Market-timing and train-timing

We suppose it is understandable, but we are hearing lots of friends and acquaintances telling us they have pulled all their investments out of the market and gone to cash during this recent correction.

Typical are comments such as "I rode it down during 2008-2009, and I'm just not going through that again."

We remember the same level of skittishness among investors after the dot-com crash of 2000-2002 -- even after the recovery of 2003, investors were adamant when they said "I'm not going through that again."

While understandable, however, such sentiments are usually very harmful to long-term success. The only alternative to "riding it down" is jumping off and then knowing the right time to jump on again. As study after study demonstrates year-in and year-out, investors (and their advisors!) not only do not improve their returns that way, but rather destroy them.

As we wrote in a post at the very depths of the last market bottom entitled "Don't get off the train," trying to time markets is a lot like trying to time trains. If you make a mistake, you can get flattened.

As we always hasten to point out, our position of not trying to time market cycles does not mean that we embrace a pollyanna-ish "buy-and-hold at all costs" philosophy. On the contrary, we believe investors should be intently aware of what is going on in the businesses to which they give capital, and should not hesitate to pull that capital when there is evidence that something significant has changed at the business itself, whether with the leadership of the company or its growth prospects.

However, we don't usually hear investors saying "I'm pulling my money out of the market because the businesses I've given capital to are doing so poorly!" It's always "the market" swings that they are trying to time, and history has shown that the belief that one can do so is a delusion, but a "persistent delusion" that refuses to die (the term "persistent delusion," in fact, comes from a lecture on that very subject given by a Professor Henry Dunn of Harvard's Business School in 1939).

We don't suggest that investors switch from trying to time markets to trying to time trains. In fact, we would suggest that both are equally dangerous, and that the sooner this message is understood, the better.

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"Austerity" is often a code word for "anti-growth measures"

This segment from CNBC's Kudlow & Company yesterday is well worth a watch, because in the heated debate that takes place, the panelists touch on many of the important issues that we have been writing about for months, and that we believe investors should understand.

The clip features host Larry Kudlow, First Trust Chief Economist Brian Wesbury, Bank of Montreal's Andy Busch, and Stifel Nicolaus Chief Market Strategist Joe Battipaglia.

The topic of the hour, what to do about the Greek debt crisis, led to a host of significant topics.

At about 4:35 into the clip, Joe Battipaglia asserted that "they need to raise taxes and cut spending," which is the "austerity" prescription countries are force-fed when the IMF shows up at their door.

We believe "austerity" is a code word for "well-meaning but anti-growth measures."

As we discussed in a recent post, growth is the answer, and the way to promote growth and unleash human creativity (which exists in Greece and the rest of Europe, just as it exists everywhere else that there are humans) is to provide a predictable environment with low tax rates and stable money (low or no inflation).

Similarly, the role of government stimulus came up, with Mr. Battipaglia's assertion at the 6:00 minute mark that "you cannot address the debt problem unless you go with aggressive stimulus, which is what the US did to get ourselves back on track."

Again, we believe that government "stimulus" is another well-intentioned but misguided drag on economic growth.

History very clearly demonstrates that government stimulus actually depresses growth, as we wrote back when the first stimulus plan was being introduced in the US House of Representatives in January of 2009.

As for the view that "aggressive stimulus" is what got the US "back on track," we pointed out back in February's post entitled "How your view of the crisis of 2008-2009 impacts your understanding of today's big issues" that the wrong mental framework for viewing the crisis and recovery would lead to very wrong conclusions about many other related major issues.

The arguments in the clip above are worth considering carefully, because the questions that are being raised over in Europe really deal with what we have called "The question of our time."

Raising taxes, relying on government "stimulus," and bailing out creditors with other people's money are all ways to shackle human innovation and entrepreneurial activity, and to drive out the growth that is the only real solution to Europe's current problems.

The good news is that, as we explain here, we do not believe that the current Greek crisis is really that big of a deal in the long run for investors who seek out growth and innovation where they can be found.

Let's hope that the jam that they are in causes more people in Europe -- and for that matter everywhere else in the world -- to realize that the anti-growth policies that have been promoted for so long are actually the heart of the problem, and to explore something that will actually work for a change.

