Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt - By James Montier

Synopsis from Advisor Perspectives (link to complete paper on GMO's site: HERE):

Markets aren't efficient. Academics refuse to jettison the efficient market hypothesis, despite evidence of its role in the recent crisis. As the 11th Circuit Court of the United States wrote in a recent opinion, "All bubbles eventually burst, as this one did. The bigger the bubble, the bigger the pop. The bigger the pop, the bigger the losses."

Relative performance is a dangerous game. Like the efficient market hypothesis, its offspring the capital asset pricing model also rests on flawed assumptions. It commits fund managers to relative performance rather than absolute performance, which leads them to follow market weightings when picking stocks rather than their own good ideas.

The time is never different. Bubbles are identifiable before they burst, and knowledge of the history of bubbles can help preserve capital. Each bubble inflates and bursts in five phases, identified by John Stuart Mill in 1867: Displacement, credit creation, euphoria, financial distress and revulsion.

Valuation matters. The principles of value investing tell us to buy when the market is cheap and sell when the market is expensive. This means, however, that we must be prepared to not be fully invested when equity prices are unattractive.

Wait for the fat pitch. The average holding period for a stock on the New York Stock Exchange is six months. This myopia creates opportunities for investors who are willing or able to act on a longer time horizon and wait for the "fat pitch" - the time when valuation figures are just right.

Sentiment matters. Market sentiment swings like a pendulum from irrational exuberance to despair. It therefore pays to be a contrarian investor. Young, volatile, unprofitable "junk" firms generate the best returns when sentiment is low. Mature, low volatility, profitable "quality" firms produce the best results when sentiment is high.

Leverage can't make a bad investment good, but it can make a good investment bad! Adding leverage onto an investment with small returns doesn't turn it into a good idea. Leverage can limit staying power, and can turn temporary impairment into a permanent impairment of capital. "Financial innovation" is usually just thinly veiled leverage.

Over-quantification hides a real risk. Risk is not volatility. Rather, risk is the permanent loss of capital. We would be better off abandoning out obsession with measurement and instead focus on the three main paths to permanent loss of capital: Valuation risk (buying an overvalued asset), business risk (fundamental problems) and financing risk (leverage).

Macro matters. Ignoring the top-down view of the markets can be incredibly expensive. The credit crisis showed precisely how a top-down view of the markets can inform and enrich a bottom-up perspective. Investors who understood the impact of the bursting of the bubble avoided financials, while those who focused on the bottom-up saw cheapness, but missed the value trap resulting from the bursting credit bubble.

Look for sources of cheap insurance. Insurance is often a neglected asset. Insurance virtually guarantees short-term losses, but also provides a big payout if an event occurs. It is best to avoid purchasing insurance right after an event occurs, because that is when it is most expensive.

Welcome Disagreement. Avoid Argument.

Warren Buffett has stated that throughout his and Charlie Munger’s long relationship, they’ve had disagreements but have never had an argument. In How To Win Friends and Influence People, Dale Carnegie made the case that disagreement is good because it allows one to get at the truth and maybe find errors, while argumentation usually results in one becoming more adamant and entrenched in his or her beliefs. The objective way in which Charles Darwin worked – where he paid special attention to disconfirming evidence and then worked to find the truth – is also a good example of the progress that can be made by paying attention to opinions that contradict one’s beliefs. And Mr. Munger has also discussed the benefits of being willing to change one’s mind and destroy one’s best-loved ideas. As his Investing Principles Checklist says: Continually challenge and willingly amend your “best-loved ideas”

Some Suggestions from Dale Carnegie on

How to Keep a Disagreement from Becoming an Argument

from How To Win Friends and Influence People

Welcome the disagreement. Remember the slogan “When two partners always agree, one of them is not necessary.” If there is some point you haven’t thought about, be thankful if it is brought to your attention. Perhaps this disagreement is your opportunity to be corrected before you make a serious mistake.

Distrust your first instinctive impression. Our first natural reaction in a disagreeable situation is to be defensive. Be careful. Keep calm and watch out for your first reaction. It maybe you at your worst, not your best.

