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russiangambit (29.12)

Financial wizards vs. scientific geniuses

Recs

37

December 22, 2009 – Comments (17)

I wrote this post to dispel the notion that you can simply put money in stocks and expect 7% on average other the years, be buy and hold and not worry about the thing. This is a look under the hood of things that are taken as axioms and are not questioned.

 

When we talk about some outstanding person of science we’d say he is a genius. But in finance the high achievers are often referred as wizards – the wizards of finance. Soros, one of said wizards, has a book “Alchemy of finance”. Why the magical connotations when it comes to finance? Finance is a sort of modern alchemy where the wizards produce something from nothing. Huge wealth is produces by shuffling money around. Money produces more money, huge amounts of it, seemingly all on its own. At least, this is what the financial press will have you believe. Just put your money in the stocks index fund, no worries buy and hold and the money magically grows by 7% each year.

On the other hand science is the opposite of magic. Science explains the order of things and science can be replicated. Having background in science I almost never accept anything without questioning it. So, let’s look under the hood of financial magic.

 

First of all, I think this subconscious treatment of finance as magic is deliberate. Otherwise, how do you get non-sophisticated people who don’t know much about finance to put their hard earned money in stocks or bonds, something they don’t understand?

 

Another deliberate attempt is focusing on the money instead of the process of the wealth creation instead. This one is pretty recent phenomena and I think it is rooted in bubblenomics. If you can’t logically explain why this or that stock should go up 10% a day, when clearly the company couldn’t have increased the underlying profits at that pace just in one day, you focus on intangibles such as information and money flow. Yes, it is possible that new information came in today and we think a company will produce 10% more profits for the foreseeable future. But this explanation doesn’t hold water when 90% of stocks in the market move up and down together. What it really comes down to is the money flow in and out of the markets, and has really little to do with the underlying process of wealth creation on short term basis. If there an abrupt stop of money flow like in fall 2008 you see a situation where even solid stocks go crashing 60-80% in just one month. When there is a sudden rush of money into the market, like at the start of QE in spring of 2009, stocks all go up together. In normal times it works the same, it is just the effects are more muted. So what we see is that the price of financial assets is not only a matter of fundamentals, but also very much influence by the money flow and supply of money in the economy. For this reason, fundamental analysis in itself can only work on multiyear timeframes where the results of money flow gyrations are smoothed out. You need technical analysis on short term. It also doesn’t help that money supply is yanked here and there by the FED whenever they feel like it. To me FED is not a smoothing out force, Fed is a destructive entity because they can never get it exactly right and they interfere with natural flow of things. My point here is, you can do all fundamental analysis you want but without understanding the role of the money flow you are hosed.

  

Money was originally invented as medium of exchange, a standard contract for - goods for goods or goods for labor. Without money commerce is pretty much is impossible. The money in itself cannot produce wealth, putting the money here or there can produce wealth in itself. Money is a representation of resources and behind all the money shuffling the movement and usage of resources has to take place. In short, money can be capital but it doesn’t necessarily always is. To be wealth producing it has to be purposeful and profitable. When you invest in a stock and expect return, you need to make sure that the company is profitable, yet you don’t overpay for profits. Some blue chip stocks are at the same price now they were 10 years ago, it is just today their P/E is at 15 and 10 years ago it was at 50. Clearly, 10 years ago people’ expectations of growth were unrealistic and they overpaid for stocks. In my experience, high P/E stocks are almost never worth it because growth projections end up being too rosy. With one exception in my experience – Google.

 

But let’s get back to the original discussion of financial wizardry.

Investing in a stock, in a simplified way, you let the company to use your resources for future growth. In return you get a share of that future growth. Of course, you expect that return to respectable, may 5-7%.  Another way is to put money in bank and let the bank invest it for you. The bank is a middleman and will want to take a cut. Bank takes a cut from you, the lender and also from the borrower. It is a sweet business, being a middle man in finance, if you manage risk correctly. And that is where we enter the world of finance. At the bank level or stock exchange the money becomes a resource. The money literally produces money in layman’s terms, but really it is resources/ capital producing profits which are represented as money. As the financial progress goes on, all kinds of financial instruments are created, which produce even more money with leverage if you guess the direction correctly.

 

However, step back and think - money represents resources, which could be put to use to do something productive. But it is not being used that way; it is being used to place financial bets. This money is tied up at the financial level and is not going back into industry or agriculture. So, as investments are taken away from the real world and put in the financial limbo, wealth creation slows down. Huge fortunes are created, but they are not value adding. They take the money /resources from others, who didn’t place their bets correctly. As much as 20% of UK and US industry is financials.

