THE GNOME OF ZURICH INVESTOR

In Search of the Obvious

noreply@blogger.com (The Gnome) — Mon, 21 Apr 2008 09:15:00 -0500

Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.
-- George Soros

One of the most interesting implications of this idea is that an investor is paid in the market not just for being correct--as most people think--but for being different. To make more money than average, you have to do something different from average. Being correct doesn't hurt, but being different is what pays the bills.

This is because most investors crave certainty and are willing to open their wallets for it, even if what they are getting is only the illusion of certainty. As a result, they almost always overpay for assurances about the future. This is exactly what Warren Buffett meant when he wrote that "you pay a very high price in the stock market for a cheery consensus."

Almost as a rule, investments that appear certain to succeed or market theses that seem certain to unfold are overvalued, while investments that have only a possibility of success are frequently undervalued--even if the potential payoff of the second group is far greater than that of the supposed "sure thing."

An exploitable anomaly, seemingly. So how can we put this idea of betting on the unexpected into practice?

Legendary hedge fund manager Michael Steinhardt used a mental model that he termed "variant perception." It sounds esoteric, but it translates roughly as "a different opinion."

In his autobiography No Bull, Steinhardt explains that he wanted his analysts to know four things about any investment opportunity:

1) the idea
2) the consensus view
3) the variant perception
4) a trigger event

This outline presents us with a strange challenge. How do we determine the "consensus view" on whatever subject we are looking for? In short, what is the "obvious"?

This may seem like a simple question to answer, and in many cases it is. In 1999-2000, it was obvious that internet stocks were going up. In 2005, it was obvious that home prices would rise forever. If it ever becomes obvious that stocks are going to go down forever, it will be time to buy them aggressively.

Still, when you apply the question to the flux of day-to-day market activity, it gets quite a bit more elusive. What is the "obvious" belief right now to be bet against? Bulls would say that everyone obviously expects the market to go down. Bears would say that everyone obviously expects the market to return to its previous highs.

To complicate matters further, the "obvious" belief may pointed in the right direction but not going far enough in that direction. For example, if it is obvious to most that we are in a mild recession (and it seems to be), the solution is not necessarily to buy stocks in anticipation of a recovery. It could instead be to batten down the hatches in preparation for a particularly bad recession.

All of this, combined with the seemingly weekly shifts in the consensus about what is "obvious," makes it a tricky time to be using this approach. Still, if the past is any guide, the markets will settle down into a new set of "no-brainer" ideas that we can then fade. I think we'll know them when we see them, but commodities and China seem set up to become good candidates at some point in the future.

Bear Gets Marked to Market

noreply@blogger.com (The Gnome) — Sun, 16 Mar 2008 20:54:00 -0500

It's amazing what having one of the most powerful investment banks in the world vaporize can do to focus your attention. Accomplishing much more in two business days than I ever have, Bear Stearns (BSC, if you dare) has fallen from over $60+ a share to what will probably be around JP Morgan's buyout price of $2.

I have to travel tomorrow (great timing, huh?), so I won't get to devote the time to this interesting situation that I would like to. But I did want to fire off some quick thoughts that were on my mind.

Please note that I've linked to some old posts here, and I have to cite George Bernard Shaw in my defense: "I often quote myself. It adds spice to my conversation."

Besides, the largest economic forces at play frankly don't change all that quickly. And for the most part I still believe everything I've posted about over the last nine months or so (that is: financials are dangerous, small-caps are dangerous, the dollar is being massacred, emerging markets are more dangerous than advertised, etc.) I don't get (or more accurately, steal) very many good ideas, but if another one comes across the desk, I'll keep you apprised.

We're now around 1275 on the S&P, a level I (and many others) think is very important. A break below here to the downside would be worrisome, since we could touch off a series of stops, accelerating a decline.

Of course, if we suffer a cascading meltdown, I will be sitting glumly in a plane somewhere, hungry and wishing I were short.

Drawing from the often-remarked-upon similarities between this market and that of the early 1970s (as that market came to terms with inflation and financial instability), I've recently been thinking of this market in terms of the two-stage decline in the 73-74 bear. By this line of comparison, we're around March of 1974, in which a break through support at 90 started a new cascading phase of the bear market. Similarly, if we break below 1275 on the S&P, I will be forced to act off of the idea that we have moved into the second phase of a runaway bear market. I'm expecting this sort of an acceleration to the downside, but am ready to be proven wrong.
Keeping with the title of this post, it looks to me like the JP Morgan buyout of Bear is effectively a mark to market of Bear's assets. The next question everyone has to ask (and, frankly, should have asked themselves a while ago) is: what are appropriate market values for other peer banks? You already know my opinion on Goldman. One thing I have always wondered is why assets that are supposed to be marketable yet have no market value have a book value of higher than zero. I suppose if I worked for a bulge-bracket firm it would make sense to me.
Along similar lines . . . a friend and I were discussing recently how there really hasn't been any panic in financials, despite the brutal declines we've seen thus far. We're still in the Oprah, hand-holding "thank God everything's going to be OK" stage. Well, to butcher an old saying, every panic contains a grain of truth. It may be that our bit of bad news has just arrived. Could the more thoughtful individuals out there who are holding stock in other i-banks start getting pretty hot under the collar?
I still think the Fed is checkmated. If they cut further (which they will, of course), gold will continue to climb. But the shock of cuts is wearing off, and I don't expect the inevitable "surprise" cuts to provide the same boosts to the upside as previous ones. The market could therefore continue to decline even with further cuts, particularly if those cuts begin to threaten the US price level. Anyway, remember that stocks fell during a substantial part of the Greenspan Fed cuts after the dot.com crash.
If I were inclined to be bullish, here's what I'd ask . . . if it's true that pessimism is as rampant as some accounts suggest, could this all be simply the process of putting in a bottom?
Anybody else wondering what the effects of the Bear collapse and the other turmoil could have on the world's $500 trillion+ derivatives market? As a point of comparison, the world bond market is estimated to be $45 trillion and the world stock market is estimated to be $50 trillion. No, that is not a typo. And yes, I realize that all of those positions are perfectly hedged and therefore we have nothing to worry about . . . if you believe in the perfect hedge.
Finally, financials and market reality, before and after:

Stay safe!

An Important Test

noreply@blogger.com (The Gnome) — Fri, 1 Feb 2008 16:26:00 -0600

A quick update . . .

