A Dozen Things I have Learned from Barry Ritholtz about Investing

Tren Griffin runs 25IQ, a blog about business models, investing, technology, and other aspects of life that he find interesting. He works for Microsoft; Previously he was a partner at Eagle River, a private equity firm established by Craig McCaw.

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A Dozen Things I have Learned from Barry Ritholtz about Investing

As part of my “A Dozen Things I’ve Learned” series of blog posts I thought I would take on a list put together by Barry Ritholtz. My self-assigned task is to add my support to what Barry wrote, while staying with my usual 999 word limit for any given blog post. The task I assigned to myself is to elaborate on what he has written (rather than just repeating what Barry wrote) since the best support for the investing maxims themselves comes from Barry himself. Given Barry’s towering intellect, this is a scary exercise.

1. “Cut your losers short and let your winners run.” Loss aversion is highly dysfunctional for investors since it causes people to hold on to “losers” for too long to avoid the pain of a loss. The first half of Barry’s first maxim pushes against that aspect of loss aversion. Cutting losses short pushed against a tendency to hold tightly to losers hoping that they recover before then need to acknowledge the loss. The second half of Barry’s first maxim helps lower transactions costs, fees and taxes, but is also about the value of opportunity cost analysis. Charlie Munger once put it this way: “There is this company in an emerging market that was presented to Warren. His response was, ‘I don’t feel more comfortable buying that than I do of adding to Wells Fargo.’ He was using that as his opportunity cost. No one can tell me why I shouldn’t buy more Wells Fargo.”

2. “Avoid predictions and forecasts.”  The less complex the system you are trying to understand, the greater the likelihood you can make a bet which is both non-consensus and correct. Making a bet which follows the consensus and it correct will only deliver beta. The most complex system of all is the macro economy since it is composed of a nest of complex adaptive systems rife with both uncertainty (probabilities unknown) and ignorance (probabilities not computable). On a relative basis, the most tractable system on which one can make an investment and try to generate alpha is an individual company. Very few people can make non- consensus bets which are also correct at a company level, but its is at least possibl;e if you are smart and work hard. 90%+ of people are better off buying a low fee index even when it comes to making bets on individual companies. The greatest for investors often comes from the fact that 70% of people think they fall withion the 10% who can generate alpha. When it comes to self-appraisals humans are too often vastly over generous.

3. “Understand crowd behavior.”  Humans often herd. People like what others like (path dependence) and especially in the presence of uncertainty or a requirement that they actually do some work, will follow other people. Most notably when diversity of opinion breaks down, crowds are often *not* wise. Buying when others are fearful and selling when others are greedy. is wise.

4. “Think like a contrarian (occasionally).” As I noted in my post about Howard Marks,  you must both adopt a view that is contrarian *and* be right to outperform the market. Being a contrarian for its own sake is a ticket to losses since the crowd is often right.

5 . “Asset allocation is crucial.” The amount you allocate to each investing category is a more important decision than the individual assets you pick within that category. My thoughts on asset allocation for muppets are here:  Giving advice to “know something investors” is something I have not yet tackled since they are know-something investors already (seems like bringing coals to Newcastle).

6. “Decide if you are an active or passive investor.” My thoughts on active vs. passive are here:  As Dirty Harry said to the cornered criminal in the movie Magnum Force: ”A man’s got to know his limitations.” “I feel lucky” is not the way a genuine investor conducts his or her affairs.

7. “Understand your own psychological make up.” As Feynman famously said, the easiest person to fool is yourself. Genuine self-knowledge is hard-won knowledge since no one has perspective on yourself by definition. On this topic it is wise to read Charlie Munger.

8. “Admit when you are wrong.” Heuristics like “public commitment consistency” bias cause us to hold on to positions long after a reasonable analysis by a neutral observer would have concluded that we were wrong. For example, once you say publicly “X is going up” it gives your brain a shot of stupid juice when it comes to concluding that you might be wrong.

9. “Understand the cycles of the financial world.” Barry seems in agreement with Howard Marks on this point. Nothing good or bad goes on forever. As Billy Preston sings in the well-known song things “go round in circles.” Mr. Market is bipolar and for that reason market swings will always happen. By focusing on the intrinsic value of individual investments And tuning out the talking heads blathering about their macroeconomic forecasts, market swings can become your friend. The irony is: the more you focus on what is micro in nature, the more you will benefit from macro trends.

