[davelj]

Agreed – a great summary of the situation.

[davelj]

“Price stability is more important to the government than a few million homeowners losing their jobs or homes. They must prevent inflation…”

You’re kidding, right? The APPEARANCE of price stability is important to the government, but ACTUAL price stability clearly is not a priority based on the evidence of the last decade. I agree with your conclusion that housing is toast. But there’s two issues: (1) How does one define “toast”? (In other words, what kind of decline qualifies as “toast”), and (2) What’s the timing of the toast? Two critical issues, I’d say.

My point is that the Fed/Government is prepared to pull all sorts of things out of its hat if it looks like things are really going south. Be prepared for bank regulatory agencies to change the stringency of their exams, a bailout of Fannie and/or Freddie, increased interest deductions for homeowners, you name it. I’m not saying it’s going to happen, I’m just saying to be prepared for the unexpected. Strange shit happens.

For example, as of 2003, in the 90 years the Fed had been in existence, it had NEVER lowered short-term rates below the rate of inflation (and for good reason). Consequently, using historical numbers, the odds of that eventuality were beyond a 3-sigma event – almost impossible. And yet it happened. Don’t be surprised if we see similar maneuvers. Ultimately, they won’t work – the fundamentals will eventually win out. But, such machinations can put a floor on the decline as well as deferring the pain out even further into the future than any reasonable person might expect.

[davelj]

As a housing bear, I agree with the vast majority of what you have to say here, but my guiding investment mantra since projecting other “obvious” future bearish scenarios and having them foiled (or perhaps I should say “deferred to a later date”) by the Fed’s dropping rates to (well below the rate of inflation at) 1% is:

“The best laid plans of mice and men are often trumped by Greenspan’s kin.”

Again, I’m a housing bear (and a stock market bear for that matter). But one thing you have to remember about being bearish is that over 90% of the world is aligned against you. The world, in aggregate, is WAAAAY long – investors, traders, governments, etc. And when these interests feel threatened, it’s amazing to what lengths they will go to prolong the “good” times. All I’m saying is to prepare yourself to be surprised at what the powers-that-be come up with to keep this crazy market from totally tanking. There’s an awful lot of entrenched interests that have a big stake in how it all turns out. They’re not just going to roll over and get stampeded without a fight.

[davelj]

I ask again…

“Foreclosures are at an all-time high.”

Are you sure that’s correct? My understanding is that the foreclosure rate was many multiples of the current rate back in 1990-1994 here in California.

[davelj]

“Foreclosures are at an all-time high.”

Are you sure that’s correct? My understanding is that the foreclosure rate was many multiples of the current rate back in 1990-1994 here in California.

[davelj]

I’ll know that we’re close to the bottom when Jim Cramer and Larry Kudlow no longer have shows and CNBC has such little viewership that it’s in danger of being sold or merged with another news-oriented channel. There should be a label at the bottom of the screen for CNBC (Bartiromo, Jim Cramer, Larry Kudlow, etc.): “These remarks are likely to be dangerous to your financial health.”

[davelj]

I’ll venture a guess (operative word, “guess”).

The “market,” which I’ll define as the Nasdaq and the S&P, has been trading above its long-term trend line for over a decade. The First Bubble popped in 2000 primarily as a result of rising interest rates and plain exhaustion (and then earnings fell after the internuts started going bk and 9/11).

Now we’re in the Bounce Bubble, where margins and valuations are lower, but both are still well above trend lines. Fair value on the Nasdaq is probably around 1200-1400 and on the S&P is probably around 750-800, again adusting for normalized profit margins and valuations relative to inflation.

As Jeremy Grantham has pointed out, we never actually got below the trend lines when the First Bubble burst before the Bounce Bubble took hold. Which is the first major bubble of the post-war period not to do so. So, we’ve had unfinished business on the downside building up for some time now.

My guess is that rising interest rates are finally spooking people into realizing that there’s a slowdown coming in the not-too-distant future and that this will impact margins and earnings. Also, I think there’s just some plain old exhaustion going on. This insanity has been going on for so long that it was bound to end at some point, the only issue was exactly when. Maybe it’s in the process of finally unwinding… but maybe not. Again, it’s just a guess.

[davelj]

“Maybe I am a fool, but I do not believe in blaming or crediting luck for things that happen.”

Is that so? Three billion people on this planet live on less than $2 per day. There are over 6 billion people on the planet currently. If I had to guess – and correct me if I’m wrong – I’d bet that you were BORN into circumstances that would put you in the top 2% or so of the planet with respect to socio-economic opportunities. I’m curious, how do you think you’d be faring right now, Chris, if you were born in the middle of China or India or Africa, etc.? My guess is pretty much like most everyone else born into those circumstances… not well.

My point: looking at things from a big picture perspective, the single most important determinant of one’s socio-economic situation is that which one is born into, which is 100% luck. If you can’t see the role of luck in “things that happen,” then you clearly haven’t thought about it in much depth.

But more specifically with respect to business, investing, etc., I don’t disagree with some of the things you’re saying. But your phrase “after the fact” is critical. Most people don’t realize that they were taking too much risk until after the fact and often such “after the fact” probabilities weren’t knowable “before the fact.”

