Sunday, October 13, 2013

Risks Found in this Week’s Readings


Each week I appear to be a one person research or reconnaissance staff looking through the information clutter trying to avoid Improvised Explosive Devices (“IEDs”).  I hope to dance through the minefield that is out there. Like most destructive forces they are initially hidden and like a wary animal I try to sense dangers before they become clear. My search approach is to look for possible analogies that could reveal dangers to all of our portfolios. This week there were four questions that popped up:

  • Possible ties between compulsive gambling and ETFs?
  • Are there parallels between the collapse of the Weimar Republic and the US?
  • Are there amateur real estate winners?
  • Is political arithmetic more important than budget math?

Is using ETFs a form of compulsive gambling?

In The Wall Street Journal’s Review section this weekend, there is an article entitled “The Real Odds On Gambling.” I am pleased that the source of the data for this discouraging article is from scholars in the UK supported by gambling business consultants in the US. The findings showed that the odds on winning big in casinos were stacked against the players 31 to 1, (31 losers to 1 winner).  The scholars also found on average, that gamblers who bet somewhat continuously over a two year period, 31 lost money for every one who made money in casino type games of chance. Poker players playing against other players did better winning about one third of the time. A number of poker players and casino players did win periodically. They kept their winnings by walking away from the tables.   

When I wrote the book Moneywise, I noted that two of my great learning institutions for adult life were the Racetrack and the US Marine Corps. Sorry about that Columbia University, where I joined the professional military through the Naval Reserve Officers Training Corps via a scholarship. Actually a good bit of my racetrack experience was learned while I was enrolled at Columbia full time, with an on campus job and a member of a world famous fencing team. What I learned by doing the math was that it was virtually impossible to walk away a winner for the racing season by betting every race. First there is the issue of racing luck/bad analysis/not picking winners. Second, the state and the track replaced the casino in terms of the take they took out of every bet. Finally, the New York betting crowd (possibly the same Wall Street players or their cousins that I competed with later) were too accurate juggling most of the track odds and the probabilities at winning.

I concluded that I materially improved my chance of walking away a winner by betting few and in some cases no races on a given day. Further I looked for opportunities where most of the attention was focused on predicting the winning horse and the odds on either of the first two or three horses aligned more favorably with my analysis of the probabilities.

What does this have to do with investing in Exchange Trade Funds (ETFs)? I believe a great deal. Over-simplifying, the bettor using ETFs is in for a fast trade, essentially betting against the market’s view of valuation; or else he/she wants to participate for an extended period of time (which is sort of like some of my relatives who wanted to cash a ticket so much that they virtually bet almost every four legged vehicle in the race). Both the short-term and long-term approaches do not have good odds on winning big, particularly when compared with other opportunities.  In truth, I should not be anti ETF as I own shares in publicly traded investment groups that are the sponsors of various ETFs. I have improved my odds by betting on the house rather than with the crowd. I will admit that I have used index funds in various institutional accounts to balance the concentrated investments of some active funds with broader and cheaper passive funds. However, I do not use them personally.

Possible parallels to the Weimar Republic collapse

The inspiration or perhaps more accurately my fear was generated by The Wall Street Journal, in this case a book review of “The Downfall of Money” by Frederick Taylor.  He describes the monetary trap that the German government, the Weimar Republic, found itself in attempting to pay off its high reparations debt calculated in terms of gold. Germany’s answer was to inflate the money supply to such an extent that the internal value of their currency collapsed. (In the week of the French invasion of the Ruhr to seize the coal it was owed, the Germans needed 7,260 deutsche marks for a US dollar. By October the purchase of one US dollar required 65 billion marks and this was not the final quote before the mark became worthless. Under such circumstances one should have seen that a charismatic leader who would fix things and repair the wounded German pride would arise to take over and indeed Hitler did. This part of the story is well known and should be taught in every school in the world.

What is not as nearly well known is the contention of the author that the economic problems actually started in August of 1914. In order to raise the money needed to feed their war machines each of the soon-to-be combatants began to inflate their money supply. By 1920 the purchasing power of the US dollar had declined by 50% since 1914. In reaction to the induced inflation one after another of the major countries returned to a gold standard pushing up the value of gold to offset the purchasing value of the internal currencies, thus wiping out arbitrage opportunities and the competitive advantage of various exporting countries. With this background we can understand the fears of some of the implications of the problems at the periphery of Europe, potential problems in Japan, China and clearly the US with its growing deficit. (At least for now our debt is all dollars based.) We could see at some time in the future a reversal of Franklin Roosevelt’s arbitrarily raising the price of gold behind the US dollar and Richard Nixon’s closing the gold window. (What a strange combination!)

These fears are a good reason that corporations are doing more of their business overseas and in some cases in local currencies. Securities investors should follow remembering that US listed securities represent less than half of the world’s securities.

Investing in residential housing has worked

In an article from the Financial Times it was noted that the UK wealth gap grows as homeowners save more but renters suffer. The article focuses on first time, but well off buyers of residences. They are intelligently reacting to some remaining softness in home prices, low mortgage rates and rising rentals. The same pattern appears to be happening not only in the UK but other countries including the US. There may well be a political as well as economic implications to this as more people begin to think of themselves as a “little bit wealthy” and change their spending, investing, and possibly their political habits.

The real arithmetic of the partial Shut Down

Both the trade press and the general circulation news media are focusing on the size of the current US deficit and the ability to pay the incurred debts. On the surface these are important, but are not the motivating drivers of the politicians leading the battle. For them the key numbers are 17 swing seats in the House of Representatives and 5 seats in the US Senate. If the elections bring additional cover for the Administration more socialistic laws and regulations should be expected. If the reverse happens there will be a stalemate on the legislative side leaving the actions to take place mostly on the regulatory front. The battle is being fought through various press releases and interviews on or off the record to influence the relatively small number of swing voters who will make up their minds in terms of local choices one year from now. Largely the long-term economic impact of what is finally decided in 2013 will have limited dollar impact by October of 2014. Thus the keys to watch are the growing changes of perceptions as to which specific local candidates will be considered less bad than the other person to fight for a better share of rewards for the swing voter. At this point delivery will be more important than wisdom

The Benjamin Graham Award

Earlier this week, I received the Benjamin Graham Award for Distinguished Service to the New York Society of Security Analysts. I have been active in the Society for more than fifty years serving the leadership with energy and advice. In a very brief acceptance speech I stated that I was delighted to get an award named after Ben Graham who was the spiritual godfather of the society. Having taken Security Analysis under his writing partner David Dodd, I was able to say that Ben taught us (including Warren Buffett) that one could lay out various principles but in the heat of the day do something different. (I believe this is an important realization for all who participate in the market at any level.) I also thanked the audience for the ability to give back to a business that has given so much to me.

How are you looking at the investment world now?        

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