10. “Be intellectually curious.” It is in “the micro and the obscure” where one can learn things which others do not know. To make a bet that is contrary to the consensus of the crowd you must possess knowledge that the consensus has not adopted. You will mostly likely find that non-consensus knowledge on the frontiers of your own knowledge. Really great investors read constantly and actively seek out alternative viewpoints. Shutting out views you disagree with is a step toward an echo chamber.

11. “Reduce investing friction.” John Bogle formed Vanguard on the basis of the “cost matters hypothesis” not the efficient market hypothesis. On that you might want to read. Paying high fees, costs and commissions is one of the simplest investing errors to correct.

12. “There is no free lunch.” There is no substitute for hard work and rational decision making.

 

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Originally published at September 2013

 

Three Commandments of Stock Valuation

Many metrics can be used to value markets. Which should you trust?
Barry Ritholtz
Washington Post, March 7 2015

 

 

 

“Faced with the choice between changing one’s mind and proving that there is no need to do so, almost everyone gets busy on the proof.”

— John Kenneth Galbraith

Let’s take a look at the valuation of U.S. markets. This is relevant to investors, as valuation determines future expected returns.

There are three commandments to consider:

●Thou shalt consider a full assortment of all valuation metrics;

●Thou shalt not cherry-pick only those metrics that support your preferred outcome;

●Thou shalt focus on the very best measure of market valuation, according to academic research and data.

These should have the force of moral law for anyone who wants to understand whether stocks are cheap or expensive.

Starting with our first commandment, let’s look at a wide assortment of metrics that can help determine equity valuation.

The equity strategy group in Merrill Lynch’s research department looks across 16 measures — a full range of metrics that describe the U.S. stock market, including trailing price-to-earnings, Shiller price-to-earnings, price-to-book ratio and the Standard & Poor’s 500-stock index in terms of the price of gold or West Texas Intermediate crude oil. This approach shows the markets as being anywhere from cheap to expensive, depending on your favored metric. Last year, the valuation spectrum showed U.S. markets as slightly undervalued. More recently, they appear to be at fair value.

It is noteworthy that those who have ignored this approach have missed significant, ongoing gains in U.S. equities.

That leads us to our second commandment: Thou shalt not cherry-pick metrics that support your preferred valuation.

Anyone can point to a metric that shows stocks as either cheap or expensive.

Those who are bearish usually go for Trailing Price to Earnings ratio (17.1 P/E), which shows stocks as pricey, or the even more expensive Shiller’s Cyclically Adjusted PE, which show stocks as very pricey (26.8 CAPE).

Conversely, those who are bullish choose other metrics: They select price to free cash flow or price to normalized earnings to show markets as cheap. The Standard & Poor’s 500-stock index is valued at 22.3 times free cash flow — about 22 percent below its average reading from 1986 to 2014. Price to normalized earnings is at 18.6 times, or 2 percent less than its post-September 1987 average.

Consider what professors Eugene Fama (University of Chicago Booth School of Business, 2013 Nobel laureate in economic sciences) and Ken French (professor of Finance at the Tuck School of Business at Dartmouth College) have observed about all of these different methods of valuation: “Different price ratios are just different ways to scale a stock’s price with a fundamental, to extract the information in the cross-section of stock prices about expected returns.”

That sounds complex, but it can be simplified as follows: Are stocks priced above or below their historic fair value? Based on that, are future returns likely be higher or lower than average?

This simple explanation is what all of these data points are really attempting to figure out. Metrics based on fundamental factors are trying to discern average historic valuation. But it is important to recognize how easily different people can reach different conclusions, like in John Godfrey Saxe’s poem about the blind men describing the elephant. Some of that is a function of what part of the beast they are touching, while other times it is a result of their own biases.

Given how many ways there are to measure stock prices, those who give in to their personal predilections have a wide variety of choices. However, selecting the metric that supports your existing position tells us nothing about the markets and everything about your previously held beliefs.

Hence, I am always wary when a specific metric is selected to prove how cheap or expensive markets are — especially if that analyst had previously ignored said metric.

So we have looked at a broad assortment of metrics. This has some value, but it is inconclusive. And this approach specifically keeps our selective perception from duping us into cherry-picking the metric that suits our preferences.

Now, the last commandment: Picking the metric with the very best historic track record.

