somewhere close to the net present value. In reality, investors are merely adjusting their risk tolerance for the prevailing interest rates and opportunity costs. With ridiculously low interest rates, investors are showing greater tolerance for risk and a thirst for yield. One of the main drivers of stock prices is the changing discount rate of investors. 

What that means is that PE ratios may continue to rise and there is no way of knowing how far. But investors will have to come back to ground when profits start to fail. We are entering the profit reporting season for the third quarter and it may give us market direction.

At this stage in the cycle investors need patience most of all, but that's what they lack according to this quote from the Wall Street Journal newsletter Wealth Adviser: 

The market’s rarest commodity: patience. Benjamin Roth’s diary of the Great Depression is highly relevant today, as is his notion of why the wealthy investors’ club is an exclusive one. In a Motley Fool column, Morgan Housel cites some excerpts, including this one: “Most people do not have the patience to wait for the bad break. The average speculator is tied up in the market to the hilt when the break comes and has no liquid cash for the bargains that prevail.”

So when the market crashes as it did in 2000 or 2008, their wealth gets caught in the whirlpool and gets flushed.

Not only do investors need patience, but we need to be willing to be wrong as Spitznagel wrote in The Dao of Investing. Investors who followed his MS Index might have exited the market last year and missed the latest run ups to record highs. Friends and family would be mocking them and they might suffer from regret. But if they stick with the index they will earn more in dollars over time by avoiding the major collapse that is coming, even if it is another year away. As Spitznagel wrote, it's counterintuitive, like many of the teachings of the Dao.

Many advisers can find good value stocks when the market is high, but keep in mind what Benjamin Graham wrote about buying unloved stocks when the market is high. Investors won't love those stocks more when the market collapses. They will drop with the crowd.

Financial Bull Riding in paperback

Laissez Faire Books has published a paperback version of Financial Bull Riding in addition to the ebook and audio book. But the paperback is available only through Amazon here right now. Reviews of the book by anyone who has read it would be nice.

Forecasting Failure

The latest revision of GDP for the first quarter of this year caught most economists by surprise. A decline of 2.9% is the worst since the latest recession. Surprising most economists shouldn’t surprise anyone. The Laissez Faire newsletter alerted me to studies by the IMF economists Hites Ahir and Prakash Loungani on the abilities of private and public sector economists to forecast recessions. In short, their records are almost perfect, failure that is.

The photo of the Queen with the comment “Why did no one see this coming?” comes from a presentation at George Washington University on forecasting by the two economists. In a second photo, a London School of Economics representative responds, “Ma’am, to see this one coming would have ruined our perfect record of failure to see it coming.”

S&P 500 Forecast Q4 2014

The Dao of Investing - It's time to sell

I recently finished Mark Spitznagel’s book The Dao of Capital: Austrian Investing in a Distorted World and highly recommend it. Spitznagel is the founder and President of Universa Investments, which specialized in equity tail-hedging, or as the book jacket says, “profiting from extreme stock market losses.”

The author began his career trading in the futures bond pits at the Chicago Board of Trade and works closely with the Black Swan, Nassim Talib. At one point he was head of proprietary trading at Morgan Stanley.

Nuts and bolts trading advice doesn't begin until chapter nine of ten. I recommend reading those chapters first so that the reader won’t hurry through the very interesting preceding eight chapters trying to get to the caramel nugget at the center.

He begins with the Chinese philosophy of Dao because Murray Rothbard once wrote that the Daoists were the first Austrian style thinkers. That may be so, but in a forthcoming book I show that Moses created the first libertarian society and laissez-faire economy, which makes him very Austrian. 

Spitznagel divides his Austrian investing into sections I & II. Investing I is about timing the market. In Financial Bull Riding I recommended that investors pay attention to reports of historically high profits as precursors to a crash. Investors should abandon the stock market before profits collapse and then re-enter in the depths of a recession. Spitznagel offers another tool that he calls the Misesian Stationarity (MS) index.

“...the MS index is very well represented by what is known as the (Tobin’s) Equity Q ratio – Total U.S. corporate equity divided by total U.S. corporate net worth – which is readily available online through numerous sources...”

The basic idea behind the MS index is that Fed monetary policy distorts the economy and thereby the prices of stocks until the distortion can continue no longer, at which point the market collapses. The author tested what might have happened to an investor who sold when the index rose above 1.6 and bought when it fell below 0.7. He bought treasury bills each time he sold out of the market. His hypothetical portfolio outperformed the S&P 500 by more than 2% per year from 1900 through 2012.