Control your temper. Remember, you can measure the size of person by what makes him or her angry.

Listen first. Give your opponents a chance to talk. Let them finish. Do not resist, defend or debate. This only raises barriers. Try to build bridges of understanding. Don’t build higher barriers of misunderstanding.

Look for areas of agreement. When you have heard your opponents out, dwell first on the points and areas on which you agree.

Be honest. Look for areas where you can admit error and say so. Apologize for your mistakes. It will help disarm your opponents and reduce defensiveness.

Promise to think over your opponents’ ideas and study them carefully. And mean it. Your opponents may be right. It is a lot easier at this stage to agree to think about their points than to move rapidly ahead and find yourself in a position where your opponents can say: “We tried to tell you, but you wouldn’t listen.”

Thank opponents sincerely for their interest. Anyone who takes the time to disagree with you is interested in the same things you are. Think of them as people who really want to help you, and you may turn your opponents into friends.

Postpone action to give both sides time to think through the problem. Suggest that a new meeting be held later that day or the next day, when all the facts may be brought to bear. In preparation for this meeting, ask yourself some hard questions: Could my opponents be right? Partly right? Is there truth or merit in their position or argument? Is my reaction one that will relieve the problem, or will it just relieve my frustration? Will my reaction drive my opponents further away or draw them closer to me? Will my reaction elevate the estimation good people have of me? Will I win or lose? What price will I have to pay if I win? If I am quiet about it, will the disagreement blow over? Is this difficult situation an opportunity for me?

………………..

And some related advice from Ben Franklin:

I made it a rule to forbear all direct contradiction to the sentiments of others, and all positive assertion of my own. I even forbid myself, agreeably to the old laws of our Junto, the use of every word or expression in the language that imported a fix'd opinion, such as certainly, undoubtedly, etc., and I adopted, instead of them, I conceive, I apprehend, or I imagine a thing to be so or so; or it so appears to me at present. When another asserted something that I thought an error, I deny'd myself the pleasure of contradicting him abruptly, and of showing immediately some absurdity in his proposition; and in answering I began by observing that in certain cases or circumstances his opinion would be right, but in the present case there appear'd or seem'd to me some difference, etc. I soon found the advantage of this change in my manner; the conversations I engag'd in went on more pleasantly. The modest way in which I propos'd my opinions procur'd them a readier reception and less contradiction; I had less mortification when I was found to be in the wrong, and I more easily prevail'd with others to give up their mistakes and join with me when I happened to be in the right.

And this mode, which I at first put on with some violence to natural inclination, became at length so easy, and so habitual to me, that perhaps for these fifty years past no one has ever heard a dogmatical expression escape me. And to this habit (after my character of integrity) I think it principally owing that I had early so much weight with my fellow-citizens when I proposed new institutions, or alterations in the old, and so much influence in public councils when I became a member; for I was but a bad speaker, never eloquent, subject to much hesitation in my choice of words, hardly correct in language, and yet I generally carried my points.

In reality, there is, perhaps, no one of our natural passions so hard to subdue as pride. Disguise it, struggle with it, beat it down, stifle it, mortify it as much as one pleases, it is still alive, and will every now and then peep out and show itself; you will see it, perhaps, often in this history; for, even if I could conceive that I had completely overcome it, I should probably be proud of my humility.

Robert Cialdini: How to be persuasive? 7 persuasive & persuasion techniques

Found via Simoleon Sense.

Related books:

Influence

Yes!

-

Eddie Lampert's Letter to Sears Shareholders

I just finished Thomas Sowell’s most recent book, Intellectuals and Society. For those not familiar with his writings, Thomas Sowell is one of the clearest and most insightful writers of our era. I look forward to every book and column he publishes. In this book, he discusses the “vision of the anointed” and how their views shape society regardless of their merit. He describes how often these views conflict with reality without altering these views and, paradoxically, sometimes strengthening them. I couldn’t help noticing the parallels between his comments and the “vision of the anointed” in the financial and business world over the past few years.