Wouldn’t it be fantastic if we could filter out the noise and go straight to a single best measure of stock market valuation? To do just that, we turn to the academic literature. As it turns out, a number of studies point to ways to assess the value of a stock market.

Perhaps the most readable of these is from Wesley Gray and Jack Vogel: “Analyzing Valuation Measures: A Performance Horse-Race Over the Past 40 Years” (Drexel University, January 2012). A close second is Tim Loughran and Jay W. Wellman’s “New Evidence on the Relation Between the Enterprise Multiple and Average Stock Returns” (Journal of Financial and Quantitative Analysis, 2010).

These papers (and others) have identified a ratio that has been described as the single most successful measure of valuation in terms of historical track record: EV/EBITDA.

EV stands for “enterprise value”; EBITDA is the acronym for “earnings before interest, taxes, depreciation and amortization.”

Enterprise value is somewhat different from a company’s market value. To calculate EV, we take the number of shares outstanding times the company’s stock price. Add in the amount of debt outstanding, then reduce by the cash/short-term investments. Lastly, subract any other holdings that have value (i.e., ownership in other companies). Enterprise value is a comprehensive measure of the core business.

EBITDA lets an investor compare revenues with expenditures. Perhaps the best way to think of this is as taking the revenue and subtracting the costs that go solely into running a business. That removes any financial engineering and many accounting gimmicks from the equation. It is a fairly simple way to consider a firm’s efficiency at its core business.

Enterprise value for the S&P 500 has risen no higher than 10 times EBITDA since stocks began their bull-market run in March 2009, according to data compiled by Bloomberg. The peak was reached last month. The EV/EBITDA ratio reached 12.6 in 2007, when the credit-fueled five-year advance ended in a broad financial crisis.

Hence, what has been considered the best-performing measure of markets suggests that U.S. stocks are not expensive — are indeed priced fairly. This strongly suggests that the expected future returns for U.S. equities will be about their historic average.

Those who have been using valuation as an excuse to stay away from equities are likely to be disappointed in their own market-timing skills.
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Ritholtz is chief executive of Ritholtz Wealth Management. He is the author of “Bailout Nation” and runs a finance blog, The Big Picture. On Twitter: @Ritholtz.

On Education

I much enjoyed this article by Steven Pinker.  An excerpt:

It seems to me that educated people should know something about the 13-billion-year prehistory of our species and the basic laws governing the physical and living world, including our bodies and brains. They should grasp the timeline of human history from the dawn of agriculture to the present. They should be exposed to the diversity of human cultures, and the major systems of belief and value with which they have made sense of their lives. They should know about the formative events in human history, including the blunders we can hope not to repeat. They should understand the principles behind democratic governance and the rule of law. They should know how to appreciate works of fiction and art as sources of aesthetic pleasure and as impetuses to reflect on the human condition.

On top of this knowledge, a liberal education should make certain habits of rationality second nature. Educated people should be able to express complex ideas in clear writing and speech. They should appreciate that objective knowledge is a precious commodity, and know how to distinguish vetted fact from superstition, rumor, and unexamined conventional wisdom. They should know how to reason logically and statistically, avoiding the fallacies and biases to which the untutored human mind is vulnerable. They should think causally rather than magically, and know what it takes to distinguish causation from correlation and coincidence. They should be acutely aware of human fallibility, most notably their own, and appreciate that people who disagree with them are not stupid or evil. Accordingly, they should appreciate the value of trying to change minds by persuasion rather than intimidation or demagoguery.

I believe (and believe I can persuade you) that the more deeply a society cultivates this knowledge and mindset, the more it will flourish. The conviction that they are teachable gets me out of bed in the morning.

Weekend Reading: Warren Buffett: These were my biggest early mistakes

Warren Buffett (1989): These were my biggest early mistakes:

To quote Robert Benchley, “Having a dog teaches a boy fidelity, perseverance, and to turn around three times before lying down.” Such are the shortcomings of experience. Nevertheless, it’s a good idea to review past mistakes before committing new ones. So let’s take a quick look at the last 25 years.

My first mistake, of course, was in buying control of Berkshire. Though I knew its business – textile manufacturing - to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long- term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.