Over say 30 years, even such a small outperformance would mean a huge increase in total dollars returns, but keep in mind that by avoiding the major collapses in the market, hedge funds that underperform the S&P 500 still can almost double actual dollar returns to investors. I go into more detail in Financial Bull Riding about this seeming contradiction.

Next, Spitznagel performs a hypothetical “tail hedge strategy” on the same portfolio.  Instead of selling out at high MS index values, he  bought 2-month ahead out-of-the-money puts as insurance against a stock market collapse. As before, he divided returns according the level of the MS index at the start of each one year period. The resulting increase in returns was even more impressive:

“When the MS index is in the upper quartile (as it is as I write), there has been an approximate 4 percentage-point outperformance of the Austrian Investing I strategy (or a tail hedged index portfolio) over only owning the index (an outperformance that fades as the starting MS index level falls).”

At the time Spitznagel wrote the book the MS Index was above the sell signal and has only gone higher since.

Spitznagel’s strategy doesn’t end with timing the market. The Austrian school suggests advice for picking individual companies instead of owning an index and Spitznagel employs that in Austrian Investing II, which also has two parts:

1.       Pick stocks of companies with high returns on invested capital (ROIC), “...best calculated by dividing a company’s EBIT (operating earnings before interest and tax expenses are deducted) by its invested capital (the operating capital required to generate that EBIT).

2.       Buy stocks of companies with low Faustmann ratios, “...meaning a low market capitalization (of common equity) over net worth (or invested capital plus cash minus debt and preferred equity) ratio.”

The author explains the rationale behind part 1:

“On theoretical grounds, we expect a firm with high ROIC to remain in such standing, as its managers will continue to reinvest in the firm (why wouldn’t they?), and this will only further solidify their positions of competitive advantage.”

“The data match up with our theoretical deduction. It turns out that high ROICs have been sustainable... we see that the Siegfrieds...- defined as firms realizing 75 percent or higher ROIC at the start of each 10-year period – have tended to persist as Siegfrieds – or have retained their elevated ROIC by the end of each 10-year period.”

From 1978 to 2012 the Siegfrieds returned avg 25% annually while the S&P returned 11%.

Investors who grasps the main principles of Austrian economics and especially the Austrian business-cycle theory will not only earn much higher returns on their investments, they will be able to sleep better because they understand how the stock market works and know they are not taking large risks with their funds. Of course, I’m using “risk” in the Austrian sense of uncertainty and not the mainstream economics definition of just volatility.

PS: That the MS Index shows that investors should have exited the market in 2012 shows that investors need to be willing to be wrong for a couple of years and be OK with that. Spitznagel proves that in the long run investors will make more money by following the Index and being wrong for a few years. But that takes a special kind of personality. 

ECB Goes Negative

Spontaneous Finance has a good post on why negative interest rates on bank deposits at the European Central bank will not encourage bank lending to businesses, especially lending to small businesses that represent greater risks. As Julien shows, the move by the ECB does little more than squeeze bank profits at a time when low interest rates have already reduced profits. The analysis covers Europe, but the same principles apply to the US because the European Basel accords regulate banking on both banks of the pond.

The Mysterious Case of Missing Inflation

When the Fed dramatically expanded its balance sheet after the latest recession began, many economists expected to meet high inflation barreling down the road. Fear of inflation helped send the price of gold to $1,800 per ounce. Instead, inflation has been very mild and Europe is flirting with deflation. What happened?

Of course, Austrians needed Hayek and Mises to remind us that the quantity theory of money shouldn't be taken mechanically. Someone has to borrow money and spend it in order for lower interest rates or QE to increase the money supply. The state borrowed and spent in the hyperinflation in Germany during the 1920’s. And the US government borrowed and spent during the 1960’s and 1970’s to create high inflation.

Today, the government borrows to maintain spending while spending increases are relatively small due to high existing debt and political opposition to increasing debt. Businesses aren’t borrowing because high taxes and massive regulation raise the profit bar to pole vaulting levels. So people are borrowing to invest in assets such as real estate and the stock market or exporting newly created money by investing overseas or buying imported goods.

Julien Noizet at spontaneousfinance.com informs us that banking regulations are directing lending to real estate. In “A new regulatory-driven housing bubble?” Julien explains the effect of risk weighted assets (RWA) on lending:

Basel regulations are still incentivising banks to channel the flow of new lending towards property-related sectors. A repeat of what happened, again and again, since the end of the 1980s, when Basel was first introduced. I cannot be 100% certain, but I think this is the first time in history that so many housing markets in so many different countries experience such coordinated waves of booms and busts.