After the recent rally, we're now at what I see as a very important test. We're about to find out if the Fed's huge injections of liquidity have indeed ended this bear market, as many seem to believe.

As far as I can tell, this rally is still pretty much textbook bear market behavior, and the long-term path of least resistance remains down.

Along these lines, the chart below implies that there are swarms of sellers in the 1400 range waiting in the wings to dump their stock into another leg up. Any new rally is going to have to work through this pretty serious supply overhang.

Stranger things have happened, of course. Look at 1998, for example, when the markets broke and then reflated with the help of well-intentioned central banks.

Because of precedents such as 1998, as well as the Fed's popular (though not official) mandate to keep equities from declining even at the cost of the purchasing power of the currency, it's absolutely essential to have circuit breakers in place so that if you're wrong you don't lose all your money if you're short.

I've been thinking about how to decide when this move will stop being "textbook bear market action," and when to admit that City Hall (Bernanke, Paulson, Bush) has won. And I still think that if the S&P seizes a position above 1400 and can prove that it can hold it, I will be forced to reconsider my strategy.

If this were to happen, it would be a frankly surprising show of buying power and one that would have to be respected.

In the interest of full disclosure, though, my humble opinion is that we look very well set up here for a potential retreat in the next week and eventually a retest of the 1275 lows on the S&P.

But the market's gonna go where it's gonna go . . .

Oh, and if you were wondering whether this sort of central bank behavior (panic 3/4 point rate cuts when the markets drop, encouraging new debt to solve a debt crisis, etc.) is good for the world in the long term, the answer is no.

A final note: if we do claw back up into the old trading range, the amount of new credit it's taken to pull us out of this natural market downturn is almost certain to inflate another huge bubble, possibly more than one. There's no telling for sure what it'll be, but those who guess correctly beforehand will make armloads of money.

I'll let you know where I think these bubbles might be if another leg up starts looking like a real possibility.

Otherwise, see ya at 1275!

Get to Know the Bear

noreply@blogger.com (The Gnome) — Sun, 20 Jan 2008 15:19:00 -0600

It's been a very ugly couple of weeks, and if the performance of global markets on Monday's Martin Luther King holiday is any guide, there will be some continued ugliness in the US markets this week too. I hope you all have been managing the carnage OK.

While we appear to be way overdue for some sort of bounce, it doesn't appear that it will happen tomorrow. It now appears that we are right in the middle of a bear market, with the decisive break having taken place below 1400. This drops us out of what I had been looking at as a long-term trading range between 1400 and 1550.

We're likely to have some very sharp rallies soon, but until we can get a foothold above 1400 and hold it, I believe that staying bearish is the right move.

So if the bear is going to be around for a little while, we might as well do like these guys and get to know him.

In a bear market all stocks go down and in a bull market they go up.
--Jesse Livermore

This quote might not literally be true, but I think it has more pertinence for the investor than the more antiseptic definition of "a 20 percent decline." In bear markets, things go down that shouldn't go down. Things go down that absolutely can't go down. Things go down that didn't even go up in the bull market. Things go down further than anyone ever thought possible, and then they go down more.

You can't really believe it until it happens to you personally, but I hope that at least some psychological preparation can help you keep your wits about you.

. . .

So what might we expect from a bear market? What should we be doing and thinking? I can't give specific answers, but here's some food for thought, along with some questions I've been asking myself . . .

As Random Roger frequently points out, market declines are nothing unusual.
For those who haven't spent much time in bear markets . . . rallies in bear markets are generally much sharper, dramatic, and emotionally charged than rallies in bull markets. This is because they are driven both by relief and by short sellers "covering" (buying back) their positions. Don't confuse the vigor of a move with its sustainability.
Check out Bespoke Investment Group's examination of historical NASDAQ bear markets (declines of 20+ percent).
The "uptick rule," which was intended to reduce market volatility and to keep speculators from thrashing stock prices around, has gone the way of the dodo. For the first time since the Depression, short sellers can now lean on the market and drive it further down without having to wait for a higher price to come over the tape. How is this change likely to affect market declines?
The uptick rule died in early July, 2007. Take a quick look at the above chart of the S&P and see if anything springs to mind.
Barry Ritholtz brilliantly borrows from Elisabeth Kubler-Ross to evaluate this market according to her "five stages of grief."
Get this book and read it now.
Basically everything in the world (except the US dollar) has gone up over the last 5 years. So where do we hide now?
Similarly, if you see bull markets as a rush of much-needed capital to undercapitalized assets, industries, and sectors, what happens to all of these destinations of capital when the rush has served its purpose by bringing the necessary supply on line?
Following from these points . . . could it at least be possible that the path of least resistance is now down for most of the assets that have seen money flow into them recently?
Given the world's massive and rising industrial capacity, the chances of a deflationary period do not strike me as zero in the face of a worldwide economic slowdown. I have to say that I do think that the deflationists' arguments have begun looking better lately.
The long trading markets of the 1970s provide a good road map for the current difficult situation. This old post may be worth looking at again.
What would have to happen for the market to recover and for the worldwide bull market to resume? What is our sign that this decline has been a fakeout and it is time to get long again? I've given you mine; you may want to think about setting up your own signposts now.
The Fed ended previous market declines in 1987, 1998, and 2001 with gargantuan injections of liquidity. With the dollar on the ropes, what options now remain? Is there any alternative that doesn't send gold to $2000/oz.?
Could all of these injections of money have convinced investors that truly brutal bear markets a la 1929-33 or 1973-74 are things of the past? Has the Fed inadvertently "trained" investors to try to hold their stocks at all costs?
Remember that the market didn't care about you when it was going up, and it doesn't care about you now that it's going down. It doesn't care whether you get even on your positions or whether you have enough money left for retirement in 10 years. Please accept that unpleasant truth and take appropriate steps.
Careful with the whole "emerging markets are safe havens" idea . . .
This chart from Crestmont Research is fascinating and extremely useful.
If we start a bear market from a market P/E near the long-term historical average (which it is now), then what kinds of prices might we see at the bottom? Mind-bendingly low ones, possibly?
There have been a handful of times in the last century when investors could go into the markets, buy basically anything with their eyes closed, and make fortunes. One was when the US entered WWII and Sir John Templeton had his broker buy him 100 shares of every US stock trading for less than $1. A little over 30 years later, in the terrible bear of '73-'74, Buffett made his Washington Post buy and his reputation. That was 30-odd years ago. If another opportunity like these comes along, will you be ready?
"Rarely do we find men who willingly engage in hard, solid thinking. There is an almost universal quest for easy answers and half-baked solutions." --Dr. Martin Luther King, Jr.

