“That men do not learn very much from the lessons of history is the most important of all the lessons that history has to teach.”
– Aldous Huxley, Collected Essays
“Would you tell me, please, which way I ought to go from here?”
“That depends a good deal on where you want to get to,” said the Cat.
“I don't much care where –” said Alice.
“Then it doesn't matter which way you go,” said the Cat.
“– so long as I get somewhere,” Alice added as an explanation.
“Oh, you're sure to do that,” said the Cat, “if you only walk long enough.”
– Lewis Carroll, Alice in Wonderland, 1865
Today, in the spirit of the wisdom the Cheshire Cat offers Alice, I would ask how you can know where you are now and where you’re going if you don’t know where you came from. You and I have lived through the first nearly 14 years of this topsy-turvy new century together, and many of its details as well as its overarching themes deserve to be recalled. But rather than offering you a dry, plodding recap of recent history, I’ve come up with a different and hopefully more fun way to revisit the past decade and a half.
I’ve been writing this letter for some 15 birthdays now, well over 10,000 pages of collected work. Every word is still at my website – a history, if you will, of what I was thinking at the time. I asked my longtime (and long-suffering) editor, Charley Sweet, to go back over this past decade and a half and give us a review of what I was saying my birthday week. When I perused what he came up with, a few things leapt out at me.
First, it turns out to be quite lucky that I was born in October, because when we assembled all the letters for the first week of that month, it turned out we hit on most of the big issues that came along in the first 15 years of the century: the tech-bubble collapse and ensuing recession; the actions of the Fed in the early ’00s, especially with regard to the housing bubble; the fundamental challenge – and promise – of accelerating change; the subprime collapse and Great Recession (including “the bailout”); the problems with Keynesian excesses at the Fed and other major central banks; the crisis in the Eurozone; and the healthcare crisis (and Obamacare).
Second, I could see my own thought process evolving and realized again how truly important it is to continually test your ideas in the marketplace.
The plan was to take a short stroll through the history of my letters to get a feel for how our world and my thinking about it have changed over time. As it developed, Charley presented me with a rather voluminous package of excerpts, one far too long to send out as a Thoughts from the Frontline letter. So I will have to viciously edit myself to make the retrospective more consumer-friendly for TFTF readers. But for those who are interested, we are posting the entire summary here (and it will remain available there).
As you read the entry for each year, think back on your own thought process and actions at the time. Surprisingly, as I did the same, it appeared to me that, more often than not, I “got it right” (even if I got it early). So let’s climb into the Wayback Machine and take a spin through the last 15 tumultuous years. We will begin with my call in October 2000 for a recession in 2001.
[Note: comments in brackets were written as we edited this. Everything else is verbatim from the original letters.]
The Probability of a Recession Grows
October 20, 2000
I get lots of mail from readers asking me to tell them if I think we will have a recession next year. I think I can say with some authority that making predictions can get you out on a limb. There are scores of variables that affect our economy. At any given time you can find trends that will seem to be pointing us to one conclusion, and other trends that might yield the opposite conclusion. It is only in hindsight that the pundits will tell us that we should have seen the most important trend all along. So instead of predicting a flat yes or no, I am going to assign some probability to the potential for a recession, and then as we go along I will either increase the probability or decrease it….
[If the yield curve is functioning as an accurate predictor of recession] we should be looking to see a recession next summer at the earliest and probably next fall. As I think back over the last few recessions, there were very few signs one year ahead that a recession was coming. For most economists and analysts, the recession was a surprise even one quarter out!…
Since the yield curve is an EARLY predictor, it would be more worrisome if we were seeing confirming signs in the economy now. That would mean the recession was probably going to be a very deep one. Thus we shouldn’t be surprised that we see no recession clouds on the horizon….
This year, the yield curve went negative for a few days in early April but has been decidedly negative since July 7. The worst the yield curve has been this cycle is a -.66, where it is today. The 90-day average is now -.40.
The Fed study says at this level there is approximately a 35% chance of a recession within four quarters. I would remind you that the study also says the probability should be raised somewhat due to the more fluid bond markets of today, so the number is probably around 40-50%….