You might think this principle is obvious, but I had to learn it the hard way – in fact, I had to learn it several times over. Shortly after purchasing Berkshire, I acquired a Baltimore department store, Hochschild Kohn, buying through a company called Diversified Retailing that later merged with Berkshire. I bought at a substantial discount from book value, the people were first-class, and the deal included some extras – unrecorded real estate values and a significant LIFO inventory cushion. How could I miss? So-o-o – three years later I was lucky to sell the business for about what I had paid. After ending our corporate marriage to Hochschild Kohn, I had memories like those of the husband in the country song, “My Wife Ran Away With My Best Friend and I Still Miss Him a Lot.”

I could give you other personal examples of “bargain- purchase” folly but I’m sure you get the picture: It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first- class managements.

That leads right into a related lesson: Good jockeys will do well on good horses, but not on broken-down nags. Both Berkshire’s textile business and Hochschild, Kohn had able and honest people running them. The same managers employed in a business with good economic characteristics would have achieved fine records. But they were never going to make any progress while running in quicksand.

I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. I just wish I hadn’t been so energetic in creating examples. My behavior has matched that admitted by Mae West: “I was Snow White, but I drifted.”

A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.

The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult. On occasion, tough problems must be tackled as was the case when we started our Sunday paper in Buffalo. In other instances, a great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, problem as was the case many years back at both American Express and GEICO. Overall, however, we’ve done better by avoiding dragons than by slaying them.

My most surprising discovery: the overwhelming importance in business of an unseen force that we might call “the institutional imperative.” In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence. Furthermore, Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.

After some other mistakes, I learned to go into business only with people whom I like, trust, and admire. As I noted before, this policy of itself will not ensure success: A second- class textile or department-store company won’t prosper simply because its managers are men that you would be pleased to see your daughter marry. However, an owner – or investor – can accomplish wonders if he manages to associate himself with such people in businesses that possess decent economic characteristics. Conversely, we do not wish to join with managers who lack admirable qualities, no matter how attractive the prospects of their business. We’ve never succeeded in making a good deal with a bad person.

Some of my worst mistakes were not publicly visible. These were stock and business purchases whose virtues I understood and yet didn’t make. It’s no sin to miss a great opportunity outside one’s area of competence. But I have passed on a couple of really big purchases that were served up to me on a platter and that I was fully capable of understanding. For Berkshire’s shareholders, myself included, the cost of this thumb-sucking has been huge.

Our consistently-conservative financial policies may appear to have been a mistake, but in my view were not. In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged. Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.

We wouldn’t have liked those 99:1 odds – and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds – though we have learned to live with those also.

Framework for Understanding Market Tops and Bottoms

Last week I received an excellent article from Variant Perception on "Market Tops", and have permission to excerpt some of it.

Here is a link to the summary page of Understanding Market Tops. What follows are a few snips from the full report.
Framework for Understanding Tops

In the following table, we summarize the signs of market bottoms and tops.

The signs can be divided into the following categories: corporate, valuation, economic, market and sentiment. Clearly many signs of a top are in place, but there are many characteristics that are currently missing. In the coming pages we will look at each category separately.



click on any chart for sharper image

Today the market shows many of the elements that are present near market tops. In particular, sentiment is extremely bullish, investors are long and leveraged, and valuations are extended on a wide variety of measures. However, leading economic indicators are still not negative, and so far breadth and technicals have not deteriorated. The medium-term stock market returns are likely to be negative due to excessive valuation, but there is no imminent sign of a medium-term market top.

Tops are a process, not a single event. They tend to last a long period of time, and markets whipsaw traders and disappoint bears and short sellers. For example, many signs of a market top were clearly visible in late 1998, but it was not until the end of 2000 that most major market indices started to collapse. Likewise, many elements of a market top were evident in late 2006, but markets didn’t begin to collapse until very early 2008.



CORPORATE ACTIVITY: WE’RE SEEING TYPICAL SIGNS OF MARKET TOPS

CEOs are bad capital allocators of corporate cash and provide contrarian clues, but insiders are much better at providing insight with what they do with their own cash.

A CEO should issue shares when they are overvalued and buy them back when they are undervalued. Likewise, a CEO should buy competitors when they are cheap and avoid overbidding when prices rise. Unfortunately, most share buybacks and most mergers and acquisitions happen at very high prices near market tops, and companies divest units and issue shares near market bottoms. Insiders, however, are smart. IPOs surge near market tops as insiders sell out. Also, near market bottoms insiders buy their own stocks.

The fewest buybacks in each cycle happened when stocks were cheapest. It is impossible to make this up. CEOs are just like “dumb money” retail investors, buying high and selling low.

