Cash Is King

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The irony is that the well-to-do investor’s well-being would not be threatened by consumer price inflation rates two or three times the current level. Compared to most of the population, he or she spends only a modest portion of income or wealth on consumables, while expending a far greater portion on asset purchases, the prices of which have inflated dramatically in recent years. Nothing will destroy the wealth of the wealthy as fast as deflation in financial and real assets. Only cash protects against that risk. Interestingly, we rarely get the question “how do I protect my portfolio against asset price deflation.” Ironically, CPI deflation will precipitate or accompany asset price deflation. Cash, the all-purpose hedge, ends up being the perfect asset in both scenarios.

Irving Kahn on Safety

There were two key questions I asked Irving [Kahn] via his grandson. One was, “If you could share a single piece of financial advice that you’ve learned over your life that is absolutely invaluable, what would it be?” [Irving] came back via his grandson. He did an extraordinary job, interviewed him over days about these things. Came back and said, “Safety.” He said, “The #1 thing is paying attention to the downside.” He said, “There are all these people. It’s like they’re on a horse and they can gallop very fast, but do they know what direction they’re going in?” It was kind of this fascinating insight that sounds really banal and prosaic in some ways, but this is coming from a guy of 108 who managed to survive the crash of 1929, World War II, Vietnam, any number of crises and crashes. When I started to think about that, this is one of those ideas that if you truly internalize it, it actually has an enormous impact on you.

He said, for example, “You’ll find that if you make reasonable gains and avoid disastrous losses, you’ll outperform all of your gambler friends.”

Qtd in The Manual of Ideas, March 2017.

"The Banker Who Said No"

Classic article

Beal plays his cards patiently. For three long years, from 2004 to 2007, he virtually stopped making or buying loans. While the credit markets were roaring and lenders were raking in billions, Beal shrank his bank’s assets because he thought the loans were going to blow up. He cut his staff in half and killed time playing backgammon or racing cars. He took long lunches with friends, carping to them about “stupid loans.” His odd behavior puzzled regulators, credit agencies and even his own board. They wondered why he was seemingly shutting the bank down, resisting the huge profits the nation’s big banks were making. One director asked him: “Are we a dinosaur?”

Now, while many of those banks struggle to dig out from under a mountain of bad debt, Beal is acquiring assets.

Ozymandias by Percy Bysshe Shelley - Read by Ben Kingsley

Reader Question

A correspondent asks,

"My father wants to buy my son something for his 1st birthday - I assume he is thinking of something that he would consider repeating (if appropriate) every year. What do you think? What would you buy a one year-old for his birthday, if your objective was to set him on the road to financial success? Maybe this would be an interesting blog post/question? Some of your readers seem to like giving free advice!"

Ed Thorp on Arbitrage

"It all depends on how confident you are about your edge. If you have a really strong conviction about your edge, then the best thing to do is sit there and take your lumps. If, however, you believe there is a reasonable chance that you might not have an edge, then you better have a safety mechanism that constrains your losses on drawdowns. My view on trend-following was that I could never be sure that I had an edge, so I wanted a safety mechanism. Whereas for a strategy like convertible arbitrage, I had a high degree of confidence as to the payoff probabilities, so reducing exposure on drawdowns was unnecessary."

Patience

Charlie Munger:

We’ve probably made a significant decision every two years.

But nobody manages money this way. For one thing, clients won’t want to pay you.

But this is not fun, watching and waiting, for people who have an action bias. Too much action bias is dangerous, especially if you’re already rich.

It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.

Alone in Siberia

Wow:

"Famine was an ever-present danger in these circumstances, and in 1961 it snowed in June. The hard frost killed everything growing in their garden, and by spring the family had been reduced to eating shoes and bark. Akulina chose to see her children fed, and that year she died of starvation. The rest of the family were saved by what they regarded as a miracle: a single grain of rye sprouted in their pea patch. The Lykovs put up a fence around the shoot and guarded it zealously night and day to keep off mice and squirrels. At harvest time, the solitary spike yielded 18 grains, and from this they painstakingly rebuilt their rye crop."

Incredible. Infinite cost of capital, the evils of government and particularly communism. What they missed the most was salt.

Who Are the Suckers in the Market?

Stableboy wrote a post called "Who's the Sucker in the Markets Today" and asked whether there are "enough of them to feed the hedge funds?" I have some ideas about who the suckers are:

• Index investors (i.e. efficient market adherents). This is a free ridership problem. The philosophy of index investing is, "other people will make good decisions for me, for free." I also call it, "buying stocks at random." An enormous amount of capital is allocated this way. There is one trillion dollars just in index mutual funds, not counting ETFs or closet index funds. Notice, most of our good shorts have been owned by index funds and not active investors. I rarely find myself on the opposite side of a group of hedge funds; more likely to be retail investors and index funds.
• Dip buyers. This is a type of behavior that evolved during the 1982-2000 bull market. The prime example is Bill Miller - have you heard his saying "lowest average cost wins"? People still use this technique even though it is a spectacular failure.
• Obviously, people who buy worthless stocks. (My concept of the worthless stock inefficiency.)
• Baby boomers, as a class, are suckers, with a free ridership problem just like the index fund investors. As William Bernstein put it, "it is simply not mathematically possible, let alone politically feasible, to expect each worker to support 0.67 retirees, no matter how many coconuts, dollar bills, stock certificates, or Krugerrands they save up in the meantime." Thus, we have the aging population and therefore falling demand for what will be a great part of my lifetime. Which brings me to my next point:

Remember my concept of investor genotypes in an investing ecosystem? During the bull market (1982-2000) within a bull market (1932-2000), any style that stopped to consider the possibility of a bear market would have been maladaptive. If you think about it in terms of expected value, for any value of caution regarding a bear market, such a framework would only have lowered expected value and could only have been maladaptive. As a result, the "cautious genotype" has largely been purged from investing.