Best of luck, and stay safe.

All That Glitters at Goldman

noreply@blogger.com (The Gnome) — Mon, 7 Jan 2008 09:12:00 -0600

So, the common understanding is that Goldman Sachs (GS), which had greater percentage exposure to "Level 3" or so-called "mark-to-model" assets than either Citi or Bear Stearns, escaped the subprime crisis, Indiana-Jones-like, completely unscathed.

After the stock crashed in July with all the other ibanks, it dutifully "uncrashed" through September as it was revealed that Goldman was short the very subprime mortgage bonds that they were marketing, as Ben Stein discussed in early December.

In the middle of this improbable success, I've been wondering . . . is it possible that Goldman's choice not to write down its Level 3 assets (a term that means that they have little or no exchange value and therefore must have a value applied to them) has been postponed until 2008 in order to keep the books together for something as trifling as end-of-the-year bonuses? Could we soon see write-downs from Goldman now that these bonuses are safely housed?

I would never argue that this is happening, because I don't know. . . But I believe that it is possible, and that the thesis would help explain an extremely unlikely rally in a company that common sense would tell anyone is in this credit crunch waist-deep. I also think that I'm receiving good odds here, and the chance of any such shenanigans (which would imply a crash in Goldman beginning basically now) is easily large enough to compensate for the risk involved.

As Jack Handey once said, "What is it that makes a complete stranger dive into an icy river to save a solid gold baby? Maybe we'll never know."

Disclosure: the author is short Goldman Sachs (GS)

A Primer on Value

noreply@blogger.com (The Gnome) — Tue, 1 Jan 2008 09:12:00 -0600

When I started investing, it took me a lot of time and legwork to get a handle on exactly what "value investing" meant. So in an expression of my bounding holiday cheer, I decided to collect all the information I wish I had known when I started investing. Here's hoping this collection of links and discussion smooths the path for others, and maybe provides some old hands with helpful review material too.

WHAT "VALUE INVESTING" IS

Charlie Munger, Vice-Chairman of Berkshire Hathaway, believes that "all intelligent investing is value investing." Others find the term "value investing" redundant, insisting that only a careful consideration of value to be received from a purchase can be properly labeled "investing" at all. So what, exactly is "value investing"?

The short answer: Buying dollar bills for fifty cents.
The long answer: here's Warren Buffett on "Inefficient Bush Theory," from the 2000 Berkshire Hathaway Shareholder Letters (via berkshirehathaway.com) . . .

"Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was "a bird in the hand is worth two in the bush." To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush -- and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.

Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota -- nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component -- usually a plus, sometimes a minus -- in the value equation.

Alas, though Aesop’s proposition and the third variable -- that is, interest rates -- are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.

Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let’s call this phenomenon the IBT -- Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights.

At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.

Now, speculation -- in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it -- is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities -- that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future -- will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

Last year, we commented on the exuberance -- and, yes, it was irrational -- that prevailed, noting that investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged 19%. That, for sure, was an irrational expectation: For American business as a whole, there couldn’t possibly be enough birds in the 2009 bush to deliver such a return.

Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value. Yet investors, mesmerized by soaring stock prices and ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them.

This surreal scene was accompanied by much loose talk about "value creation." We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get.

What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the "business model" for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.

But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street -- a community in which quality control is not prized -- will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.

At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it. Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to "A girl in a convertible is worth five in the phonebook."). Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores."

(source: http://www.berkshirehathaway.com/letters/2000.html)

PILLARS OF THE VALUE OUTLOOK

Intrinsic Value: The underlying economic worth of a business, as distinguished from market price. Definitions vary considerably, running the gamut from estimated liquidation (breakup) value to calculations of probability-weighted averages of possible future cash flow scenarios. Generally, though, I would say that any appropriate intrinsic value estimate should account for the future amount of cash to be taken out of a business by shareholders, weighted by the probability that that cash will be received, and adjusted by an appropriate discount rate. This definition, heavily informed by Buffett's above discussion, accounts for virtually any scenario that the value investor will confront -- from determining the value of a real estate holding company to Google -- and it's the one that I use.
Margin of Safety
Mr. Market

WHY BE A VALUE INVESTOR, ANYWAY?

Here are some compelling arguments for thinking about the markets in value-oriented terms.

Warren Buffett, The Superinvestors of Graham-and-Doddsville
Tweedy, Browne Co.., LLC. What Has Worked in Investing

MANY WAYS TO SKIN A CAT

As you might imagine from Buffett's above assessment of the value hunt as a pursuit that rewards flexibility, there are a number of different paths by which an investor can approach the value "promised land." Here are just a few examples.

BOOKS TO READ

Once you've digested these, you'll want to study the following very carefully:

BLOGS

Thanks to the internet, you can look over the shoulders of experienced investors as they pursue some of these strategies. Here are some excellent blogs to subscribe to.

Hope these give a helpful introduction. Have a great New Year.

Liquidity Zombies

noreply@blogger.com (The Gnome) — Wed, 5 Dec 2007 20:49:00 -0600

Because of all the conflicting signals this market is throwing off lately, I have few very firm convictions about what is going to unfold over the next several months.

Since there is nothing to do as I see it, I'm not doing anything, with a couple of small exceptions I'll explain later. I remain fairly defensive. This leaves me very vulnerable to a sustained upward push in the market.

The dollar pessimism appears to have reached an apogee for the medium term, and I believe that the path of least resistance is now up for the dollar. Although my long-term view on the dollar is very bearish, I am now net long the dollar, but not by much. My US cash position is hedged with positions in the Swiss franc (FXF), the yen (FXY), and gold (GLD).

I retain several unsexy long positions in Berkshire Hathaway B-shares (BRKB), which has proven a surprising winner as a haven of liquidity in a liquidity-starved world, Johnson & Johnson (JNJ), and the Toronto-listed former Saskatchewan Wheat Pool, now called Viterra (VT.TO).

The fact that I am neutrally positioned does not mean I don't have expectations about what is likely to unfold, though. It just means that I don't currently see a way to exploit these expectations profitably.