Business leaders, regulators, public officials, and journalists have become an echo chamber of self-support and self-congratulation, whether on TV, in print or at numerous conferences. Their words and their actions are often self-serving (whether right or wrong), and they are typically regarded and reported on as if they were obvious and selfless. They get repeated as if there were no alternative views or possibility of error in their thinking. Dominant narratives develop and get defended primarily by repetition and secondarily by attacks on those who disagree with those narratives. When these favored people and views become endorsed in laws and regulations, some may benefit, but many get harmed.

There are several examples of issues that have been smothered by dominant narratives. Accepting these narratives without critical evaluation can be a contributing factor to some of the negative unexpected consequences they produce. Did the seizure of Fannie Mae and Freddie Mac (the largest nationalization in our country and likely in history) calm or ignite fear in the financial markets and did those urging or supporting the seizure profit from it? Has raising minimum wage rates helped or harmed the individuals that those advocating such policy intended to help? Is there any link between a higher minimum wage and high unemployment? Has the consolidation in financial services helped or hurt depositors and borrowers? Why were some institutions saved and others seized, merged or left to fail? How does regulatory and policy uncertainty impact investment and risk-taking in society?

I fear that Americans have been provided a false choice between a little more and a lot more regulation and taxes. We keep hearing more ideas to create jobs and generate growth that almost exclusively require more government spending. Jobs can come from government, but those jobs get paid for by taking money from the private sector, reducing the private sector’s ability to provide jobs. On the other hand, there are many who believe that less regulation, less government interference, less arbitrary regulation when it does exist, and lower government spending will generate more growth and more jobs. I agree with those views.

As one of the largest private sector employers in the United States, Sears Holdings recognizes the challenges of finding good talent, developing good talent and keeping good talent. We have created not just new jobs, but new job categories and job descriptions as our industry changes and as new technology provides both new opportunities and new challenges.

Some contend that there is an inherent conflict between labor and capital, yet they fail to appreciate that without investment there will be no growth and no jobs. For there to be investment there needs to be an expectation of profit, and, for there to be an expectation of profit, there needs to be hope and belief in the future and confidence in the rules of the game.

The straw man frequently used to justify more regulation and to criticize free markets is to assert that the proponents of free markets blindly believe that they always work and that they always produce good results. Most free market advocates don’t actually make this claim, and they know that it is not true. Free markets respect individual rights and freedom, preserve choice and accountability, and produce superior results compared with non-free markets. When free markets experience problems and produce poor results, critics are fast to proclaim that things would have been better if only there was more, but better regulation. However, in most industries and societies where there is more regulation, there is typically lower growth, lower employment, and less innovation.

Self-regulation is a better idea and it is a better choice, whether for an individual or a corporation. Any corporation can choose to limit or make investments, increase or decrease compensation, and manage risk at different levels. Companies can compete by promoting their “safety and soundness” or by their “willingness to take risks.” Investors, customers, and workers can choose which companies and their associated behaviors and philosophies appeal to them. Let the media and politicians explain, compare, criticize, and contrast the various policies, so there will be little doubt that success or failure is determined by choice and not by ignorance. Then, make sure that government doesn’t reward failure and punish success by interfering with outcomes based upon political contributions, undue influence, or the personal beliefs of the policymakers.

………………..

Related book: Intellectuals and Society

Charlie Rose: 2009 Interview with Lee Kuan Yew

It took a parable from Charlie Munger to finally get me to watch this interview that has been saved on my DVR since October, but it was one of the better interviews I have ever seen and I highly recommend it. (And H/T to Shai, who was well ahead of me on getting it posted).

Link to: October 2009 Interview with Lee Kuan Yew

To watch it now, you actually need to go to the Charlie Rose Home Page, click on the 'Recent Shows' tab, and then scroll down to the interview from 10/23/09.

.....

One of my favorite excerpts (taken from the transcript):

CHARLIE ROSE: What’s the most important change and significant change in your way of thinking about the world over the last 20 years?

LEE KUAN YEW: That the impossible can happen. I never thought the Soviet Union would implode so easily, and I never thought the Chinese would abandon the communist system and move into the free market so readily. It was unthinkable 20 years ago.

Both have happened. The world has changed.