That also means there is a 50% chance we won’t have a recession. But every time we have been at these yield curve levels for the last 40 years we have had a recession.
[A recession ensued in March 2001 and persisted through November.]
Rules of Engagement
October 4, 2001
[A month after 9/11 and a month before recession officially ended]
As far as the economy this week, not much has changed. Japan just gets worse and Europe is getting weaker, which means the US will have to lead the world out of a global recession. But our consumers are saving dramatically more and spending less, manufacturing is down, as is capacity utilization etc. etc. Long bonds are back to new highs. Same old, same old.
But the cavalry is on the way. The Fed cuts again and again and pumps $100,000,000,000 into the economy in a few weeks; Congress is likely to provide significant fiscal stimulus; and travel and business are starting to pick up again. I can hear the bugles, but I don’t see the troops yet. It is still not safe to get out of the fort, but it is time to make plans for the future….
We are now in a new type of war. The enemy is a few thousand individuals in 60 countries hidden in communities of millions, unknown to 99% of their neighbors, sympathized with and supported by nations and peoples who hate us for reasons most of America does not comprehend. They intend to first destabilize us, then demoralize us, and finally provoke attacks upon various countries and groups within the Islamic world. They will try to tell the poor of these countries that an attack upon Muslim terrorists is an attack upon all Muslims, turning their terror into a religious war. They hope to stir the Islamic masses to overthrow any moderate governments and install governments based upon the terrorists’ radical religious beliefs.
Faced with an enemy which is both deadly and disperse, with goals that don’t value the lives of either their enemies or themselves, and with a methodology of war that is unlike anything we have experienced in this country, we are now having to develop new strategies for conducting this war.
The Rules of Engagement for warfare have changed. I think it is fair to say that our nation, if not much of the world, has realized that. What would have been unthinkable only a few weeks ago is now promoted as necessary and wise by (almost) all parts of the political equation. It is clear that our military leaders are hoping to avoid the most costly and typical of all military mistakes: using the tactics of the last war to fight the current one.
All’s Turbulent on the Investment Front
I am going to suggest that the Rules of Engagement, as it were, for investing are changing as well. The advent of this war is going to accelerate that change. What has worked for the last 20 years is now going to frustrate those who want to use the old investing rules to fight the next investment war. If you do not see and adjust to these changes, in my opinion you will not be happy with your investment returns over the next decade.
[And you weren’t!]
History Versus the Fed
Longtime readers know I am a big fan of History. Central bankers, businessmen, and investors continually try to beat History to a pulp, and often win a few early rounds. Like Mohammed Ali and his rope-a-dope strategy, History lets his opponents wear themselves out throwing ineffective jab after futile blow. In the end, my man History always wins in the final rounds. Betting against History can look good for the first few rounds, as History looks drugged, but the outcome is always the same.
History told us there would be a recession in the fall of 2001 because of the inverted yield curve in the fall of 2000, which I wrote about in August and October of 2000. An inverted yield curve is always followed a year later by recession. Greenspan and the Fed fought back by aggressively lowering rates. They lost. Hopefully they can do better fighting deflation….
A little deflation is not the end of the world, if the Fed can “reflate” the economy. Prolonged, systemic deflation will not be good, however. It will lead to lower home values, which will hurt the housing market, which will hurt jobs, which will hurt consumption and trigger a serious recession.
The Fed increasingly understands this. Dallas Fed Research Director Harvey Rosenblum notes that “There is a distinct possibility inflation could morph into deflation.” Greg Weldon notes a recent strange comment by the Richmond Fed president: “The Fed knows what to do, if the Feds fund rate has been pushed to zero, and prices are falling.” As Weldon points out, that must mean that at least a few people in the Fed system think this is a distinct possibility.
There is a huge discussion on this issue going on inside the walls of the Fed. At least some of the leadership understands the problem. They need to act NOW. If Greenspan lets deflation get away from him, the next sword at his neck will not be the Queen knighting him.
The Nature of Change
My career path echoes that of a million other entrepreneurs and businessmen and women. We all deal with change. In fact, the amount of change that I have had to deal with is rather unremarkable. There are millions of people who go through far more abrupt changes.