For example, here is what I expect and am watching for . . .

I believe that the market is currently in a long-term topping process that is nearly complete. The sharp up days smack to me of short-covering, and are exactly what you would expect from counter-trend rallies. We've moved into a long-term trading range between bull (S&P above 1550) and bear (S&P below 1400) markets.

(yahoo.com)
Where we break out from here should determine the direction for another year or so. My guess is that the direction will be down, but since I'm not forced to act on that sentiment, I choose not to do so. I'm no perma-bear. If we go up, we go up.

And when my money's all gone
I'm on the telephone
Hollering "Hey hey mama
Can your daddy come home?"
Johnny Horton, "Honky Tonk Man"

Unfortunately for the cause of real global growth, the threat of further US dollar flagellation by holders in Asia and the Middle East means that "Mama" (the Fed) has to think twice about using her money (liquidity) to bring Daddy (the broke honky tonk man) home.

I do find it difficult to imagine a new leg of the bull market beginning without a huge injection of liquidity of some sort or another, which would crush the dollar. However, the extreme negativity and the almost universal conviction that financials are in big trouble could provide more surprising pressure to the upside. So I remain agnostic.

Liquidity Zombies

Despite the current churning, I believe that there are some concerns bubbling beneath the economic surface that have not been fully discounted by the market. The world economy contains a number of non-self-financing, debt-reliant, easy money-coddled "zombie companies" that exist simply because of the lush liquidity environment of the past five years. Not only have these walking dead thrived under the unprecedented infusion of liquidity, but they have grown their tendrils around it, changing their function and their purpose to exploit cheap money.

We've already uncovered a couple of these in Fannie Mae (FNM) and Countrywide Financial (CFC), but the transformation of the US economy from a service to a financial economy has left many other companies--General Electric (GE) comes to mind--much more beholden to the credit markets than most people are generally aware. I also believe that liquidity has put much of the sheen on today's emerging markets, and that many high-flying "miracle economies" could find themselves in deep trouble very soon.

The Small-Cap Trap

Domestically, I believe the most fertile ground for such liquidity zombies, if they do in fact exist, is the small-cap arena. It's important to remember that there was a time when large companies commanded a premium in the marketplace to small companies because of the much greater likelihood of failure among these small companies.

No longer. The iShares Russell 2000 ETF (IWM) is priced at 17.7x earnings versus the S&P 500's 15.7. The Russell 2000 has well outperformed the S&P since 2000, a long enough period that there are many people in the market today who have never encountered a real small-cap bear market.
(yahoo.com)
Having never experienced a brutal small-cap bear market personally, they follow age-old Wall Street custom and deem such a thing impossible.

The big picture supply-demand of stock supports this view. Small-caps seem to have begun a new downtrend, marked by lower highs and lower lows. This seems to be a crowded trade, but there should be enough room for everybody.

(yahoo.com)

I've been taking occasional shots at these on the short side via TWM (the Russell 2000 UltraShort), without much success so far.

If the current illiquidity does not get better, and quick, I believe the carnage among the small-caps will surprise a lot of people.

Links of Fury

noreply@blogger.com (The Gnome) — Wed, 14 Nov 2007 20:16:00 -0600

Only the best for my readers.

Inflation in China is at an 11-year high. People over there have been getting more and more upset for months over rising consumer prices. The PBC is going to have to take this inflation threat seriously, which places upward pressure on Chinese interest rates. Don't look for a return to the kind of footloose lending that drove this boom.
Ken Fisher argues that this bull market is being driven by the yen carry trade. When the yen goes up, the assets it's being borrowed to buy go down. A spike in the yen could spell real danger in the global asset markets.
Has the backlash against Cramer begun? I've always wondered what would happen to Cramer when the bull market ended. Will he be tarred and feathered like all other bull market gurus when his disillusioned followers blame him for their mistakes? We may be about to find out.
Bill Gross surveys the subprime damage.

Other Thoughts . . .

Is the eye-popping oil-natural gas spread exploitable? The obvious--too obvious--play is to be long NG, but I need to know what I'm missing. If you follow NG closely and have an opinion on this, drop me a line.

If you are one of my purely value-minded friends, please turn away from your computer right now so you don't vomit all over it . . .

I'm still short the financials, but I'm ready to be proven wrong. We'll probably pop back up to 34 or so in the next few weeks, but I have a moral obligation to be short this chart long-term. Prove me wrong, banks.

I'm not a nut for moving averages, but my own experience suggests that decisive crossovers (and retests, like we have here) of the 200-day are good for catching the beginnings and endings of very large, long-term trending moves. Here's the 5-year chart, which shows that we're below the 200-day while the average is declining for the first time in this bull market. Make of that what you will (also, notice the tremendous support around 30 that should keep this market from going straight down).

Smallball

noreply@blogger.com (The Gnome) — Mon, 12 Nov 2007 17:23:00 -0600

Because of the choppy market these days, I've recently been investing somewhat differently than usual.

Ideally, I'd like to have lots of money invested in companies that I hope will offer prospective long-term returns of somewhere north of 20-25 percent per annum. I don't see any right now, but I hope that within the next two years we may see enough of a decline (or at least a sideways market while earnings rise) that I can get some money into great companies that are deeply undervalued.

But because I don't want to be sitting on huge, moderately undervalued long positions in this fragile market environment (with the exception of extremely financially secure companies like Berkshire Hathaway and Johnson & Johnson), I've been playing "smallball" instead. I've been taking gains of 10-20 percent on both the long and the short side when they present themselves and then reverting some position that approximates neutral.

I think of this strategy as hitting singles rather than home runs. I'd like to be Barry Bonds, but the market isn't offering that chance, so Ichiro will have to suffice. As far as I'm concerned, it's just not longball time right now. Just as a matter of probability, home runs are going to be much rarer in the fifth year of a bull market than they would be in, say, 2002.

This smallball strategy is very conservative, and has forced me to leave money on the table at points. For example, I was heavily short Countrywide Financial (CFC) and D.R. Horton (DHI) during the August breakdown, but covered them far too quickly.

Still, I think that the ability to remain liquid while seizing the occasional opportunity has made up for these lost profits. The whole idea is to maintain my capital in real terms so that when it's time to play longball again (read: prospective long-term annualized returns of 20% or greater), I will have enough money left in my pockets to play.