CHARLIE ROSE: And it’s not clear exactly how it’s all going to...

LEE KUAN YEW: No, it is not clear when it will happen, but that it will happen now in the long term, 50 to 100 years, yes.

………………..

Previous Charlie Rose Interviews with Lee Kuan Yew:

2004

2000

Book: From Third World to First : The Singapore Story: 1965-2000

$1.68M Lunch With Warren Buffett

Berkshire Hathaway CEO Warren Buffett and Salida Capital CEO Courtenay Wolfe weigh in on the annual charity auction that awards the highest bidder a lunch with Buffett.

Link to: VIDEO from Fox Business

McKinsey Global Institute: Debt and deleveraging: The global credit bubble and its economic consequences

I’m a little late posting this, but better late than never.

Link to: Debt and deleveraging: The global credit bubble and its economic consequences

-

Hussman Weekly Market Comment: Notes on a Difficult Employment Outlook

Aside from the shorter-term suspicion that unemployment has not peaked, I want to be clear that my main concern about the employment situation is with servicing debt, not providing for the basic needs of the population. I'm certainly not talking about Malthusian macroeconomic shortages or an inability for our nation to support itself. It is the gap between cash flows and household debt service that strikes me as problematic.

On the broader issue of supporting a growing population, it has historically been true (and is likely to continue to be true even in the event of further credit strains) that the needs of the U.S. population can be supported through productivity growth and to some extent by importing the output produced by cheaper foreign labor. In the long run, productive investment is the cornerstone of economic stability. Over the past decade we have greatly threatened that that stability through the ridiculous misallocation of resources in speculative bubbles and unproductive "investments," but I am convinced that we will re-learn, painfully or otherwise, to better allocate our resources. My impression continues to be that the current deleveraging cycle will likely be a multi-year process that is presently far from complete.

Foreign trade can also be the source of mutual economic benefit, but only if it ultimately improves the allocation of resources. On our current path, we have instead relied on cheap imports from China and other countries while at the same time destroying our own capital through poorly allocated speculative investments, followed by bailouts to the lenders who provided that capital. The only plausible outcome of that dynamic is that foreigners will gradually acquire claims on our nation (Treasury debt or private securities), and with them, the ability to acquire our productive assets. No doubt many analysts on the financial channels will gurgle with excitement every time a foreign acquirer bids for ownership of a U.S. company, but this is how we will pay for our the difference between our consumption and our income. Again though, I am convinced that we will ultimately re-learn to better allocate our resources.

Millions of Unemployed Face Years Without Jobs - By Peter S. Goodman

Even as the American economy shows tentative signs of a rebound, the human toll of the recession continues to mount, with millions of Americans remaining out of work, out of savings and nearing the end of their unemployment benefits.

Economists fear that the nascent recovery will leave more people behind than in past recessions, failing to create jobs in sufficient numbers to absorb the record-setting ranks of the long-term unemployed.

Call them the new poor: people long accustomed to the comforts of middle-class life who are now relying on public assistance for the first time in their lives — potentially for years to come.

Yet the social safety net is already showing severe strains. Roughly 2.7 million jobless people will lose their unemployment check before the end of April unless Congress approves the Obama administration’s proposal to extend the payments, according to the Labor Department.

Here in Southern California, Jean Eisen has been without work since she lost her job selling beauty salon equipment more than two years ago. In the several months she has endured with neither a paycheck nor an unemployment check, she has relied on local food banks for her groceries.

She has learned to live without the prescription medications she is supposed to take for high blood pressure and cholesterol. She has become effusively religious — an unexpected turn for this onetime standup comic with X-rated material — finding in Christianity her only form of health insurance.

“I pray for healing,” says Ms. Eisen, 57. “When you’ve got nothing, you’ve got to go with what you know.”

Warm, outgoing and prone to the positive, Ms. Eisen has worked much of her life. Now, she is one of 6.3 million Americans who have been unemployed for six months or longer, the largest number since the government began keeping track in 1948. That is more than double the toll in the next-worst period, in the early 1980s.