If you look exclusively at the US, you can see that M&A levels are very frothy and are near where they were in 2007. Greed is alive and well in the US. They are significantly below levels seen in 2000, but that was the biggest M&A wave ever and marked the peak of telecom, media and internet bubble. It included the likes of AOL’s purchase of Time Warner and other mammoth deals.

One area that currently is frothy is the biotechnology sector. The number of biotech deals is the highest it has reached since 2000, and the dollar value is the second highest in history.

During the final phases of bull markets, not only does the number of IPOs rise, but the quality of IPOs deteriorates. The following chart shows that only during the final phases of the internet bubble did we see such a high percentage of money-losing IPOs. Investors are chasing unproven business models.


In the past decade, private equity players have become more important “insiders”, and the number of IPOs from private equity backed groups has now reached all-time highs. Furthermore, the follow-on deals from private equity sponsored groups are also at all-time highs. Smart firms were buying companies in the bad times and are now floating them and getting out while they can.



CEOs and managers tend to overpay for share buybacks and for M&A activity with shareholder money. They don’t mind sticking it to investors. However, when it comes to their own personal money, they are much shrewder. Insiders consistently sell their own stock when markets are high and buy large quantities of their own stock when markets fall sharply and become cheap.

CREDIT SIGNS OF A TOP: TODAY LOTS OF JUNK DEBT AND VERY LOW QUALITY

In May 2013 Variant Perception wrote a report titled Credit Bubble, Toil and Trouble. We argued that ultra-low interest rates were already leading to a bubble in corporate debt. Investors were issuing large quantities of corporate debt at low spreads. The situation has only got worse since we wrote in our report.

As the following chart shows, in 2013 we saw the highest issuance of junk bonds ever. This was true in absolute numbers and as a percentage of all corporate debt.



Not only is the issuance of junk at record highs, but we have seen the highest LBO transaction volume since 2007. In fact, the market peak in 2007 is the only year where we saw more leveraged buyouts.
There is much more in the 28-page report. You can request a copy from the link at the top.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com 

More Signal, Less Noise

Its Friday, the day I like to step back and get all Zen on y’all.

As promised yesterday, our subject this morning — indeed, over the past few months — is how to reduce the meaningless distractions in your portfolio (and your life). You want less of the annoying nonsense that interferes with your investing, and more of the meaty data that allows you to become a less distracted and more purposeful investor.

This is a continual process. For me, finding moments of quiet contemplation to think things through is very important. Sometimes that means taking a walk through the woods, or sitting on a boat deck or merely relaxing in a hammock with no distractions. You may prefer meditation, jogging or yoga. Anything that allows you to get out of your self for a few is enough.

My daily process of waking before dawn and writing things down is an enormous aid to me figuring out what I think, to refining my understanding of what is really going on and why. I liken it to an editing process. I spend most of my quiet time deciding what to eliminate. After this process, whats left is almost all signal, no noise.

Here are some things you need to understand if you want to decrease the noise:

More Signal, Less Noise

1. News is Old — it is misnamed and not especially forward looking;

2. Data first and foremost; avoid the anecdotes and narratives;

3. Everyone talks their book (i.e., Whats their agenda?)

4. Recognize what financial chatter is merely idle gossip;

5. What is within your control? What is not?

6. Understand empiricism and probability analysis;

7. Eliminate all sources that are biased, or are not driven by your goals, or have a different agenda; (Delete money losers with Extreme Prejudice)

8. Understand the concept of time, and the long game

9. Separate what is for Fun and what is for Real

10. Refining your process is your goal. Get that right and the outcomes will improve naturally;

Your consistent focus should be to keep yourself concentrating on that which truly matters and learning to reduce or even better, ignore that which does not . . .

If there is interest, I might expand this into a full WaPo column.

 

 

Previously:
Things I Don’t Care About (January 15th, 2013)

What Do You Control? (May 30th, 2013)

Asking the Right Questions (July 18th, 2013)

The Price of Paying Attention (November 2012)

Who Do You Trust? (January 2008)

Lose the News (June 2005)

 

What Will the World Look Like in 100 Years?

George Friedman, geopolitical forecaster and founder of the Austin, Texas based private intelligence firm, STRATFOR Global Intelligence (click here for website), delivers a fascinating list of future political, military, and economic scenarios in his new book, The Next 100 years: A Forecast for the 21st Century.