Some of the changes were forced upon me. Some of them I willingly embraced. I have told my friends that I hope this is the last time I have to “reinvent” myself. [It was not.] I succumb to the fantasy that most investors have: that the trends of today will continue. And yet I know that this is not likely. The field in which I plow and reap is changing rapidly, and it is unlikely that in 10 years it will look the same at all…. [It most decidedly does not. The goal posts keep getting moved!]
When I began 30 years ago, there were no faxes, no overnight delivery, and phone service was expensive. Computers? Not until 20 years ago, and they were toys compared to today’s machines. It cost a lot of money to deliver a newsletter until just a few years ago; now the marginal cost is almost nothing. One or one million is pretty much the same to me.
Research was a visit to the library to pour through books, plus a few magazines and newsletters. Now I get scores of letters and articles every day delivered to my “mailbox,” plus an almost infinite amount of data at my fingertips using something called Google. I have almost five gigabytes of research and other articles from just the past few years stored on my computer, which I can search with a few strokes [how quaint]. To write a letter like this even ten years ago would take a week, after a month of research. Now I can access huge amounts of data each week, and I write the letter on a computer in about five hours on Friday afternoon….
International readers? Very few ever graced my musings in the last decade. Now I have thousands of international readers, often from some amazingly remote locations. Soon, I am told, my words may be translated into Mandarin.
In short, the changes have been dramatic. At times, I complain that it has been hard to adjust. A lot of times those changes were just plain not fun. Some of them were very expensive lessons….
Since I plan to write for another 30 years, I will probably witness another 2-3 cycles. I will see yet another secular bull market, in which long-only funds will be precisely where you should put your money. Some new technology will drive a fundamental change in the world. Things will change. We’ll end up in 2030 (or whenever) with a new cast of characters telling us that “this time is different.” Nanotechnology and/or artificial intelligence and/or cold fusion and/or whatever alchemy we invent in the coming decades will be predicted to somehow repeal the business and investment cycle that has prevailed since the Medes were trading with the Persians. It will be interesting to see if I can recognize when the “times are a’changing.”…
I am not certain about much, but I am certain about this: the future will be different than we think it will be today. We can plan and dream, but more than ever we need to think about Plan B and C and D. The odds are, your personal world is going to change dramatically in the next ten years. How you cope with the change, and even use it to make your life better, will be the measure of how well you thrive.
It is the unique ability of Americans to deal with change that makes me an optimist. We are going to have to face some very difficult changes, which, given the acceleration of change, will be even more challenging than what we have already faced. But coping with change is in our DNA. It is what we do.
I hope I can be part of your “let’s think about the future” planning for a long, long time. And I bet you we find the future far more fascinating and fun than we can even begin to imagine.
Horse Racing and the CIA
This week we explore in depth an essay on how we think from that bastion of investment analysis, the US Central Intelligence Agency. We look at the rookie mistakes made even by pros. I describe one of my own more embarrassing rookie moments and how it highlights an investment principle that the best-performing professionals always keep in mind. I finish with a note on what you can give me (and your friends) for my birthday. It should make for a lively letter….
Jim Williams, founder of the Williams Inference Center, recently sent me a pile of fascinating research which I am wading through. One of the first articles I read was an essay by Richards J. Heuer, Jr., entitled “Do You Really Need More Information?” It was published in a book called Inside CIA’s Private World: Declassified Articles from the Agency’s Internal Journal 1955-1992.
Buried among articles on how (and how not to!) to spy is this rather straightforward piece on what to do with the information you get and the problems with objective and accurate analysis that are caused by our human thought process. The essay is quite timely, even though it was written in the spring of 1979. While reading the critique, one could not help but wish that it would be required reading at the CIA today. Perhaps we could have avoided a few problems. But that is a topic for someone else. Our beat today is thinking about money.
I am guilty. Mea culpa. I am constantly researching, looking at (sometimes obscure) data, trying to discern patterns and trends. But what to do with all of it? How do we filter it into useful and investable ideas?
This article challenges the often implicit assumption that lack of information is the principal obstacle to accurate intelligence estimates…. Once an experienced analyst has the minimum information necessary to make an informed judgment, obtaining additional information generally does not improve the accuracy of his estimates. Additional information does, however, lead the analyst to become more confident in his judgment, to the point of overconfidence.
