An Economic Theory that Leads to Smart Investing

 

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.

Now everyone knows better. Or at least they should.

The average person’s 401(k) was turned into a 201(k) in 2000, and was destroyed again in 2008 if they were brave enough to stay or get back in the market. Many people swore off stocks after the last crash only to watch the S&P 500 triple. Now the Fed’s zero interest policy has pulled them back just in time for the next market train wreck.

Those educated in the Austrian School understand how the central bank creates the business cycle’s booms and busts. And they know there is a better way than just buying, holding, and hoping. But how does one apply it using Friedrich Hayek’s and Ludwig von Mises’ theories to make money in the market?

In a very readable 107 pages, Roger McKinney shows you how to turn theory into profit and financial survival in his book Financial Bull Riding.

Now is the perfect time to read McKinney’s book. Stocks are trading at all-time highs. More margin debt is outstanding than ever before. Price/earnings ratios are stretched, with market darlings like Netflix and Amazon trading at P/Es of 196 and 581, respectively.

However expensive it may be, if you’ve missed this market move, every day it goes up, you feel the regret and are tempted to jump in. If already fully invested, you’re rationalizing away any concerns.

Eugene Fama may have shared the Nobel Prize for his EMH work, but McKinney disposes of the idea using a folksy story from a serially successful investor — Warren Buffett — that strict adherents to EMH would deny the existence of.

Buffett finished his story about coin-flipping orangutans with “I think you will find that a disproportionate number of successful coin flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville.”

Common sense still makes sense in the plains.

Buffett has a point. Even in the speculative world of junior resource investing, the legendary Rick Rule is an ardent adherent to the teachings of Ben Graham and David Dodd.

McKinney’s book may be about beating the markets, but the author gains his clear perspective not just through the lens of Austrian economics but from operating as a financial adviser far, far away in the flatland of Oklahoma. His perspective isn’t clouded by the canyons of Wall Street. Common sense still makes sense in the plains.

Bull Riding is Rothbardian in its scope of history used to support the book’s premise. Richard Cantillon is not a household name, but McKinney provides a brief, enlightening history of the man who made a fortune in the crash of John Law’s Mississippi Bubble in 1720 France.

And how many books on investing mention the University of Salamanca as the beginning of the marginal revolution? “Had [Adam] Smith been more familiar with the writings of the Salamanca scholars, he would not have made that mistake.” “That mistake” being the labor theory of value.

Readers shouldn’t worry about the author getting too bogged down in theory or history. He condenses these matters, as well as the Keynesian takeover. He then quickly gets into explaining the Austrian business cycle theory as the bedrock for investment timing.

Hayek’s and Mises’ insight was that monetary intervention by a central bank forces interest rates below their natural rate. This fools entrepreneurs into believing savings have increased and demand has shifted from consumer goods to higher-order (investment) goods. Of course, savings haven’t increased, and this misdirected capital becomes what Austrians call malinvestments, to be liquidated in the downturn.

Selecting good companies to invest in is important, but timing is everything. “If we can predict with some accuracy when profits will change in the business cycle,” McKinney writes, “we should have some idea of when stock prices will change.”

The author follows the money and, in turn, the profits of various business sectors, providing a road map to help investors determine entry and exits points in the market. It’s what he calls avoiding the “business cycle horns.”

Investors have different temperaments and risk tolerances. Very few are all-around cowboys. McKinney lays out three strategies for this investment rodeo depending upon what kind of cowboy you are.

You may be a calf roper, with plenty of skill and, most importantly, plenty of patience. But calf ropers don’t make as much as other cowboys. Steer wrestlers make more, but timing is more critical, while less patience is required.

The big money in any rodeo is made by bull riders, who risk life and limb for an eight-second thrill ride. The investment bull rider will try to ride all market fluctuations using margin, options, and futures. Bumps and bruises should be expected, but the rewards can be enormous for a successful ride. Especially if you use Austrian business cycle as a big-picture guide, with technical analysis to navigate the market’s daily bucking.

The best freedom is financial freedom. Rather than hand your hard-earned savings to a broker or money manager whose primary interest is to generate commissions or increase money under management, take control of your own nest egg.

Sincerely,

Doug French
for The Daily Reckoning

How not to predict the stock market

Investing expert Bert Dohmen said that “Looking at earnings, dividends and P/E ratios in order to predict future stock prices are all a waste of time” in a recent Forecasts & Strategies email issued by the economist Mark Skousen. The email continued:

Dohmen explained, “If a P/E were meaningful for predicting future price performance, why is a stock like Facebook selling at a lofty P/E of around 90, and Amazon with a P/E of 300, both still highly recommended and rising, while other stocks, like Apple, with a low P/E of around 10, [are] declining and down 35%?”