What Keeps Me Up at Night

noreply@blogger.com (The Gnome) — Sun, 11 Nov 2007 23:54:00 -0600

It's well past midnight here in Oklahoma, and I'm having some difficulty sleeping. I've been thinking and re-thinking my positions as we go into what is likely to be an eventful week in the markets.

I suppose I could have more serious problems keeping me up. Lady Macbeth (pictured) sleepwalked because of the guilt of having the King of Scotland's blood on her hands.

I suspect that my subconscious somehow knows when I've left myself overexposed, and won't let me relax until that exposure is dealt with. So I'm going to think through my positions yet again . . .

First, I worry that I could be overexposed against the dollar with my substantial gold position. I bought gold as it broke out above $700/oz, but as we run closer to gold's all-time nominal high reached in 1980 of $850, we should hit some pretty stout selling. Additionally, pessimism is rampant, and I'm not comfortable staying in a crowd that is this committed to one side of the trade.

I have to determine whether I'm going to be happy with a quick 20 percent or if I'm willing to put up with some turmoil in order to see gold through above $1000/oz, which I believe is on the way. My current stance is to stick it out and hang on, but that view will take a lot of stomach if a gold decline pulls back into the $600s. It isn't fun to see a perfectly good profit disappear on principle.

. . .

I'm also concerned about the very sizable short position I have against US financials as they appear to have started breaking down . . .

I've been bearish on financials for some time, and remain so. My research convinces me that the credit downturn has much further to go, and that people who think that banks can write down $300 billion in assets and then continue on their merry way frankly haven't done their homework.

Credit crises are crises of faith. When people stop believing in the value of an asset, whether it is the US dollar or the value of a mortgage derivative, they don't just begin believing again.

Particularly strange to me are the "value investors" who are piling into the financials they now call "bargains." I have no idea how these people, many of whom quote Warren Buffett and Ben Graham like scripture, have determined the asset values of these companies when even the companies themselves don't know what they're worth.

I would urge buyers of financial stocks right now to really think their purchases through. The analyst consensus for EPS growth at Citigroup (C), for example, is 8% over the next two years, just 2 points below the growth rate of the last five years.

Exactly where is all this growth going to come from, particularly since the i-banks are in the process of dismantling one of, if not the highest-growth areas, the packaging and selling of derivatives?

I believe that even 8 percent growth is too optimistic. Like the tech stocks in 2000 and like the homebuilders in 2006-2007, the financials' growth rates will not just slow, they will go negative. The investment banks are going to go into the red, and the 7 P/Es will, like those of the homebuilders, balloon out into double digits as the earnings denominator shrinks while the price numerator declines more slowly.

For these reasons, I've avoided financials for some time (Berkshire Hathaway being the main exception), but the apparent breakdown in the form of lower highs and lower lows is finally giving me reason to act against them aggressively.

However, as I look more closely at the chart, I realize that could have been more patient. I should have bought half of my position at current prices and then waited for the rally that should be here next week to retrace to 33 or so, where I could sell the rest short.

The volatility of this ride isn't going to be fun either, but I would be surprised to see the financials make new highs here.

That said, I accept that it could happen. If they begin a new uptrend, I'll get out.

Don't let the bedbugs bite.

The painting of Lady Macbeth is by Henry Fuseli, German-Swiss painter who was from Zurich.

James Grant Interview

noreply@blogger.com (The Gnome) — Fri, 9 Nov 2007 22:33:00 -0600

James Grant of Grant's Interest Rate Observer has a view of the current financial situation that is very similar to my own.

Grant also sees an unusual problem created by simultaneous credit and currency troubles, and believes that we are right in the middle of what he calls an "Old Testament credit crisis." Wish I'd come up with that term . . .

Check it out.

Checkmate for the Fed?

noreply@blogger.com (The Gnome) — Wed, 7 Nov 2007 19:20:00 -0600

For the first time since the 1970s, the United States is facing the potential of a serious banking crisis and a serious currency crisis at the same time.

So it appears that the stopped-clock permabears may be right, at least for the time being. Let me explain . . .

The Fed's customary solution to financial problems has, of course, been to pump money into the financial system when it is under strain. This strategy worked OK in 1987, after the Asian Crisis (despite creating the tech bubble), after the tech crash (despite creating the housing bubble and the current credit bubble), and during the first phase of the subprime crisis. Bears have each time proclaimed each crisis to be the end of the world, and their fears have always been overblown. And of course, the world won't end this time either.

But I believe that the current situation differs slightly from previous crises, for a single reason: today's Fed faces much steeper consequences for resorting to its favorite solution of credit injection.

Today's dollar market has stopped shrugging off injections of credit. Worried about the decline in the dollar, people now appear to believe that rate cuts and other forms of liquidity injection and preservation plans (the super-SIV plan) place enormous further downward pressure on the dollar. The Chinese, in particular, are reacting to worries about the weak dollar by dumping it and threatening to dump more, which is what most people paying attention have expected to happen for several years.

In many ways what we have is a financial crisis that is based in a crisis of belief. People around the world have stopped giving the dollar the benefit of the doubt simply because it is the dollar.

Notice how the gold ETF has continued to rise after the September surprise half-point rate cut, even while the bank index appears to have received little benefit from these cuts . . .

(Yahoo! Finance)

What does this mean? It means that the Fed's primary weapon of liquidity/credit injection has begun to backfire.

Further injections of liquidity, surprise or otherwise, will almost certainly endanger the dollar, to the point of sparking a free-for-all to escape from it among foreign holders. The Fed, in short, appears to be checkmated.

You have to make your own judgment about how you want to be positioned here, but I am currently positioned very short the money center banks via the Financial Select Sector SPDR (AMEX:XLF) and long gold (via GLD).

If the Fed chooses to try another bailout (the most likely development given its previous behavior), the run on the dollar could turn into a rout, driving gold past $1000/oz. If the last cuts are any indication, further bailouts shouldn't provide a great boost to the banks.

If the Fed opts not to bail out the banks, XLF will really be in for it, and gold should not suffer.

However, a dollar rally (way overdue) will decimate my gold position, so I will be very wary.

Additionally, my current sense from looking at the price action is that the "Smartest Guys in the Room" at the banks are trying desperately to get out of these stocks before everyone else realizes how bad the crisis really is.