Horse Racing and the CIA
Heuer describes a study done about betting on horse races. They took eight professional handicappers (someone who sets the betting odds based on calculations of the outcome of a contest, especially a horse race) and asked them to rank 80 different pieces of data about a horse race as to what they thought was most important. Do you factor in the jockey’s record as well as the recent record of the horse? The weather? The competition? How much weight is the horse carrying? What is the length of the race? There are scores of variables.
Then the handicappers were given what they felt were the five most important pieces of data and asked to project the winner of a race (actual names and races were not given, so as to not bias the projections). They were also asked to rank their confidence about their predictions.
Now it gets interesting. They were then given 10, 20, or 40 pieces of what they had individually considered to be the most important information. Three of the handicappers actually showed less accuracy as the amount of information increased, two improved their accuracy, and three were unchanged. But as a group, their accuracy did not improve and in fact was slightly down.
But with each increase in information, their confidence went up. In fact, by the end, their confidence had in fact doubled. If they had actually been at the track and were betting, would they have doubled their bets as they became more confident? Human nature says yes, they would. But that confidence would not have made them any better predictors. They just doubled their bets, which magnified their gains or losses. Think of it like adding leverage to your stock portfolio.
“A series of experiments to examine the mental processes of medical doctors diagnosing illness found little relationship between thoroughness of data collection and accuracy of diagnosis.” Another study was done with psychologists and patient information and diagnosis. Again, increasing knowledge yielded no better results but significantly increased confidence.
The inference is clear and quite important: “Experienced analysts have an imperfect understanding of what information they actually use in making judgments. They are unaware of the extent to which their judgments are determined by a few dominant factors, rather than by the systematic integration of all available information. Analysts use much less available information than they think they do.”
Ah, Brave New World
Last week we looked at how technology has the potential to slow and possibly reverse aging within the next two decades. Marvelous cures for the main causes of death, including cancer, heart disease, dementia, and Alzheimer’s, not to mention the potential to manage weight, are in our future. Amazing innovations in communications are rapidly coming at us, too, as is an increased ability to process information. Hunger and malnutrition are in our sights, as we increase the ability to bring in harvests that yield more, as well as develop biotech and nanotech processes to manufacture food.
Further down the road, the ability to manipulate molecules at the quantum level will mean we can produce the materials we need at much lower costs. As we map and reverse engineer the software that runs our brains, powerful new software can be developed on machines, which can aid in the development of whole new technologies as well as allow us to directly access information and communicate with each other. It will mean I can get rid of this annoying keyboard, which is bouncing around as the plane I am on hits a little turbulence.
(At the end of the letter, I will speculate about how we invest in these trends. Next week, we get back to our usual beat of finance; but judging from the letters I am getting, a lot of you are enjoying the speculation about the future.)
Ray Kurzweil, in his latest book, The Singularity is Near, writes of an almost utopian future. For him, as well as others, such a future of marvels cannot come too soon. They see a transition to a world where we merge with our machines, allowing us to think and work at far faster speeds than our unaided biological “wetware” is capable of. And we’ll do it from bodies that do not succumb to disease or aging.
There are many objections to his work from a variety of quarters. To his credit, he does not dodge or ignore them. He spends almost a hundred pages in Singularity outlining the various criticisms of his views of the future and then rebutting them.
Ray sees us approaching a “singularity” or point in the future where humanity and machines evolve into something we would call distinctly post-human. At that point, things change in ways we cannot predict or presently even comprehend…. Ray sees this event as happening around 2045, with life extension from biotech and nanotech happening in the 2020s and 2030s.
The Inflation of Expectations
This week we had two more Federal Reserve members repeat what has become the theme for their chorus, but not one the market seems to be paying much attention to. It should be. The market believes the Fed will soon start to cut rates, perhaps as early as first quarter of next year. It is not altogether clear that this will be the case.