He added, “Analysts tell us that ‘earnings’ are the most important thing affecting stock prices. Really?! Well, corporate earnings in 2015-2016 have had the largest decline since the crisis in 2009, but the DJI and the S&P 500 are within about 1% of making new record highs.”

Then Dohmen asked the all-important question, “So what is the major determinant of stock market trends?”

Of course, the answer is “future earnings.” Stock prices are always based on the forward-looking views of investors. That’s why high-priced stocks such as Facebook are selling for 90 times earnings. It also explains why Amazon is selling for 300 times earnings and Tesla is selling for $230 a share even though it has no earnings! Investors are upbeat about their future. Meanwhile, Apple is selling for only 10 times earnings because it’s not viewed as a growth stock anymore.

Market crash overdue says Spitznagel

According to the legendary hedge fund manager and author of The Dao of Capital: Austrian Investing in a Distorted World, Mark Spitznagel, the stock market should follow Canadian geese and head south any day now. I reviewed his book here because he uses the Austrian business-cycle theory (ABCT) to guide his investment decisions. It has proven the most popular post I have written.

Spitznagel created his own index for tracking the market cycle he calls the Equity Q Ratio. Calculating the ratio starts with the relationship of the cost of titles to capital (stock prices) to the cost of the capital the title represents. That part is roughly comparable to a price-to-book value. Then Spitznagel compares the actual ratio to the historical average. The deviation from the historical average is the Q Ratio. The stock market in October was 71% above the long term average. It was higher only just before the dot.com crash of 2000.

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.

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.

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.

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. 

Fed Inflates Capital Markets!

In an email newsletter sent out by the Wall Street Journal called Macro Horizons, Michael J. Casey appears to grasp a point about monetary policy that few other mainstream economists can get a grip on, while Austrian economists have taught it for decades: inflationary monetary policy benefits the rich. He wrote,

Easy money translates into gains for those who are rich in assets, especially financial assets, and that excludes a large swath of the population [italics in the original].

I assume Casey is a mainstream economist because the main point of his post was the need for central banks to maintain monetary “stimulus.” The quote above follows this:

The subject of disinflation is the focal point of Wednesday’s data, where we are being reminded of its nonexistence in the industrialized world and of the risk that it could morph into outright deflation. This is most evident in Wednesday’s CPI data out of Europe, which is why the notoriously stimulus-shy Deutsche Bundesbank insiders even came around to telling the Journal Tuesday that they were considering backing actions at the European Central Bank’s June meeting to attack the disinflationary trend. But we’re likely to see the same later in the U.S. producer price data and in the U.K., whose economy is otherwise growing strongly, the Bank of England indicated that it still sees no great impetus for inflation to breakout. There was a time when this scenario of growth, coupled with low inflation, was seen as a “Goldilocks” scenario, a perfect not-to-hot, not-too-cold combination where policy would stay accommodative but gains could be had in the economy and markets. But the longer we flirt with deflation – which translates most directly into near-zero wage growth – the more that the adoption of hyper-accommodative policies tends to exacerbate the other great scourge of our age: inequality. 

Recession without rising rates?

Can a recession, and the simultaneous meltdown of the stock market, happen without the Fed raising rates? Hayek wrote Prices, Interest and Investment to show that it could and he used Ricardo Effect as the principle to demonstrate it. 

When I decided to teach an intro class in economics at a small private college, I worried about delivering mainstream economics when I had become convinced of the Austrian approach after earning an MA in managerial economics at the University of Oklahoma. But as I taught I realized that mainstream economics textbooks teach a lot of Austrian economics; mainstream economists just don’t know it.

Mainstream economics textbooks present economics as a series of unrelated topics. Even mainstream macro economists have recognized the animosity between micro and macro. I found that the Austrian aspects come out when I stitch together those disjointed topics. Here is an example of how I teach the Austrian business-cycle theory and Hayek’s Ricardo Effect using nothing but the tools presented in standard intro textbooks.

Resurrecting Hayek’s Ricardo Effect will disappoint a few Austrian followers who, having done a quick search of the internet on the topic, have decided that critics demolished Hayek’s theory decades ago. Hayek introduced the effect in his Prices, Interest and Investment and amplified it in The Pure Theory of Capital. The only contemporary author that I’m aware of who takes it seriously is Jesus Huerta de Soto in his book, Money, Bank Credit and Economic Cycles. I include it in my book, Financial Bull Riding.