Friedman claims the current Islamic assault on the West is failing, and will cease to be a factor on the international scene within the decade. Russia will take another run at becoming a superpower, which will fail by 2020, and leave the country even more diminished than it is today. When standards of living in China level off or reverse in the 2020’s, chronic resource shortages could cause the Middle Kingdom to implode and break up. China is far more fragile than we realize.

Japan may deal with stagnant economic and population growth the same way it did during the 1930’s by invading China as early as 2030. Japan may also take a bite out of indefensible Siberia when it remilitarizes. Poland, a unified Korea, and Turkey will develop into regional military and economic powers in their own right.

Friedman then describes a theoretical war by a coalition of Turkey and Japan against the US in 2050, resulting in an American victory, which leads to a new US golden age in the second half of the century. Scramjet engines make possible the development of unmanned hypersonic aircraft, which can launch a precision attack any place on the planet in 30 minutes. Warfare will move into space and be fought from “battle stars,” which will also become major energy sources for earth. Friedman kind of lost me when he predicted that the next Pearl Harbor could come from Japan, but not via the sea going aircraft carriers of old, but from caves on the moon.

The big challenge towards the end of the 21st century will be the emergence of a Hispanic nation in the Southwest, which is culturally isolating itself by not integrating with the rest of the country. This could lead to the secession of several states, or a new war with Mexico, which by then, will develop into a major power in its own right. I think to avoid a second Civil War and offload some huge state deficits, Washington just might say “¡Adios!

You can argue that someone making many of these predictions is loony. But if you had anticipated in 1970 that China would become America’s largest trading partner, the Soviet Union would collapse, Eastern Europe would join NATO, the US would enter a second Vietnam War in Afghanistan, and oil would hit $150 a barrel, you would have been considered equally nutty. I know because I was one of those people. It does seem that long-term forecasters have terrible track records.

All in all, the book is a great armchair exercise in global real politics, and an entertaining contemplation of the impossible. More than once, I heard myself thinking “He’s got to be kidding.” To get preferential pricing from Amazon on this thought provoking tome, please click here.

George Friedman

The Next 100 Years

Modern Day Fairy Tale of 3 Economic Wizards (Except It’s True)