I must admit to being somewhat baffled as to the apparent disregard by the stock market for what I view as a tough environment in the medium term, with either a slowdown or a mild recession being suggested by numerous factors. [I was forecasting a recession the next month due to the yield curve, along with other factors.] While there are a lot of positive features to the economy, to me the risk to the economy still seems to be to the downside. I take small comfort in the fact that this perspective is shared by Fed Vice Chairman Donald Kohn, a very solid economist and financial market observer….
A Slowing Labor Market
Central to [the Fed’s] problem is the employment rate and consumer spending. Housing is definitely slowing down. At the height of the housing market, consumers (on a national basis) were borrowing almost 10% of their income as mortgage equity withdrawals. This cash-out refinancing added over 1% and maybe as much as 1.5% to GDP. Such re-financing has dropped to under 6% and looks like it is in freefall on the charts. Bernanke said in his speech that a slowing housing market could shave 1% off of GDP. GDP last quarter was 2.6%. Between housing and lower consumer spending due to less borrowing, it doesn’t take a lot to get that down to the 1% range.
There is a close correlation between housing prices and consumer confidence, and thus consumer spending. Consumer spending does not have to contract, it just has to slow down for it to have economic repercussions when home building is going to slow down over at least the next two quarters.
[Housing prices peaked in mid-2006, and by Dec. 2007 we were officially in a recession.]
The Slow Motion Recession
Let’s recall what John Hussman said earlier about recessions being caused by a mismatch between the goods and services supplied to the economy and the demand for them. In past recessions, this has generally come to a culmination where employment turns down relatively quickly and profits take a dive.
Let me offer a scenario where it might be different this time. In past recessions there were generally some portions of the economy that grew beyond the respective demand for their products or services and/or a bubble in some sector burst. Such an event happened relatively quickly, and it took some time for there to be a shift of employment to other sectors and for the economy to start growing again.
If we see a recession now, it is going to be because of the bursting of the housing bubble. But housing is different. There is no “mark-to-market” pricing. You can’t look up the value of your house on a computer screen like you can your stocks or bonds. People tend to think their houses are special. They know how much time and effort they put into maintaining the house, and experience has taught them that over time, if they are patient, they will get a good price for their home. They become reluctant to sell at a reduced price.
Enter reality. Home values are starting to fall, and in some areas by a lot, for several reasons. First, because homebuilders are cutting prices in order to move inventory off the market. They have to raise cash in order to pay back loans, even if it means losing money on the sale of houses. They are in survival mode.
A story on Bloomberg notes that some smaller home builders are selling homes at a 40% discount in order to raise cash. D.R. Horton put 58 condominiums up for auction in San Diego. Local real estate agent Steven Moran said, “I ran the numbers, and the condos sold for between 68 cents and 74 cents on the dollar, based on the original asking prices.”
The fact that some homebuilders may lose money is not a problem for the general economy. The problem is that anyone trying to sell or refinance a home in one of those neighborhoods is now going to see the value of their home come down – perhaps substantially – in the appraisal they will need for the mortgage. Appraisers look at recent sales of comparable homes to come up with a value for the home. If your neighbor’s home sells for 20% less, then your appraisal is going to come down 20% as well. And the amount of money you can borrow on your home depends upon that appraisal.
OK, then you can just stay in the home and make that mortgage payment. And if you made a conventional loan, that’s what you would do. You might not like the fact that your home is worth less, but you won’t go through bankruptcy and risk your other assets by not making the payments.
Except for about 2,900,000 home buyers who did not get conventional mortgages. [Says] good friend Gary Shilling:
Subprimes leaped to $1.3 trillion, or 73% of all Adjustable Rate Mortgages (ARMs), in the first quarter, a 17 times jump from 2001. And 57% of mortgage broker customers with ARMs were unable to refinance into new loans in August, given their low initial down payments and falling prices that have put their equity in negative territory. Estimates are that the cumulative loss on subprime mortgages will be $164 billion in home equity and cost financial institutions $300 billion.
The Curve in the Road
The “bailout plan” was passed. Will it work? The answer depends on what your definition of “work” is. If by work you mean no more government intervention and no further costly programs and a functioning market, then the answer is no. But there are things it will do. This week I try to help you see what might lie ahead around the Curve in the Road. We look at how the rescue plan will function, see what is happening in the economy, and finally muse as to whether Muddle Through is really in our future….
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