Hayek didn’t respond to many of his critics so some assume that Hayek had given up on the Ricardo Effect, but he hadn’t. Hayek recognized that his critics didn’t understand the effect because they had a poor grasp of capital theory. In fact, anyone who has read the three descriptions of the effect mentioned above will immediately grasp that Hayek’s critics attacked straw men, but never Hayek’s Ricardo Effect. Hayek answered his critics with Pure Theory of Capital.

Escape from Mass Opinion

L. Albert Hahn, a great economist in the decades after WWII wrote Common Sense Economics because he thought that most mainstream economics had drifted into fantasy land as a result of the rise of Keynesian economics. I like the cover picture that shows a piggy bank sinking under water, which is what conventional investment wisdom will cause.

In section five on the stock market, Hahn wrote this:

 “As every experienced market operator knows, success on the stock market depends decisively on the ability to go against the prevailing tendency, i.e., against mass opinion, at the very moment when its correctness is least in doubt. The ability to go against the prevailing tendency, however, presupposes in the first instance that the individual remains conscious of the persuasive influence of mass opinion on his own opinion. This, in turn, presupposes a correct assessment of its force. Everyday observation shows the strength of mass opinion to be very great indeed. It engulfs not only those who easily succumb to foreign influences but even those with normally detached views and sober judgment. An almost superhuman effort is needed to evade the influence of mass opinion-particularly in the United States, where price movements and thus the opinions of others are continuously reported to the farthest corners of the country by the ticker. The ticker assembles, as it were, all the buyers and sellers in one room. The ticker influences speculation as the flag influences troops. As long as the flag is carried forward, every single man knows that the others still have the courage and strength to go on, and this knowledge sustains his own courage and strength. Once the flag retreats, every man concludes that the others' courage and strength is waning. As he knows that he cannot advance alone, he, too, retreats, even though he would not himself be forced to.

 “There is, of course, no general rule on how to counteract the influence of foreign opinion on one's own opinion. One of the most important aids for emancipation from mass opinion and its influence is to bear in mind that all prices are almost always necessarily wrong. It is further important to remember that mass suggestion wields its strongest influence when only one opinion is stated and discussion is prohibited. An experienced stock market operator will always listen with special attention to any arguments in opposition to the prevailing opinion.”

It’s old, but still good advice for investors. The time to follow the crowd is the period after the bull market starts until just before it ends. The crowd won't get out of the market until long after they have lost close to half their nest egg. Most individual investors don't get into the market until it has reached close to its top. The market is near its top today so successful investors will start rebalancing into cash or gold, but those who do will get a lot of criticism from most other investors. Being a good investor means learning to enjoy solitude. 

                                                                                                                                         

From Common Sense Economics by L. Albert Hahn, London: Abelard-Schumann Ltd., 1956, 213-214.

QE to Infinity and Beyond and Cantillon

Mainstream economics denies that Cantillon Effects exist. Cantillon Effects are one of those insights that Austrian economics offers followers that help us avoid nasty surprises like the Great Recession. Recently, McKinsey and Company provided research that supports the Austrian view of Cantillon effects from QE. Here is one of their charts:

Presidential Returns

In honor of President's Day this week I decided to take a look at a popular cyclical candidate running to help you time the stock market - the presidential election cycle. Jeffrey Hirsch, chief market strategist at the Magnet Æ Fund and author of The Little Book of Stock Market Cycles wrote about the technique in "Using Seasonal and Cyclical Stock Market Patterns" in the June issue of AAII's Journal. Hirsch's Stock Trader's Almanac has followed this cycle for fifty years and found it profitable.

Here is his graph of the average returns for the Dow Jones Industrial Average in each year of the four-year cycle from 1833-2012:

 

Hirsch explains that, "In an effort to gain reelection, presidents tend to take care of most of their more painful initiatives in the first half of their term and 'prime the pump' in the second half so the electorate is most prosperous when they enter the voting booths. The 'making of presidents' is accompanied by an unsubtle manipulation of the economy...By Election Day, he will have danced his way into the wallets and hearts of the electorate and, it is hoped, will have choreographed four more years in the White House for his party."