So far we’ve had two main waves: the first one started when Basel regulations were first implemented in the second half of the 1980s. It busted in the first half of the 1990s before growing so much that it would make too much damage. The second wave started at the very end of the 1990s, this time growing more rapidly thanks to the low interest rate environment, until it reached a tragic end in 2006-2008. It now looks like the third wave has started, mostly in countries where house prices haven’t collapsed ‘too much’ during the crisis.

The Basel regulations require banks to hold more reserves for riskier loans. The safest loans go to governments, which carry a zero risk according to Basel. Real estate carries the next lowest risk. Business loans are among the riskiest and force banks to keep more cash idle.

One of the latest casualties of the Basel regulations has been the Bank of England’s Funding for Lending Scheme. The scheme set aside funds for loan to small and medium enterprises, but as Julien writes,

Since the inception of the scheme, business lending has pretty much constantly fallen… According to the FT: Figures from the British Bankers’ Association showed net lending to companies fell by £2.3bn in April to £275bn, the biggest monthly decline since last July.

The Basel accords pretty much guarantee that lending in the future will go mainly to governments and real estate, not so much to businesses. Most governments in the West are trying to limit spending, so for the foreseeable future we can expect repeated real estate and stock market bubbles and little CPI price inflation. That makes bonds a better prospect when real estate and the stock market are in bubble territory, but it also makes gold less attractive.

Of course, I could be wrong, so always hedge. 

The Famous Fama - Investing is Gambling

Eugene Fama, the 2013 Nobel prize winner in economics, a professor at University of Chicago and a director and consultant for Dimensional Fund Advisors, recently said at a conference,

 I have one word for you and you're not going to like it - chance.

Of course, Fama is famous for his support of the Efficient Market Hypothesis (EMH) which states that the stock market is so efficient at pricing new information that investors can never beat broad market indexes such as the S&P 500. Fama's advice to investors is, 

You decide how much you want to tilt to these [types of risks and] returns and then you diversify the hell out of it," Fama said. Choose your asset allocation and then make sure you get fully diversified portfolios that get you there.

Investors who followed Fama’s advice lost enormous sums in the market crashes of 2000 and 2008. So many “anomalies” in the EMH have popped up that they gave birth to a new industry called behavioral investing that insists investors are not rational and make many mistakes.

In the short run, say under three months, movements in the stock market are essentially random. In the very long run the market tends to converge to the net present value of future earnings (NPV). So in both periods the EMH is correct. But in the medium run, the market deviates a great deal from NPV, and thus supports behavioral investing theories.

Austrian economics untangles the confusions of both the EMH and behavioral investing for serious investors. A chapter in my book, Financial Bull Riding, goes into more detail about what is wrong with both the EMH and behavioral investing schools of thought. Short run deviations in the market, such as what day traders attempt to profit from, are impossible to predict, while the long run trajectory offered by NPV is highly subjective because the analyst must forecast earnings (very difficult) and choose a discount rate (constantly changing). 

However, the medium term market is fairly predictable because it follows profits closely and responds to the risk tolerance of investors. The value may diverge from the long term NPV, but that doesn’t mean investors are irrational as behavioral investing insists. Investor risk tolerance and knowledge changes over time depending on circumstances, mostly profit reports. I use quarterly corporate profits and price/earnings ratios in the forecasts I publish on this blog and the model explains about 70% of the change in the quarterly averages. For economic and financial models that is a good fit. 

In addition, Fama and most analysts look to the percent returns of indexes as the standard measure for investment performance. For example, if the S&P 500 is up one year by 10% then your investments had better return more than 10% or you have failed. But as I show in my book, hedge funds consistently fail at matching the S&P 500’s percentage returns, yet make their clients far more money than those clients would have made passively investing in an index. They can do that by avoiding large declines in the market, such as happened in 2000 and 2008.

Professors like Fama forget that compounded interest works against the investor in bear markets just as it works for him in bull markets. To recover from disasters like 2000 and 2008, investors need extraordinarily good returns in bull markets. For a simplistic example, assume the stock market fell 30% at the beginning of the year and stayed down the entire year. Not only has the investor lost 30%, but he has forgone interest he might have earned in bonds. Then the market going up 30% the next year will not recover his losses because his base is lower. He will need about a 60% increase in order to recover his lost investment plus opportunity costs.

The Wall Street Journal printed a critique of hedge funds in the May 27, 2014 southwest edition page C6, with the headline “Hedge Funds Don’t Live Up to Their Billing.” The article said that HFR’s composite index of hedge funds returned 72% over the decade ending last month compared to a return of 100% for the Vanguard Balanced Index Fund, which has an allocation of 60% stocks and 40% bonds. Hedge funds got their names because the managers hedged against market downturns using short selling and derivatives. Hedging is the same as buying insurance against a market decline. Obviously, the costs of the insurance will weigh down returns in percentage terms, but will pay off handsomely after a disaster.