Please remember that these are my opinions, and you must formulate your own investment strategies.

The Fed is full of smart people, and it will be quite interesting to see how and if they can escape from this pickle . . .

Dr. Doom Interview

noreply@blogger.com (The Gnome) — Mon, 5 Nov 2007 23:15:00 -0600

There are only a handful of people you'll ever see on TV that are worth listening to on financial subjects.

Jim Rogers is one. To complement the other day's Rogers interview, here's an interview with Marc Faber, the Michael Jordan of bearish commentary.

Understanding Writedowns

noreply@blogger.com (The Gnome) — Sun, 4 Nov 2007 12:35:00 -0600

This is a skill that's going to come in handy over the next year or so, particularly when evaluating financial companies.

Here's a good primer.

Macro Reflections

noreply@blogger.com (The Gnome) — Fri, 2 Nov 2007 10:30:00 -0500

Although my basic outlook on the market is value-based, I frequently like to commit the Grahamian sin of thinking through the major economic factors affecting asset classes in order to determine what markets I want to be in. Quantitative analysis only gets you so far.

I do this is by framing hypotheses about the main story in each asset class. Once I have formulated these, I sit and wait. Over time, the markets either prove or disprove them, and I adjust my stance accordingly.

I discard the hypotheses for two reasons. Either 1) They are proved wrong or 2) They have been proven so completely that they are common knowledge, and are therefore fully valued.

An example of the first was my belief at Google's IPO that it was overvalued, and that it would be dangerous to buy a company trading at 50X earnings. So I opted to sit it out. This is obviously a decision I regret, and it has forced me to accept that a few extraordinary companies are worth paying up for.

An example of the second was my belief this year that U.S. financials were extremely weak and quite vulnerable to the problems of rising interest rates. This view was proved correct, and so I reduced my bets against financials . . . although I still do expect this situation to worsen considerably.

Here are the hypotheses I currently subscribe to:

1) ACCELERATING INFLATION.
The world is in a period of accelerating inflation which still remains largely unrecognized, fueled both by 1) decades of underinvestment in commodities (creating the current supply-side problems) as well as 2) loose credit from the world's central banks (demand pulling prices up).

Money supply in many areas worldwide is growing at double digits . . . and the arguments of individuals who defend the CPI calculations leave me pretty blank. To understand why the Fed understates inflation, you have to think about the Fed's motivations as people rather than as an institution. They are afraid of economic slowdowns, but also of wage inflation.

The moment that the average person begins to realize that his or her cash is being destroyed, they demand higher wages, which pushes prices higher, and so on (the wage-price spiral). "Fixing" the CPI to understate inflation is a way to avoid this extremely unpleasant outcome.

POSITIONING:
Stocks (which should continue to rise until people realize that inflation has been driving the bull market)
Hard Assets (which I will begin to buy once wage inflation begins)

2) DOLLAR TROUBLE REDUX.
This is obviously something that everybody and his grandma are worried about. So I agree with Jim Rogers that a rally--probably a huge one--is in the offing soon.

Still, the dollar is in for still more hurt over the long term in my view. As George Soros explains in The Alchemy of Finance, because so much of a currency's value is collateral value, the decline in a currency tends to picks up speed as it goes.

This applies especially well to the US dollar right now. The dollar is valuable throughout much of the world because, as the world's reserve currency, it is seen as a store of wealth. But each decline in the dollar further erodes its value as a safe haven, thus prompting more selling. So the selling spiral is likely to accelerate until there is a crisis.

Add to this the fact that there is no real constituency inside the Fed or outside of it that wants to see the dollar defended, and it looks like the path of least resistance is down.

This hypothesis has been very profitable so far, although there is likely to be some turbulence soon with the coming dollar rally.

POSITIONING:
Gold
Swiss Franc (FXF; an excellent currency)
Berkshire Hathaway (Large overseas currency holdings as well as increasing commitment to finding earnings streams in overseas companies, such as the Iscar purchase)

3) EMERGING MARKETS' PROBLEMS ARE MASKED BY CHEAP CREDIT.

I discussed this point before.

POSITIONING:
Prepare to go short in these areas at signs that credit is drying up. Emerging market banks will be especially vulnerable . . . as their loan portfolios go bad, they will go under.

4) THE WORLDWIDE BOOM IS PULLING OIL ALONG.
I have been long oil for some time for the simple reason that I can't see how oil prices are going to decline when the global credit boom (described above) is throwing so much money into the pockets of the industrializing world for capital expenditures and personal consumptions (cars, specifically).

I'm not a "peak oil" believer, per se, but I think some of their arguments are great, such as the fact that OPEC member nations are incentivized to overstate their reserves, allowing them to ramp up output. This means, of course, that worldwide crude stocks are vastly understated.

This has worked well so far, but I'm beginning to worry that a bullish consensus is forming on oil . . .

As part of this outlook, I also like oil exploration companies. If you look at the bull market in oil stocks over the last several years, the market has gone up almost entirely because of higher earnings. P/Es haven't expanded. I believe that if the bull market in oil stocks is like every other bull market in history, eventually P/Es will rise to reflect the growth these companies have shown, and we could see these stocks double very quickly.

Right now, you can buy the iShares Oil and Gas Exploration Index for 5.6 times cash flow. It's likely to do well even if oil prices collapse, and you have no company risk.

POSITIONING:
Oil (USO)
Companies that are leveraged to higher oil prices (IEO)

Note: I currently hold the following securities mentioned in this article: BRKB, GLD, IEO. I will try to remember to include these disclosures, though you have my word that I am not using this blog to try to move the world gold price in my favor.

Jim Rogers FT interview

noreply@blogger.com (The Gnome) — Mon, 29 Oct 2007 12:59:00 -0500

I have to say I've learned more over the years from Rogers' take on the markets than from anyone else.

So here's a four-part interview with the original gnome of Zurich investor.

"Lynch Rebates"

noreply@blogger.com (The Gnome) — Fri, 26 Oct 2007 14:56:00 -0500

Most people today who write about value investing emphasize discounted cash flow valuations and various other techniques that rely on projections of future earnings or cash flow in determining the intrinsic value of a stock.