Once upon a time (today), in a land not so far away (USA), there lived a trio of economic wizards (economists), whose names shall remain anonymous (Paul Krugman, Greg Mankiw, Ben Bernanke). A fourth wizard, Murry Rothbard, is no longer among the living but resides in the netherworld. The above wizards seldom agree with each other because they come from competing schools of wizardry. Three Schools of Economic Wizardry
  1. Keynesian School of Fiscal Voodoo and Witchcraft
  2. Monetarist School of Monetary Voodoo and Witchcraft
  3. Austrian School of Sound Money, Sound Economic Principles and Common Sense.
"Dark Arts" Wizardry The first two wizardry schools belong to a class of wizardry promoted to aspiring wizards as the "Dark Arts". Philosophical Beliefs
  • Keynesian wizards believe governments can spend their way to economic health and although fiscal deficits may matter at some point in time, they never matter now, in practice.
  • Monetarist wizards believe money will cure any and every problem if enough is dropped from helicopters and interest rates held low.
  • Austrian wizards believe that economic problems are created by unsound money, haphazard loans, excessive debts, and government manipulations.
  • Keynesian and Monetarist wizards believe in the voodoo principle "the problem is the solution if only you do more of it". The former relies primarily on fiscal voodoo, the latter relies primarily on monetary voodoo.
  • Austrian wizards do not believe "the problem is the solution", no matter how many times it is repeated.
Grand Poobahs
  1. Paul Krugman is the economic "Grand Poobah" of the Keynesian wizards.
  2. The "Grand Poobah" of Monetarist Voodoo is Fed chairman Ben Bernanke.
  3. Murray Rothbard, no longer alive, was the last great proponent of  school of Sound Money, Sound Economic Principles, and Common Sense.
"Dark Arts" Schools Overflowing With Students The "Dark Arts" are very enticing to modern day wizards-in-training because nearly everyone likes money from helicopters and deficit spending (even when they claim they don't). In response to demand for voodoo economists, the "Dark Arts" schools for voodoo economics are overflowing with young wizards all hoping to win a Nobel Prize in Voodooism with "fresh thinking" and new voodoo proposals. Voodoo Proposal Example - Purposely Make Money Go Worthless Aspiring Grand Poobah Greg Mankiw (Professor of Economic Wizardry at Harvard University) put forth a proposal that caused a stir in both the real world and the world of wizards. Mankiw proposed that purposely making money go worthless over time would be of great economic benefit. No Demand for Common Sense The average non-wizard, living in the real world, with an education level beyond 2nd grade, would quickly see the ridiculousness of making money go worthless. However, at the highest political levels, there is virtually no demand for common sense, and shockingly high demand for voodoo wizardry. For example, if you ever expect to make chairman of the president's Council of Economic Advisers or become an economic adviser to Mitt Romney (Wizard Mankiw did both), then common sense must go out the window. Aspiring wizards hoping for careers in politics better quickly learn that politicians never want to hear they cannot spend money. Instead, politicians want to hear economic voodoo. "Dark Arts" Feuds Given Keynesian and Monetarist wizards both believe in voodoo, one might think the two schools would get along reasonably well. One would be wrong. There have been numerous public squabbles between Mankiw and Krugman but the mother of all verbal wizardry battles came when Krugman went so deep into fiscal voodoo theory that Bernanke Called Krugman "Reckless" Ivory Towers and Academic Wonderland Unlike non-wizards, modern-day economic wizards do not live in the real world, in real cities. Instead, they live in ivory towers in secret villages for wizards only, typically tucked away in obscure corners of major U.S. universities. Collectively, these secret villages are known as "Academic Wonderland". "Academic Wonderland" is strictly off limits to non-wizards with the exception of "Dark Arts" wizards-in-training. It is even off limits to those few aspiring wizards who believe in Sound Money, Sound Economic Principles, and Common Sense. Real World Experience "Dark Arts" wizards of the Keynesian and Monetarist schools generally have never worked in the real world. Instead, they sit in their ivory towers and devise empirical formulas as to how they expect the real world to behave. Occasionally the "Dark Arts" wizards surface in the real world, primarily to explain their mathematical formulas as to how the world functions. It is seldom of concern to economic wizards if the real world does not follow their mathematical formulas. Decision Making at Night "Dark Arts" wizards are very concerned about such nebulous concepts as the "Decision Making at Night". Here is set of equations from an aspiring wizard-in-training. "Decision making at night" is of course different from "decision making in the day". Both are distinctly different than "decision making with no news". Voodoo Wizards Like Secrecy The voodoo wizard-in-training making the above proposal is a big proponent of secrecy, believing that Grand Poobahs need to keep what they are doing a big secret lest it change real-world decision making processes of non-wizards during the day or night. Austerity No "Dark Arts" wizard worth his weight in salt would ever propose that any country live within its means. For a recent example, Paul Krugman, the Grand Poobah of the Keynesian School of Fiscal Voodoo and Witchcraft writes about Estonian Rhapsody.
Since Estonia has suddenly become the poster child for austerity defenders — they’re on the euro and they’re booming! — I thought it might be useful to have a picture of what we’re talking about. Here’s real GDP, from Eurostat: So, a terrible — Depression-level — slump, followed by a significant but still incomplete recovery. Better than no recovery at all, obviously — but this is what passes for economic triumph?
Left Unsaid Here's what Grand Poobah Krugman failed to say about the Booming Estonia Economy.