 

Now, back to the question of the 7% average return. My argument is that past performance is no guarantee of future results and this is why - last several years we got addicted to easy money, low interest rates.  Looking at Japan, I think we are never going to give it up. Our politicians and Congress will never give it up. It used to be that bank’s CDs paid 5-7% interest on your money, not anymore. Why? Because FEDs easy money is crowding you out.  Now, if you can’t get 5% at the bank anymore for putting your capital at work why do you think you should expect 7% in the stocks?

 

It seems that easy money policies basically destroyed fixed income instruments, when interest rates can’t go any lower why invest in bond funds? It makes no sense. It might make some sense to buy actual bonds if you plan to hold them to maturity, but who’d want to do that?

Because fixed money instruments are not attractive, the money flows elsewhere right now – emerging markets, commodities, stocks. It is not fear of inflation that drives them, I think, it is the fact that there are no alternatives and all this new money needs to find home.

Still, to keep the remaining markets – stocks, commodities, going you need to have constant money flow. And here is the thing – if there is little new real wealth creation, only financial alchemy, there is little new capital to invest. FED will keep interest rates low now forever unless there is a full blown currency crisis. But they can’t keep printing money at the same rate as last year or we’ll really get the currency crisis. So, they will restrict the flow somewhat. That is not going to be good for stocks either.


Now, you may agree and disagree with my thoughts, they are still work in progress. And I didn’t even talk here about risk and leverage, just the money flow.

This is just an attempt to illustrate you how incredibly complicated markets are. You can analyze them to death and still come up with a wrong answer. That is why most advisors rely on statistics. But to me statistics don’t mean anything if the prerequisites are no longer the same. And I’d say the markets today are very different from markets 20 years ago. So, what good these statistics from 20 years ago are? They are not measuring the same thing.

17 Comments – Post Your Own

#1) On December 22, 2009 at 10:21 AM, carcassgrinder (35.71) wrote:

This is an awesome post Russian....

I wish also you would focus a bit on how "alchemy" is being sold as "science" in a fraudulent race to consume public and private sector money.  Anyway....sweet topic, rec..... and Merry Christmas!!!

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#2) On December 22, 2009 at 11:06 AM, vriguy (68.37) wrote:

Excellent post.  Purely analytical models breakdown because of the large degree of uncertainty embedded in each and every assumption one makes.  A new paradigm is needed. 

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#3) On December 22, 2009 at 11:31 AM, binve (< 20) wrote:

russian,

This is a truly excellent post

This could easily be one of the smartest paragraphs I have ever seen written on Caps

For this reason, fundamental analysis in itself can only work on multiyear timeframes where the results of money flow gyrations are smoothed out. You need technical analysis on short term. It also doesn’t help that money supply is yanked here and there by the FED whenever they feel like it. To me FED is not a smoothing out force, Fed is a destructive entity because they can never get it exactly right and they interfere with natural flow of things. My point here is, you can do all fundamental analysis you want but without understanding the role of the money flow you are hosed.

Some of us who try to understand and articulate the macroeconomic situation focus on this a lot. It is the biggest driver of all market activity. In addition you need FA and TA. And no matter what some blowhards say, they are not mutually exclusive.

Here is another great paragraph

However, step back and think - money represents resources, which could be put to use to do something productive. But it is not being used that way; it is being used to place financial bets. This money is tied up at the financial level and is not going back into industry or agriculture. So, as investments are taken away from the real world and put in the financial limbo, wealth creation slows down. Huge fortunes are created, but they are not value adding. They take the money /resources from others, who didn’t place their bets correctly. As much as 20% of UK and US industry is financials.

This is precisely why I call financials the cancer of the economy. Not because financials, in and of themselves, are bad. The do perform a very vital role of facilitation the dispersion of resoursces. It it not productive, so there is a loss of efficiency, but there is an overall economic good that comes out of it.

But today, financials comprise a dispropotionate size of the economy to the amount of economic usefulness they perform. This non-productive garbage has to be cleaned out, just like cancer.

Excellent post man! Thanks!!.

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#4) On December 22, 2009 at 11:33 AM, GNUBEE (25.25) wrote:

Rec for you good sir, I agree with most everything you've said.

I personally am preparing for higher rates, as I hope this will help to reset the game.