That's fine. But if you read the beginning of Graham and Dodd's 1940 edition of Security Analysis you find that Graham's entire argument for asset-based investing is that projection of current earnings trends into the future is inherently an unreliable exercise. Anticipating today's behavioral economists, Graham understood far better than most (with the help of being bankrupted by the Great Depression) that we as investors are not nearly as accurate in predicting the future as we think we are.

To fight this bias, Graham argued for investment in stocks that had share prices trading at less than two-thirds of their net current asset value. Buying cheaply in this sense, or at any other deep discount to readily ascertainable corporate value, meant that an investor didn't have to predict anything to make money.

Many extremely literal readers of Graham and Dodd (we could call these "value fundamentalists") took this advice to mean that investors must only buy Graham's "net-nets." So they sat around through the second half of the twentieth century with their hands in their pockets as the population of always-rare net-nets thinned out further and further.

Peter Lynch introduced a brilliant solution to this problem in One Up on Wall Street, a book that is far too often caricatured as a simplistic "buy what you know" manifesto. Lynch's technique is to take the net cash of a company--that is, cash on the books net of long-term debt, and apply that figure to the share price as a "rebate" of sorts.

Here's an example of how this works . . .

Take 4Kids Entertainment (NYSE:KDE), which licenses the rights to use Pokemon and several other children's entertainment franchises that may or may not have value.

The stock closed today at $16.85. According to the most recent balance sheet, the company has 105.64 million of cash and liquid short-term investments, along with no long-term debt. For the sake of simplicity, this is assuming that there are no substantial lease obligations or other obligations that are not readily ascertainable from the balance sheet. That gives us a figure of about $9 a share in cash or assets readily convertible to cash.

So you subtract that $9 from the share price of $16.85, leaving you an effective share price of $7.85, since you're getting paid 9 bucks to hold each share. So you're buying the business at about a 53% discount.

You then compare that $7.85 to the value of each share of the business to see whether the business is worth that discounted price. I don't know if the business at 4Kids is attractive at that price, but it's clear that it's considerably more attractive than it would appear without getting this sort of discount.

In my experience, this technique is a terrific way to find businesses at extremely attractive values.

Disclosure: I do not own shares of KDE.

China Goes Parabolic . . .

noreply@blogger.com (The Gnome) — Wed, 10 Oct 2007 11:11:00 -0500

See for yourself.

I believe China is headed for a 1929-style wipeout, which will be bad news in the short term for them, but good news in the long term as they implement a range of market and economic controls that mirror those imposed in the US depression era.

China now has the financial clout of a world power, but the market infrastructure of an emerging country. This is great for them on the upside (the above chart) as it accelerates the boom, but is going to make the bust equally ugly.

And unlike Japan in the 1980s, I don't believe China has a stable, coordinated-enough banking system to prop its equities up indefinitely.

We're likely to see some great opportunities in China over the next 5-7 years--I mean the exact same companies now, but at PEs of 3-5.

Keep your powder dry.

Reading Berkshire's Chart

noreply@blogger.com (The Gnome) — Fri, 5 Oct 2007 10:24:00 -0500

I've found that Berkshire Hathaway (BRK-A), run by a man with no use for technical analysis, is more technically driven than just about any stock I deal with.

That may not be the definition of irony, but it's not far off.

I guess this is because 1) there are not many traders who want to swing 115K chunks of stock around and 2) the stock attracts people who are thinking in the long term anyway.

Look at how BRK has struggled to clear each major round number, then usually dutifully held above it.

I'm holding the B-shares, which basically mirror the performance of the A-shares. Are we about to see a break above 120K?

Quiet Booms

noreply@blogger.com (The Gnome) — Fri, 5 Oct 2007 09:17:00 -0500

Those of us who live in commodity-producing areas have noticed something recently that many others haven't: the commodity boom is beginning to make its way into the broader economies of these areas throughout the US and Canada.

Cash generated by high prices for tangibles is trickling out into banks, real estate, luxury purchases, and capital investment of every part of North America that has an economy reliant on production or distribution of "stuff."

Minyanville's Ryan Krueger, for example, sees a petrodollar-driven boom unfolding in the oil-refining region of Port Arthur, Texas.

There has been some scattered coverage in the national media about this. Both New York Times and the Los Angeles Times have noted Houston's boom-town characteristics over the past year.

By the time it's all said and done, Houston will prove to have been just the first (and probably the biggest) of many of these kinds of booms.

Dallas, Denver, Kansas City, Oklahoma City (where I live) and other centers of commodity production and distribution will experience similar effects on capital investment, luxury spending, and high-end real estate as oil, grains, livestock, and metals prices remain high.

Maybe it's some facet of this boom-time mentality that has rich OKC oil execs barely able to disguise their lust for other cities' sports teams.

The point I would take from this whole phenomenon of quiet booms, as illustrated by Mr. Krueger's observation, is to avoid letting a blanket conviction obscure the potentially profitable subtleties of a situation.

You don't want to let the idea, for example, that "all real estate is going down" lead you astray any more than the thought that "all real estate is going up" led many investors astray several years ago.

Gross national figures can be illusory: there's no reason an economy or an asset market has to correspond to a national boundary.

They say "all real estate is local." Well, all economics is local, too . . . and it's worth it for an investor to pay very close attention to what's really driving the economy of a particular area before those numbers get folded into GDP.

An Emerging Consensus

noreply@blogger.com (The Gnome) — Wed, 3 Oct 2007 12:25:00 -0500

Recently, more and more investors and journalists have begun to argue that the center of world financial gravity is shifting decisively away from the US.

There's an emerging consensus that emerging markets are the place to be for the near future, and potentially for longer.

This author points to the fact that increased accumulation of foreign reserves has put many emerging market countries in the position of being net creditors, describing emerging markets as being in a "golden age."

The Washington Post has a piece that is even more eyebrow-raising, showing how hot money is pushing further and further out along the risk curve by investing in "frontiers" around the world. For a potential target, the piece even points to the hyperinflationary disaster that is Zimbabwe, once one of Africa's most promising states before the tyrannical Robert Mugabe (pictured) single-handedly ran it into the ground.

Past performance, of course, doesn't necessarily have any bearing on what's going to happen in the future. It's worth looking at the explosive growth these markets have already experienced over the last five years, though.

All the "golden age" talk has me skeptical. Emerging markets' expansion has run in lockstep with the unprecedented credit expansion in the developed world beginning in 2001-2002, and as we know, a rising tide lifts all boats.