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More troubling analysis of Senate financial bill

New disturbing features of the so-called "Reforming American Financial Stability Act of 2010" continue to come to light.

The Wall Street Journal today cites Vanguard Chief Investment Officer Gus Sauter's concerns about a provision of the bill that he feels would enable the FDIC to play favorites among bondholders of a corporation undergoing resolution (see "Vanguard's Bailout Warning"). The actual powers proposed in the bill can be found in the Senate bill linked above, in sections 202 through 210, beginning at page 115.

This strikes us as an ominous development and one which should discourage investors from lending any capital to corporations which the federal government could decide are "systemically important."

Of course, if you are the Chief Investment Officer of a firm that advocates "indexing" as Vanguard does, you do not have the luxury of being selective with the companies to which you give capital. (We have explained some of the reasons we do not advocate indexing in previous posts such as this one, and the argument we made in yesterday's post that investors should seek growth whether they are investing in stocks or bonds also points out the problems with the "just index" approach).

While we do not advocate indexing, we are in complete agreement with Mr. Sauter that this aspect of the proposed bill is very dangerous.

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Growth is the answer: the primacy of human creativity

Today in the Wall Street Journal's opinion page, University of Chicago finance professor John H. Cochrane has a hard-hitting and powerful analysis of the Greek sovereign debt crisis and its implications entitled "Greek Myths and the Euro Tragedy" (hat tip: Scott Grannis).

It should be required reading for all those who wish to understand the situation through the clear lens of economic logic, rather than through the soundbites and misleading assertions that have been repeated ad infinitum by politicians and the media in recent weeks.

At the end of his piece, Professor Cochrane declares: "The only way to solve the underlying euro-zone fiscal mess (and our own) is to slash government spending and to focus on growth. Countries only pay off debts by growing out of them."

This is an incredibly important point on many levels, and deserves to be understood by all interested observers, including politicians and all investors. Economic growth is the answer to the fiscal woes of Europe, and everywhere else -- not "austerity" (a la the IMF), not bailouts, and not government spending.

Pioneering thinker, author, futurist, economist, and investor George Gilder provides some crucial insights into this concept in a recent interview with Switzerland's Daily Bell.

He makes several important distinctions and all of them point to the importance of one thing: human creativity, the real engine of economic growth. He focuses on this single magical ingredient rather than on red herrings such as "free markets" or "spending cuts."

At one point in the interview, he says "there can be no free markets without free entrepreneurs. Entrepreneurs are not tools of the market, they are creators of new tools. The entrepreneur precedes the market. Without him, there is no market." In a later related point he says, "I wrote more about the fruits of enterprise and creativity than about the perfection of 'free markets' themselves. Like 'perfect competition,' a cant of 'free markets' has become an excuse for oppressive regulations and controls. As markets are never finally free or competition ever perfect, critics can always find reasons for new beadles and bureaucrats."

To enable the human creativity that alone drives growth, George Gilder stresses the need for freedom, saying "Only freedom can enable innovation and empower progress." Specifically, in the interview he mentions low tax rates and sound monetary policy -- in other words, freedom from excessive taxes and inflation.

Later, he warns against "movement libertarians" who always prefer "the quixotic ideal (radical spending cuts) to the feasible improvement of lower tax rates."

It strikes us that this focus on growth (and its essential elements of human creativity and innovation) is what is missing from most discussions of current economic events, and even from most discussions of investment in general. Professor Cochrane has done investors a great service by framing the discussion of the Greek crisis in terms of growth, and by exploding the myth that spending cuts, creditor bailouts, or greater government spending of taxpayer funds (and the higher taxes that accompany them) can ever solve the problem.

Unfortunately, there are many politicians of all political stripes who do not understand this critical insight (see for example the recent comments from the independent National Commission on Fiscal Responsibility and Reform).

Investors should think about these lessons in light of their own investments. They should analyze every investment in terms of growth, whether they are lending money or buying shares. When you buy the bonds of a company, you are lending money to that company, just as Greek bondholders were loaning money to that nation. All countries, and all companies, are not equal in their current potential for growth.

In times when the obstacles to human innovation mentioned by George Gilder are on the rise (namely, taxes and inflation), seeking out reservoirs of innovation and creativity become more important than ever.