Men have suffered the largest numbers of job losses in this recession. But Ms. Eisen has the unfortunate distinction of being among a group — women from 45 to 64 years of age — whose long-term unemployment rate has grown rapidly.

In 1983, after a deep recession, women in that range made up only 7 percent of those who had been out of work for six months or longer, according to the Labor Department. Last year, they made up 14 percent.

Twice, Ms. Eisen exhausted her unemployment benefits before her check was restored by a federal extension. Last week, her check ran out again. She and her husband now settle their bills with only his $1,595 monthly disability check. The rent on their apartment is $1,380.

“We’re looking at the very real possibility of being homeless,” she said.

Every downturn pushes some people out of the middle class before the economy resumes expanding. Most recover. Many prosper. But some economists worry that this time could be different. An unusual constellation of forces — some embedded in the modern-day economy, others unique to this wrenching recession — might make it especially difficult for those out of work to find their way back to their middle-class lives.

Labor experts say the economy needs 100,000 new jobs a month just to absorb entrants to the labor force. With more than 15 million people officially jobless, even a vigorous recovery is likely to leave an enormous number out of work for years.

Some labor experts note that severe economic downturns are generally followed by powerful expansions, suggesting that aggressive hiring will soon resume. But doubts remain about whether such hiring can last long enough to absorb anywhere close to the millions of unemployed.

Inflation Won’t Solve Our Debt Problems – By Catherine Rampell

Thanks to Ian for passing this along.

Lately I have seen a few suggestions, here and there, that the United States should consider inflating its way out of its rising debt burden.

The country essentially inflated its way out of much of its debt during the Great Depression, and again in the 1970s, according to Harvard’s Kenneth S. Rogoff. But as anyone who remembers the 1970s can attest, inflation can be painful. It’s no fun to get your paycheck and then find out that you cannot buy as many groceries or as much gasoline as you did the week before because prices have gone up so much.

The more powerful argument against inflating away debt is that it will not work, says Alan Auerbach, an economics professor at the University of California, Berkeley.

Why? Because so much of our long-term spending obligations are indexed to inflation. In other words, the debts will rise along with inflation, so they won’t “feel” any smaller. Here is how Professor Auerbach explained it in an e-mail message (links added are mine):

Sudden inflation can only inflate away the debt that is (1) not indexed, the way TIPS are; and (2) not very short term (i.e., not T-bills), so that the interest rates cannot be reset to much higher rates that would compensate for inflation. Also, there is no net gain to inflating away debt held within the government (e.g., the Social Security trust fund, etc.). So, as of the end of November (data from the Treasury Web site; probably can be updated through December now), that left about $5.4 trillion worth of debt that could be made to disappear with a sudden, rapid inflation.

But most of our long-term imbalance, which Bill Gale and I have estimated at $53-$126 trillion (in our paper published in Tax Notes in October), depending on how far out one looks, comes from exploding entitlement programs, which are either explicitly indexed to inflation — Social Security — or implicitly indexed (Medicare and Medicaid) because they provide services that will also grow in cost with inflation. So the best we could do, using the lower estimate of the long-term gap (a 75-year number) would be to eliminate 5.4 of 53 trillion, or about 10 percent.

In other words, even if the government printed a lot more money and lowered the purchasing power of the dollar, 90 percent of the country’s debt problem would survive.

So what are the other strategies for bringing down the country’s long-term deficits?

The one countries always hope for is growth.

If the economy grows quickly enough, tax revenues can rise faster than spending. This helps explain why the country had budget surpluses in the late 1990s and early 2000s. A booming economy — greased by the stock bubble, of course — helped push tax revenues even higher than the government had expected they would be.

But the grow-your-way-out-of-debt option is usually too rosy, especially during a recession.

A country loaded with debt can try to simply tighten its belt, by raising tax revenues and/or slashing spending. But there are major political obstacles for these policy initiatives because they are so painful, at least in the short-run.

Finally, a country can restructure its debt or default, which is generally considered the worst-case. Just as a person defaulting on a loan can mar his ability to borrow in the future or even get a job, a country defaulting on its debt obligations will have trouble getting other nations and investors to trust it in the future, too.