Studies have shown that hedge funds have significantly under performed the broad indexes in percentage terms while returning more to the investor in dollars than a broad index would. It sounds counter intuitive, but it’s worth checking out. As Fama said, “This is arithmetic, not a hypothesis.”

Of course, a better way is to learn how Austrian economics ties the stock market to the business cycle to fine tune your hedging as I show in Financial Bull Riding.

Microwaved Marx - Piketty and his Capital

Thomas Picketty’s book Capital in the Twenty-First Century is on the best seller lists, so although it’s not about investing, it’s about economics, I felt I should add my comment to those of many others. 

1.       Piketty makes a grave statistical error: when comparing groups, those groups should be as homogeneous as possible in all areas except the one being investigated. In other words, don't compare apples and oranges. Piketty assumes that the economic regimes in place over the past three hundred years were all the same. They weren’t. The West veered sharply from laissez-faire policies in the late 18^th and early 19^th centuries to various flavors of socialism in the late 19^th century. Germany implemented socialist policies in the 1870’s. The UK and US followed later, with the US having become almost pure democratic socialist under FDR with tax rates on the rich higher than Piketty recommends in his book as a cure for inequality. Piketty ignores those changes in regimes and classifies the entire period under his investigation as capitalist. In fact, the growing inequality since 1970 that he complains about has happened because of increased socialism.

2.       Piketty assumes that increasing inequality is a feature of capitalism, ignoring the fact that inequality was never higher than that which existed in the old USSR and communist Eastern Europe. His assumption is pure Marx with no supporting evidence. In fact, the Nobel-prize winning economist Robert Fogel in his Escape from Hunger and Premature Death demonstrated that laissez-faire regimes cut inequality in half in the UK and US by 1900. But Piketty doesn't like the Gini coefficient that Fogel and most economists use; it contradicts Piketty's thesis. So he invented his own metrics. 

3.       Piketty pimps for a tax of 80% on the wealthy. But as most bad economists and Marxists, he assumes that the wealth of the rich is idle, consisting of dusty old gold coins sitting in a warehouse. In reality, which completely escapes Piketty, all wealth held by the rich today is working hard at businesses to create jobs. The economist Thomas Stanley, famous for his The Millionaire Next Door demonstrated that 85% of the wealthy in the US earned their wealth by growing businesses. Only 3% inherited it.

So what happens when governments take 85% as Piketty demands? The money dedicated to investment gets turned into greater consumption when the government distributes it to the rest of the nation. Investment declines and consumption increases. Any freshman taking intro to economics knows that will cause the production possibility frontier to collapse, which means in laymen’s terms that we all get poorer together.

4. Piketty ignores the fact brought out by McCloskey in her Bourgeois Dignity that the wealth of even the poorest in the West is roughly 30 times, not 30%, but a factor of 30, greater today than in 1900. Inequality is rising, but from a point at which even the poor today are amazingly wealthier than a century ago. 

Piketty’s book appears to be microwaved Marx with a dump truck load of data designed to smother the reader and prevent him from thinking. Like a magician, Piketty uses data to distract the reader from what he is really doing. 

It doesn't help that many conservative economists defend the status quo. It's hard to deny that in at least some ways a lot of Americans are worse off. For example, Vern Gowdie, an Australian financial planner, wrote recently in "How the Fed Creatively Tortures the Data:" 

"Michael Greenstone and Adam Looney of the Hamilton Project went deeper into the median income numbers and discovered this rather depressing finding:

"[M]edian earnings for men in 2009 were lower than they were in the early 1970s. And it gets worse… Between 1960 and 2009, the share of men working full-time fell from 83% to 66%, and the share not making formal wages tripled from 6% to 18%. When you take all men, not just those working full-time, [you see] a plummet of 28% in median real wages from 1969 to 2009." 

Conservative economists need to quit defending the US as a capitalist economy. It hasn't been even close to capitalist since 1929.  We need to place the blame for rising inequality where it belongs - on socialist policies. These include the Fed's inflationary policies that benefit the rich at the expense of the poor and regulations that reduce competition and enrich established corporations.  

Some of the best reviews of the book I have read can be found at these links:

"The return of patrimonial capitalism":

"Capital Punishment"

"Piketty's Capital I"

"Piketty's Capital II"

"Piketty's Capital III"

"Piketty's Capital IV"