We have written about this subject at length in previous posts, and recommend revisiting some of them, such as "The Four Pillars," "What Benjamin Franklin can teach us about free enterprise," and "The Question of our Time."

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Another black swan?

In a blog post we published back in December of 2008, we discussed the term "black swan," coined by Nassim Nicholas Taleb to describe statistically improbable "large-impact events."

We argued then that the events of 2008 should have caused a major re-evaluation of the world's rush to embrace "investing" via quantitative "black box" strategies and the other monstrous offspring of the "modern portfolio" theorists who for decades have attempted to pin down the markets with their mathematical algorithms.

Interestingly, Dr. Taleb figures prominently in this recent Wall Street Journal article discussing possible factors in the chain reaction that caused major indexes to drop precipitously last Thursday in a plunge that left even professional traders shaken.

While the hedge fund for which Dr. Taleb is an advisor argues that their large bet on bearish derivatives "couldn't have caused the meltdown" all by itself, it does appear that their trade caused more selling from other major market players, resulting in a downdraft that fed on itself. Although Dr. Taleb was not necessarily involved directly in Thursday's events, it is ironic that the hedge fund near the center of the incident would be one associated with the author of The Black Swan: The Impact of the Highly Improbable.

We view this irony as confirmation of the lesson that we take from Dr. Taleb's "black swan" concept, which is that modern portfolio theory has led portfolio management down the wrong road for over thirty years, because unforeseen (or, in many cases, foreseen but dismissed as too improbable) "black swan" events have a way of showing up and overturning even the most carefully-constructed computer algorithm, quantitative strategy, or financially-engineered synthetic debt instrument.

It is amazing to us that sophisticated professional investment firms and hedge funds continue to rely on "black box" strategies in which the keys to the car they are riding in are turned over to a computer, especially after 2008 and 2009 wiped out so many black box practitioners.

As we wrote in our previous post, investors whose strategy is to own good businesses through temporary market cycles should not have been hurt at all by the sharp one-day plunge.

However, there is the very real likelihood that events like last Thursday's "flash crash" will cause regular investors -- who should have nothing to do with such black-box strategies anyway -- to reach the erroneous conclusion that what we would call "real investing" is a lost cause as well, and we believe nothing could be further from the truth.

We believe that the follies that led to last week's short panic should drive investors back to real investing (for more on what we think that term means, see here and here for example). This is a very important point that is not being explained by the media in the aftermath of last week's selloff.

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Don't panic!

The recent volatility in the market, coming only a year after the bottom of the most vicious bear market in recent memory, spooked many investors.

Many asked themselves, "Why would I want to leave any money in the stock market, where months -- or even years -- of gains can be erased in a single day?"

These investor jitters are understandable, and we remember the same phenomenon after the bear market of 2000 - 2002. However, it is exactly during such turbulence that a business focus, rather than a market focus, is most valuable to investors.

Back in November, 2009, we illustrated this very issue with a post entitled, "Would you sell your successful local restaurant because of a debt hiccup in Dubai?" At that time, markets were reeling over a debt crisis in the tiny Arab Emirate of Dubai -- a debt crisis that most investors have now forgotten all about, by the way.

While Dubai was a serious matter for the parties involved, we noted that it would be foolish for a local businessman to sell his successful business which he had spent years building just because of some panicky headlines about a situation on the other side of the globe.

Similarly, investors who own shares in well-run, growing businesses would be foolish to sell those shares because of a market gyration caused by concerns about Greece's overly generous welfare promises to government employees (unless those businesses are directly involved with doing large amounts of business with the Greek government).

This is part of the larger point we have made many times before about owning growing businesses through market cycles. This is not to say that investors should "buy and hold" -- far from it. Rather, we urge investors to make their capital allocation decisions based on the performance of the business, not the performance of the market.

As the chart above shows, the recent market gyration was severe, but investors who have ignored the day-to-day fluctuations were probably well served by remaining calm. While we are sympathetic to investors who fear that they can "lose all their gains for months or years in a single day," in fact they only really lose those gains if they sell into a panic (the fact that many investors, and their advisors, succumb to such fears is a key element in the consistently poor long-term performance captured in the Dalbar study year after year).