Sixteen months after it joined the struggling currency bloc, Estonia is booming. The economy grew 7.6 percent last year, five times the euro-zone average. Estonia is the only euro-zone country with a budget surplus. National debt is just 6 percent of GDP, compared to 81 percent in virtuous Germany, or 165 percent in Greece. Shoppers throng Nordic design shops and cool new restaurants in Tallinn, the medieval capital, and cutting-edge tech firms complain they can’t find people to fill their job vacancies. Estonia’s achievement is all the more remarkable when you consider that it was one of the countries hardest hit by the global financial crisis. In 2008-2009, its economy shrank by 18 percent. That’s a bigger contraction than Greece has suffered over the past five years. How did they bounce back? “I can answer in one word: austerity. Austerity, austerity, austerity,” says Peeter Koppel, investment strategist at the SEB Bank.
Estonia vs. Fantasyland Estonia is not Nirvana. Estonia is not "Academic Wonderland" either. In contrast, Krugman is in "Academic Wonderland". The Grand Poobah clearly believes Estonia would be in better shape with helicopter drops of fiscal stimulus than a very nice partial recovery and no debt, in spite of the fact the eurozone in general is going to hell in a hand basket. Debt Never a Problem In modern-day ivory towers, with voodoo economics, debt is never a problem. The only thing that matters is GDP. One might think that a Nobel prize winner would figure out that government spending will make GDP rise by definition (government spending is part of the equation) and the debt must be paid back. However, one would be wrong. Bear in mind, Japan has tried both Keynesian voodoo and Monetarist voodoo for over 20 years. The result is a nearly unfathomable debt-to-GDP ratio of 220% and rising. Krugman would have you believe still more spending is the answer. Monetarists like Mankiw would propose making the Yen worthless. Remember the Voodoo Motto! Please remember the voodoo motto: If it doesn't work, keep doing more of it, even if that is what got you in trouble in the first place! Anyone with an ounce of common sense would realize that artificial stimulus will always end, but the debt will remain, hanging like the Sword of Damocles over the economy. Sadly, these modern-day economic wizards do not have the common sense of the average 6th grader who inherently knows that you cannot keep spending what you do not have. Invalid Comparisons No doubt Krugman will point to the misery in Spain and Greece. The comparison is invalid. Estonia is booming not solely because of austerity but rather because it did a number of common-sense things that Spain and Greece did not fully do.
  1. Slashed public sector wages
  2. Raised the pension age
  3. Reduced job protection
  4. Made it more difficult to claim health benefits
Keynesian wizards would be against all those things! Was Krugman a Housing Bubble Proponent? In a 2002 New York Times editorial Krugman said "To fight this recession the Fed needs…soaring household spending to offset moribund business investment. [So] Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble." Krugman claims "that wasn't a piece of policy advocacy, it was just economic analysis." For further discussion please see Krugman's Intellectual Waterloo When wizards get into trouble they claim they were misquoted, someone did too much, someone did not do enough or any number of other excuses. No, it was not "policy advocacy", it was simply economic voodoo that Krugman condoned. Krugman a Panderer to Public Unions One of the reasons Estonia is recovering is it had the common sense to slash public sector wages. In contrast, Krugman is a strong backer of public unions as noted in Wisconsin Power Play. The reasons Krugman supports unions should be obvious:
  1. Krugman wants to waste as much money as possible (because that is what Keynesian voodoo economics is all about).
  2. There is no better way to waste taxpayer money than overpay for services from public unions.
Wizards in ivory towers have not completely figured out that money to pay public unions has to come from somewhere (namely taxpayers in general). Of course liberal Keynesian wizards (the worst kind) have an answer for that as well: take from productive members of society and slosh it around to public unions. Never mind that public unions have bankrupted numerous cities and even in economic la-la land (otherwise known as California), backlash against unions is justifiably high and rising. Moral of the Story The average non-wizard non-union employee has long ago figured out the moral of this story. Those in ivory towers in "Academic Wonderland" have not, so I need to spell it out. It is indeed possible to have a genuine economic debt-free recovery, along with austerity, as long as other sound economic measures are incorporated at the same time. Yes, there will be some short-term pain. However, any attempt to avoid pain via heaps of fiscal and monetary stimulus is nothing but voodoo economics and can-kicking witchcraft. Mike "Mish" Shedlock http://globaleconomicanalysis.blogspot.com Click Here To Scroll Thru My Recent Post List

Keys To Success

Jim Rogers' Keys to Success (taken from the titles and sub headings of each chapter of the new book, "A Gift To My Children"): 1. Do not let others do your thinking for you 2. Focus on what you like 3. Good habits for life & investing 4. Common sense? not so common 5. Attention to details is what separates success from failure 6. Let the world be a part of your perspective 7. Learn philosophy & learn to think 8. Learn history 9. Learn languages (make sure Mandarin is one of them) 10. Understand your weaknesses & acknowledge your mistakes 11. Recognize change & embrace it 12. Look to the future 13. “Lady Luck smiles on those who continue their efforts” 14. Remember that nothing is really new 15. Know when not to do anything 16. Pay attention to what everybody else neglects 17. If anybody laughs at your idea view it as a sign of potential success Jim Rogers is an author, financial commentator and successful international investor. He has been frequently featured in Time, The New York Times, Barron’s, Forbes, Fortune, The Wall Street Journal, The Financial Times and is a regular guest on Bloomberg and CNBC.
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