Stableboy quotes an author named Steven Crist, who was the publisher of the Daily Racing Form. I ordered two of his books: The Horse Traders and Betting on Myself: Adventures of a Horseplayer and Publisher.

Latest Hussman Column

"my greatest worry is that the challenges we've had during the recent cycle will provoke any of them to capitulate and chase the market at these levels, possibly capturing some short-term gains, but ultimately doing damage to their financial security."

Pressure to Invest

Earlier, I wrote about my China-avoidance policy and how it had kept me out of trouble. The reason this is a problem is that U.S companies have slowly disappeared from the deep value screens (e.g. net current assets), leaving only Chinese companies.

Coinstar (CSTR) Shows What Happens to the Momentum ("Relative Strength") Strategy

Coinstar (CSTR) is a momentum stock that had doubled in the past year. Right now it is down 25% in after hours trading after pre-announcing lower Q4 revenue and earnings than expected;

guiding $391 million, below the company’s prior forecast of $415 million to $440 million, and shy of the average estimate of $427 million. EPS is now expected in a range of 65 cents to 69 cents, versus a prior 79 cents to 85 cents. Analysts have been modeling 84 cents.

What's funny is that Zack's research put out a report on Wednesday titled WATCH FOR COINSTAR TO POTENTIALLY REBOUND AFTER FALLING 1.78% on Tuesday.

This is why the "buy the dips" / momentum / relative strength strategy is a loser in the long run. Let's say you had "bought the dip" in CSTR today based on the Zack's recommendation.

Sure, a company that rents archaic DVDs for a dollar at McDonalds could be criticized as overvalued or obsolescent, but that's not what's important! The thing has momentum! It has doubled in the past year - are you an idiot? You're missing out! Just set a tight stop loss order and "buy the dip!"

Except the company issues a surprise announcement that spooks your fellow owners renters of the stock and they dump it like a bad habit, and you get stopped out at a 30 percent loss. You have no conviction about the name - you only owned it because it was "going up" - so you walk away chastened.

As you know, the past several months have been really challenging for value investors. Junk has massively outperformed quality, all in the name of momentum.

In the long run, it is a great strategy to fade the rallies of junk. The long term trend is for quality (i.e. undervaluation) to outperform junk (failing businesses, etc.), so there are powerful mean reverting forces at work in the background.

All you have to do is be patient. If you are a value investor, time is on your side. If you are a momentum investor, you live on borrowed time.

New Weekly Market Comment from Hussman

Among the most zealous articles of economic faith here is the idea that additional "liquidity" provided by the Federal Reserve has to ultimately either "find its way" into the asset markets or produce an increase in economic activity, as if the economy and financial markets are simply a set of vessels to be filled.

This Week's Weekly Market Comment From Hussman

Hussman has posted his Weekly Market Comment. He comments on how his Fund had a slight loss, which

"resulted from our defense against an overvalued, overbought, overbullish, rising-yields condition and a runup in risk assets that was still unresolved as the year came to a close. While it was small from a long-term perspective, the decline felt excruciating in the final weeks of the year as stocks characterized by low-quality, low yield and high risk persistently outperformed those ranked higher in quality, yield and stability."

I concur wholeheartedly. His tone is very apologetic, and you can tell that he is really exasperated with the rally and the manic sentiment.

His bearishness is nothing to be apologizing for. In his fund, he has consistently created or preserved value for investors. If anything, he was not bearish enough during 2007-2008, basically treading water during a period when Credit Bubble Stocks was finding companies that were zeroes, like Bank United or Countrywide. [But, he vastly outperformed mainstream investors.]

Keep in mind that some of the managers who are most bullish now never sold their junk holdings, like New Century Financial or Downey Financial, even at the bitter end.

Recently, Hussman has climbed aboard my theory that the Treasury will not be able to "inflate its way out" of its very short maturity debt.

Buy the Dip

Xtranormal is fantastic.Probably worth about $5 billion?

Problems that Haven't Gone Away

European sovereign debt crisis
Fraudclosure crisis
Rising energy costs
The glut of casinos
Extremely high positive sentiment

Shortsellers, Stand Ye Steady!

"Buying on the Dips in Your Strategy"

[F]or a strategy with long-term positive expectancy, the appropriate response to a drawdown is to increase exposure – not reduce or eliminate it – on the view that the performance of the strategy will revert to its mean.

A strategy that has performed well over the long run should never be abandoned after a decline unless there is overwhelming evidence that something about markets or the strategy has changed so fundamentally that the strategy will never work again.

Extraordinary Popular Delusions

Toward the end of August, I was getting emails about Hindenburg omens every day. The S&P 500 has leapt almost 7% since then, and bearish sentiment has dried up.

Today on the CBOE, two equity calls are trading for every equity put.
Zero Hedge reports that corporate insiders sold $651 worth of stock for every $1 purchased last week.
Other sentiment indicators are showing that the bulls are overextended.

Equity Call Buying at Extremes Again

The equity only ISE sentiment index hit 276 today. This implies that retail traders are buying calls vs. puts at an almost 3:1 ratio!

To say that this is rare is an understatement. While we’ve only had this metric for a little over 4 years, out of 1070 data points, only 2 other days showed a bigger daily call binge: June 15th 2007 (280) and October 8th 2007 (279).