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#5) On December 22, 2009 at 12:52 PM, JaysRage (88.89) wrote:

This is a great post.    It shows a great understanding of how the system works, including the flow of money to create wealth.    There are some natural conclusions on how to accumulate wealth using these understandings, but you barely touch upon them.   I will eventually write a blog around the velocity of money that directly targets the "buy and hold" block of investors.  

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#6) On December 22, 2009 at 1:01 PM, Option1307 (29.65) wrote:

Just plain awesomeness Russian, good post!

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#7) On December 22, 2009 at 1:37 PM, leohaas (31.85) wrote:

Nice post!

But when it comes to your analysis, you really overestimate the effect QE has had between March and December this year. In particular, in this paragraph:

"When there is a sudden rush of money into the market, like at the start of QE in spring of 2009, stocks all go up together."

Sure, prices on the stock market are exclusively the result of demand and supply. With the supply about stable and the amount of available money increasing, prices go up. This is true for all asset classes, including stocks.

But it ignores the impact of our fractional reserve banking system (click on the link if you need an explanation). In an environment with foreclosures and bankruptcies still rampant, money is being destroyed as fast as it is printed. QE is intended to offset this destruction. So, between March and now we haven't seen a dramatic increase in money supply. Even the government haters at shadowstatics.com (scroll to bottom, see bottom-right chart) recognize that: they have estimated M3 barely increasing over the past year or so...

The real question is what will happen once the flow of foreclosures and bankruptcies ebbs, and banks increase lending again. That is the moment a real rush of money is released into the system. QE will have to end, but I am not so sure it can be ended quickly enough. That will also the moment price inflation will shoot up, and asset prices will go through the roof. I am convinced that will happen, I just don't know when.

Any ideas about investing with this in mind? Inflation-protected treasuries? Commodities? Currencies of commodity-rich countries? Precious metals?

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#8) On December 22, 2009 at 3:25 PM, russiangambit (29.12) wrote:

> But it ignores the impact of our fractional reserve banking system (click on the link if you need an explanation). In an environment with foreclosures and bankruptcies still rampant, money is being destroyed as fast as it is printed. QE is intended to offset this destruction. So, between March and now we haven't seen a dramatic increase in money supply. Even the government haters at shadowstatics.com (scroll to bottom, see bottom-right chart) recognize that: they have estimated M3 barely increasing over the past year or so...

Agree, the velocity of money collapsed, the money is not being lent. And I don't want to go into the discussion of the shadow banking since I don't know enough about it, but I know the shadow banking is pretty much nonexistent right now and that is why multiplication effect of money is back to like 1.3  for each dollar from over 4.

However, it doesn't mean that all the enw money sits in cash. It is put in the financial assets, such as treasuries, money markets, stocks, commidities. And there is a lot of it . It is just not being lent for productive activites and that is a problem.

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#9) On December 22, 2009 at 5:20 PM, leohaas (31.85) wrote:

"However, it doesn't mean that all the enw money sits in cash. It is put in the financial assets, such as treasuries, money markets, stocks, commidities. And there is a lot of it ."

No! Not true! In the balance, there is *not* a lot of new money right now. That was the whole point of my comment. Every time someone is declared bankrupt or a home is foreclosed on, banks lose an asset on their balance sheet. To compensate for that, they are required by law to scale down their lending by up to ten times the amount they lost! 10 times!

All the stimulus in the world, all the printing of new money can barely keep up with this destruction. That is why there simply is not a lot of new money. The new money is just replacing the money that disappears because of foreclosures and bankruptcies.

It is not until the glut of foreclosures and bankruptcies is over that this destruction will abate. But when it does, a lot of new money can become available quickly because of our fractional reserve banking system. That is when you'll see assets being bid up because of the extra availble money.

What we have seen over the last nine months is mostly a response to the end-of-the-world lows we saw in March. Those were caused by the expectation of a new Great Depression that was priced in. Today, a slow recovery from a recession is expected and priced in. The 60% move up since March reflects that, and nothing else!

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#10) On December 22, 2009 at 5:45 PM, binve (< 20) wrote:

No! Not true! In the balance, there is *not* a lot of new money right now. That was the whole point of my comment. Every time someone is declared bankrupt or a home is foreclosed on, banks lose an asset on their balance sheet. To compensate for that, they are required by law to scale down their lending by up to ten times the amount they lost! 10 times!,

That is why the Fed is directly monetizing Mortgage Backed Securties (MBSs) It has already monetized 1 Trillion of the 1.25 Trillion set aside through QE. The Fed is not allowing many of these assets to fail. It is going and monetizingprivate debt directly.