We have yet to see how these countries will respond to slowing growth in their primary export markets, or if they truly are as immune to the need to access credit markets as the bulls contend.

My opinion is that the emerging market talk is evidence that the longtime market advance is probably picking up speed as we enter a euphoric phase. Viable investment opportunities are saturated with capital, so creative investors are moving to places that aren't really viable, as they assume that the bull market will continue forever.

Speculators should see this as an opportunity to ride a sector that is beginning to go parabolic, and may have already begun to do so.

Long-term investors, however, should tread lightly. All of this stuff should be available in the future much more cheaply, after these countries have proven that they can thrive when credit is not so plentiful.

A Bubble in Retrospect

noreply@blogger.com (The Gnome) — Mon, 1 Oct 2007 13:09:00 -0500

Barry Ritholtz's excellent summary of the housing market's woes got me thinking as he discussed David Lereah, the former chief economist for the National Association of Realtors. Lereah wrote a number of ill-advised and ill-timed investment books, ranging from tech stocks to real estate.

In 2005, Lereah published Why the Real Estate Boom Will Not Bust, which looks fated to become an inadvertent classic of bubble-market psychology, taking its place alongside James Glassman's Dow 36,000 and the South Sea Bubble-era launch of "an undertaking of great advantage, but no one to know what it is."

I was curious about what people said about the book when it was published, so I looked back at the oldest reader comments from Amazon, circa 2005.

What I found was interesting. The first thing that jumped out was that a few people recognized that following the book's bullish advice would be dangerous.

But at the same time, the emotional momentum remained with the bulls. As you move from older to newer comments, you can see the bulls disappear and the bears gain confidence as the comments shift from optimistic to dismissive.

I think this little exercise shows that--contrary to the views of Alan Greenspan and others--it's entirely possible to identify financial bubbles as they are going on.

The trick is having the stomach to resist the crowd. I have to say that it does gets easier, though, as you experience and read about more historical bubbles.

Here are a couple of books that will help out by giving you indigestion at stories of monks who day trade:

Edward Chancellor, Devil Take the Hindmost: A History of Financial Speculation
John Kenneth Galbraith, A Short History of Financial Euphoria
Charles Kindleberger, Manias, Panics, and Crashes

The Gnome's 10 Most Valuable Financial Reads: Honorable Mentions

noreply@blogger.com (The Gnome) — Thu, 27 Sep 2007 10:43:00 -0500

Before I start on the top 10 Most Valuable Financial Reads, here are the honorable mentions, divided by category:

Fundamental Investing:

Philip Fisher, Common Stocks and Uncommon Profits: why sell a quality business? This book is the most cogent defense of buying great companies and hanging on as long as they stay that way.
Joel Greenblatt, You Can Be a Stock Market Genius: A silly title, but the content is sound. Don't believe that there could be a book explaining bankruptcy investing to a middle-schooler? Well, here you go.
Robert Hagstrom, The Warren Buffett Way: The best place to start learning about Buffett. New readers should be aware, though, that the Buffett bag of tricks is quite a bit deeper than this book lets on.
John Neff, Neff on Investing: A very humble and matter-of-fact introduction to what Neff calls his "low P/E shooter" investing style. It blends biography and investing strategy seamlessly, showing the stomach it took to stick to his guns, particularly in the rough-and-tumble 1970s.

Technical/Trading:

Nicholas Darvas, How I Made $2,000,000 in the Stock Market: The title is ridiculous, Darvas's risk management leaves much to be desired, and some have questioned if any of this ever really happened. But this is still probably the best introduction to how stock prices work. Plus, you can read it on a Saturday afternoon.
Edwards and Magee, Technical Analysis of Stock Trends: The Bible of technical analysis. The sections explaining the logic behind support and resistance work are unmatched, anticipating by more than half a century much of what modern behavioral finance is only starting to discover about how people think about and act toward their stocks.
William O'Neil, How To Make Money in Stocks: Great investment book or cross-promotion machine for Investor's Business Daily? Well, a little of both. Clearly O'Neil hit on something with his CANSLIM strategy. The problem for the serious investor is that it's difficult to integrate the CANSLIM method with other approaches (let me know if you've done this successfully). The problem for the serious reader is the incessant IBD trolling.
John Train, The Money Masters: A group biography of highly successful investors, this is one of the best ways to gain quick exposure to a variety of fundamentally based investing styles. The chapter on Robert Wilson's harrowing Resorts International short is classic.

Macro/Other:

Jim Rogers, Investment Biker: Primarily a travelogue, the parts of this book on macro investing are among the most useful material any investor can read, and aren't really duplicated anywhere else. Really understanding Rogers's approach to global investing is one of the most valuable investments you can make with your time. Now if he would just write a book that focused purely on his investment style. Are you listening, Jim?
Victor Sperandeo, Trader Vic: Methods of a Wall Street Master: This eclectic read provides a great introduction to Austrian economics suitable for investors, very helpful definitions of a trend and a trend break, and deals with the emotional side of trading to boot.
Nassim Taleb, Fooled By Randomness: An excellent discussion on how randomness, by definition, cannot be controlled for, and how we frequently ascribe to skill much that is in fact produced by variance.

Next installment: Most Valuable Financial Read #10.

Links of Fury

noreply@blogger.com (The Gnome) — Wed, 26 Sep 2007 12:23:00 -0500

The Economist wonders if the global age of stable growth is over
Returns around the globe since the start of the bull market I didn't realize how high the P/Es were in China. Good thing those stocks always go up . . . as the day trading monks have already informed us.
Investing with the stars--literally
Oil's not made of dead dinosaurs? The Russians have what you could call a contrarian opinion on the nature of so-called "fossil fuels" . . .
Goodbye, Age of Agriculture . . . It's been a great 10,000 years.
The Kirk Report's link post is the daddy of them all

Napoleon on Investing

noreply@blogger.com (The Gnome) — Tue, 25 Sep 2007 06:20:00 -0500

A quote that applies well to finance, courtesy of Napoleon Bonaparte, of all people:

"The whole art of war consists in a well-reasoned and extremely circumspect defensive, followed by rapid and audacious attack."

Replace "war" with "investing" or "trading" and you have a pretty succinct blueprint for doing well.

The point, of course, is to obsess over covering your tail. . . but to strike quickly and decisively when the situation warrants it. I could think of worse advice to follow.