After the election, reality asserts control:

ABCT Extends to Emerging Markets

Trouble in emerging markets has provided the rationale for at least part of the recent correction in the stock market. Emerging markets, such as, Brazil, Russia, India, Turkey, Thailand and China, are suffering largely because of the withdrawal of US dollar investments from them and this confirms the effects of monetary policy as described by the ABCT, the Austrian business cycle theory. Here is a chart showing the performance of emerging market stocks relative to the rest of the world:

To refresh your memory, the ABCT states that inflationary monetary policies such as those of the Fed for the past five years will cause an unsustainable boom as new money pours into the economy and stimulates demand for consumer goods and for investment. Usually we think of the ABCT in terms of a single nation, but the EM problems demonstrate that it has international implications, especially in a world of increasing trade integration and a currency that other countries use for trade and their banks for reserves.

Krugman advertises ignorance

ABCT Investing is based on the Austrian business cycle theory, so I become mildly concerned when others criticize the theory. I never become seriously concerned because I have learned over the years that most critics are unbelievably lazy. If they bother to read Mises or Hayek they do so through the lenses of mainstream econ and fail to understand what the authors are actually saying. 

The Social Democracy blog has posted a long diatribe against Ludwig von Mises, which I would normally ignore had Paul Krugman not advertised it. Krugman even gets wrong much of what the blog says, but the blog gets a few things wrong so here are my responses:

Natural rate of interest

The blog is right that the “natural rate” of interest doesn’t exist. Of course, neither does “equilibrium.” Both are theoretical constructs to help us think about economics. Wicksell defined the natural rate as the rate of interest in a barter economy. Interest would exist if we were forced to barter goods because interest is nothing but the opportunity cost of giving up the use of something for a period of time. Austrian economists picked up on the idea as a useful way to explain how interest under barter differs from interest using money. It’s a teaching devise. But if you don’t like it you can ignore it. It helps teach the ABCT, but has little importance to the working of the theory.

Mises and fascism

Bubble Detectives

“One important conclusion is that the probability that the S&P 500 index is currently in a bubble is only 20-33 per cent,” according to Gavyn Davies in his recent article for the Financial Times, “How to detect amarket bubble.” “But that could change fairly quickly during 2014 if the recent pace of advance in equity prices continues.”

Davies approves of the New Palgrave definition of a financial bubble:

Bubbles are typically associated with dramatic asset price increases followed by a collapse. Bubbles arise if the price exceeds the asset’s fundamental value. This can occur if investors hold the asset because they believe that they can sell it at a higher price to some other investor even though the asset’s price exceeds its fundamental value.

Davies then mentions two other bubble detectors:

Based on the Shiller cyclically adjusted p/e (CAPE), the probability of a bubble is estimated at 33 per cent in December 2013, while the price/dividend model produces a bubble probability of 20 per cent.

Financial Bull Riding is out!

Laissez-Faire Books has released Financial Bull Riding. I would love to hear what you think!

The book examines the faulty economic theory behind conventional investment wisdom, especially the idea that business cycles are random events, explains the ABCT and offers some guidelines for investing. Here is the table of contents as of today:

How to pick stocks

The Austrian business cycle theory suggest that investors buy stocks in the capital goods sector, or cyclical stocks, in the early years of an expansion and switch to consumer goods makers in the later years. Investors can do that easily with exchange traded funds (ETF) which cluster stocks in a dizzying array of industries, commodities and countries. For example, one of the better known tech stock ETFs is QQQ, which contains the stocks of a lot of capital goods companies.

But as happens with any grouping of large numbers of companies, most will be dogs. Only a few will be excellent companies whose profits grow well and whose stock prices reflect that growth. Most of the members of the ETF will act like an anchor on the value of the ETF. The only solution is to buy individual stocks, but analyzing thousands of individual companies takes more time than most part time investors enjoy.

Foxhole conversions

There are no atheists in foxholes is an old saying meant to express what crisis will do to one's thinking. The recent crisis has encouraged many mainstream economists to look at what is wrong with their theories that prevented them from seeing the crisis coming. As a result, prominent mainstream economists have begun incorporating at least parts of the Austrian business cycle theory in their work.

 Coordination Problem discussed a recently published paper by Guillermo Calvo of Columbia University and the National Bureau of Economic Research, “Puzzling over the Anatomy of Crises: Liquidity and the Veil of Finance.” Calvo wrote the following:

“Critical Puzzle 1. There is a growing empirical literature purporting to show that financial crises are preceded by credit booms (Mendoza and Terrones (2008), Schularik and Taylor (2012), Agosin and Huaita (2012), Borio (2012)). This was a central theme in the Austrian School of Economics (see Hayek (2008), Mises (1952))...”