All the stimulus in the world, all the printing of new money can barely keep up with this destruction. That is why there simply is not a lot of new money. The new money is just replacing the money that disappears because of foreclosures and bankruptcies

If you think that was the end of QE / Debt Monetization / money printing, I think we are all in for a shock. QE will continue to exist (even if it is under a different name) and the size of it will surprise everybody. 

As long as there is a Fed, the outcome was never going to be deflationary. But that I mean true deflation = monetary deflation. Asset prices will fall, no doubt, but not due to deflation.

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#11) On December 22, 2009 at 6:10 PM, starbucks4ever (97.43) wrote:

+1

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#12) On December 22, 2009 at 9:49 PM, jatt22 (49.47) wrote:

great effort , lot of good points . + REC

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#13) On December 23, 2009 at 8:53 AM, vtBrunson (42.75) wrote:

Great post. Wow. 

Love this statement:

"What it really comes down to is the money flow in and out of the markets, and has really little to do with the underlying process of wealth creation on short term basis."  

Disreguarding easy money for a minute, I've been concerned about Baby Boomer retirement and the money flow situation in the markets.  

Many of the "market scientists" that speak of wealth creation in the stock market have experienced it first hand (growing up during the greatest bull market in the history of financial markets)... So I think it would be hard for people who have experienced this to be objective about the possibility that "The market doesn't always goes up". 

The usual retorts always talk about how the US and the market has endured (great depression, world wars, etc.) and how our variety of free-market capitalism is unlike any other country (i.e. Japan) And the basis for this is looking at the performance over the last 80 years or so.

Boomers looking to cash out are financially incentivized to perpetuate this "guarantee" because, they to keep the money flowing in to allow the money to flow out (to them).  I'm not trying to say there is a great conspiracy here or the whole market is a "ponzi scheme" but I too question whether analyzing the individual fundamentals of a given stock over a period of time is a valuable exercise.

Also I can't seem to find any examples of something in nature that shares the same growth pattern (compounding in perpetuity) (I looked at human population and even the spreading of viruses, but those grow exponentially until they reach a certain limit)  

"The future aint what it used to be" -- Yogi Berra 

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#14) On December 23, 2009 at 10:04 AM, russiangambit (29.12) wrote:

#13 -  there is definitely a big element of ponzi in the markets last 20 years.

The rise in stock prices is comprised of  = wealth/ profits created + delta in money inflow/outflow + inflation.

The money infloiw/ outflow element is the Ponzi part. Last 20 years we got boomer generation in their prime eraning years putting the money in the markets. We got the rise of  401K and mutual funds. There was hugepositive delta in terms of money inflow into the marklets because of that. Now these effects washed out and actually turning negatrive. This is a big drag on the stock market.

It is being masked by all the government induced liquidity sloshed around. I think FED will never pull all this liquidity back for this very reason. The stock market lost one of its three legs ( the positive money inflow) and is very wobbly.

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#15) On December 23, 2009 at 4:46 PM, Tastylunch (29.20) wrote:

One of the best posts I've ever seen on CAPS.

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#16) On December 28, 2009 at 7:37 PM, alexxlea (66.68) wrote:

Yeah, rates don't reflect reality, the government is approaching official bankrupty (It's already defaulted on its debt in the eyes of the world on a running basis), and anyone that thinks that equities go up forever is clearly invested heavily in the game.

 

Oh wait, what's that? Yup. The sound of impending doom. 

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#17) On December 28, 2009 at 8:36 PM, tkell31 (24.42) wrote:

+1 Leo.  Excellent job describing what took place.  I'm not so sure money was destroyed.  I look at it as as a correction to over inflated prices created by ridiculous lending practices.  Either way we're safe from inflation until, as you pointed out, the correction/destruction stops.  Hopefully it is a smooth transition because I'm not sure how to deal with it from an investment standpoint.

I think there is a lot of irony built into our system.  Irresponsible lending had a large part to play in landing in this mess, yet now that standards have rightfully tightened up it's one of the first things people complain about as causing problems.  People complain about too much govt intervention/spending, but it is that intervention that allows us to provide for lower income people, public education, all forms of social services, a stablized world order (compared to the the 3000 previous years the last 60 have been very stable), and generally create a society with a high standard of living we've come to take for granted.

I dont know what the future holds, but being an optimist I would like to think as the global economy grows and national borders become less important we can focus on progress as a people v progress as consumers.

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