The markets are back up after it has become clear that Europe and the IMF will create a "safety net" for Greece and other irresponsible borrowers. There are potential inflationary consequences to this path, and we have written many times before that in an inflationary environment, owning innovative growing businesses is an essential foundation for preserving wealth. Investors should understand this perspective, and return to it when short-term gyrations generate that feeling of approaching panic.

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The question of our time

Economist Scott Grannis at his blog the Calafia Beach Pundit has an excellent post from May 5 entitled "The silver lining to the Greek crisis."

Towards the end of the post, after discussing some of the implications of the market reactions in bond yields and currencies around the world, he provides a completely different paradigm for viewing the ongoing Greek debt problem, as opposed to the point-of-view being offered by the financial media, which consistently depicts the situation in Greece as a major threat to the world economy.

Mr. Grannis writes: "Call me an eternal optimist, but this 'crisis' has a bright silver lining, since it focuses the world's attention on one of the biggest problems faced by all major economies these days: bloated government."

He goes on to ask, "What is so scary about cutting government spending? The only ones who will suffer will be the government workers that have been enjoying rising salaries, supremely generous pension and retirement benefits, and job security."

This is an exceptionally important point, and it highlights the issue of our time (or at least one of the top contenders for that title), which is that the cost of the generous pensions promised by many governments such as those in Greece and California (as well as by a few now-bankrupt automobile manufacturers) are unsustainable.

In order to receive a bail-out, the Greek government has had to enact "austerity measures," which is to say austere in comparison to the ridiculously lavish benefits they have grown used to. Predictably, there has been a backlash -- in this case a backlash that has proved to be both violent and deadly.

In the financial world, markets are down, and pundits in the media speak with concerned expressions in serious tones about what it all means for Europe and the world. However, to the extent that the crisis in Greece focuses attention on this issue -- truly one of the foremost economic issues we face in the current century, as well as the one fought over for most of the previous century -- we would join Scott Grannis in saying that there is a silver lining to the clouds over Greece.

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TED spreads and US debt

The "TED spread" (short for for "T-Bill/Eurodollar spread") is a measure of the difference ("spread") in yield between the three-month US Treasury bill and the three-month London Interbank Overnight Rate (LIBOR).

The measure is useful as an indicator of the difference in confidence lenders have when choosing to loan money to the US (buying US Treasurys) or to loan money to other developed nations (in this case, nations in Europe).

When the spread is low, lenders see little difference between the two as places to put their money.

However, when general fear of economic chaos rises, the demand for short-term US Treasurys tends to rise versus the demand for the debt in other countries, causing the debt of other countries to have to pay a higher yield to attract investment. In other words, the "spread" between the world's safest asset (US Treasurys) and the asset of any other alternative increases.

Looking at the spread between US Treasurys and Europe's LIBOR is helpful, because Europe is much more economically-developed than many other parts of the world, so a jump in the TED spread shows that investors are buying US Treasurys over even a relatively advanced alternative such as European debt.

Not surprisingly, the TED spread has been climbing as the Greek debt problem unfolds, as the chart above showing the TED spread for the past month clearly indicates (investors can find charts for the TED spread at Bloomberg).

This recent increase in the TED spread is nothing compared to the record levels reached during the panic of 2008-2009, as seen in the five-year TED spread chart shown below:

However, we bring up the subject of the TED spread to highlight the point that, when things get shaky, investors still run to the perceived stability of the United States, which continues to be -- far and away -- the growth engine at the heart of the world economy.

There is a certain line of alarmist rhetoric floating around in the broad economic dialogue which argues that US debt is in danger of losing its appeal and that countries around the world which hold US Treasurys (China being the country mentioned most often) will destroy America's ability to raise capital when they "dump" all of their US debt.

We believe this discussion of the TED spread should help investors see through this fallacious thinking. Other countries (or investors) do not buy US debt out of some sense of charitable intent. They buy it because they think it is a safe place to put their money -- in fact, the safest place in the world to put it. In periods of economic crisis, their demand for that safety goes up, in direct proportion to the perceived severity of the problem.

The fear that other countries will "stop lending" to the US is overblown.

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