Were the business owners bankrupted by Katrina stupid for locating their businesses in New Orleans? Were the companies crippled by the World Trade Center terrorist attacks dumb for locating themselves in those towers? Is it reasonable to plan your business around $8 per barrel oil?

I will agree with you that many, and probably most, failures are the result of bad planning somewhere down the line. But, not all are – some are just plain bad luck.

Life is full of randomness that as humans we don’t want to admit and are not wired to comprehend. Such randomness has a far more profound affect on our lives that we care to think about, particularly if we’re successful and value a large measure of control over our destinies.

[davelj]

One of the problems with discussing things over the internet is the need for brevity. Who, after all, has the time and inclination to thoroughly explain complicated issues in a forum setting? The problem with brevity is that it unitentionally leads to misunderstanding.

Obviously, where accumulating wealth is concerned, it is better to be relatively frugal vs. relativey extravagant. After all, common sense dictates that the more capital you have, the easier it is to compound capital (in absolute terms, that is – once you have too much capital, it can get progressively difficult to compound that capital in relative terms – ask Warren Buffett about this problem). I agree with that particular point made in The Millionaire Next Door (how can one not?). It is logically incorrect to say, however – as The Millionaire Next Door implies – that, “You’re likely to become a millionaire if you’re really frugal and take some risk on the investing (or business) side.” You may be MORE likely to become a millionaire, but as Taleb correctly points out, the bankruptcy world is littered with smart, frugal people who took some risk. The problem is that the winners’ risks worked out and the losers’ didn’t. Some of that, of course, can be controlled through risk management. But, much of it cannot and can only be attributed to… “luck” or “fate.”

One of the reasons that our particular generation of humans has survived and thrived on this planet is that we are poor estimators of risk. We are overconfident and often take on more risk than we are aware of. This evolutionary trait encourages risk-taking and has advanced mankind in the aggregate although clearly lots of individuals fail. As an investor, it’s important to be aware of the fact that you, me and almost everyone routinely underestimate risk because of lots of internal evolutionary behavioral factors that I’m not going to go into (read up on Behavioral Finance). This will never change, but at least your decision making will improve at the margin by being aware of your inherent biases as a human.

There’s plenty in The Millionaire Next Door that’s good information, but that doesn’t mean you should accept the author’s conclusions (as Taleb points out).

I agree with most of the posters that you have a lot of opportunities to make your own luck or exploit luck when it presents itself. I always liked Ronald Reagan’s quip, “You know I’ve been lucky all my life, but I always found that the harder I worked, the luckier I got.” There’s a lot of wisdom there. Having said all that, I’ve also found that bad luck trumps all: intelligence, hard work, etc. But obviously there are certain things you can do to minimize your odds of getting sunk by bad luck.

Addressing one of the other topics in this thread, if you worry about money all the time, something’s wrong in your life. In my view, the primary value of money is freedom and security – it gives you freedom to do things you want to do and security to sleep at night and not worry about finances so much, both of which hopefully lead to “inner peace” (or “contentment”) which I think is the primary measure of the quality of your life. If you’re rich and not content, what’s the point? If you’re dirt poor but truly want for nothing, then you’re probably content. Everyone’s wired differently and has to find out what makes them tick on these fronts. And I can tell you that a lot of people simply lack the introspection necessary to figure out what is going to make them content. Instead they defer to “society” to answer the question for them… this rarely turns out well as you might have noticed.

[davelj]

What luck. With one quick search I found a couple of interviews with Taleb online. Here’s a very abbreviated copied-and-pasted discussion of what he spends a great deal of time on in his book:

“There are two technical problems in randomness — what I call the soft problem and the hard problem. The soft problem in randomness is what practitioners hate me for, but academics have a no-brainer solution for it — it’s just hard to implement. It’s what we call in some circles the observation bias, or the related data mining and survivorship bias problems. When you look at anything — say the stock market — you see the survivors, the winners; you don’t see the losers because you don’t observe the cemetery and you will be likely to misattribute the causes that led to the winning.

There is a silly book called A Millionaire Next Door, and one of the authors wrote an even sillier book called The Millionaire’s Mind. They interviewed a bunch of millionaires to figure out how these people got rich. Visibly they came up with bunch of traits. You need a little bit of intelligence, a lot of hard work, and a fair amount of risk-taking. And they derived that, hey, taking risk is good for you if you want to become a millionaire. What these people forgot to do is to go take a look at the less visible cemetery — in other words, bankrupt people, failures, people who went out of business — and look at their traits. They would have discovered that many of the same traits are shared by many of these people, like intelligence, hard work, risk taking and even frugality. This tells me that the ‘unique’ trait that the millionaires had in common was mostly luck. But the author and most of his readers are not mathematicians or statistical researchers so this obvious and substantial methodological flaw is almost never discussed.

This bias makes us miscompute the odds and wrongly ascribe skills. If you funded 1,000,000 unemployed people endowed with no more than the ability to say “buy” or “sell”, odds are that you will break-even in the aggregate, minus transaction costs, but a few will hit the jackpot, simply because the base cohort is very large. It will be almost impossible not to have small Warren Buffets by luck alone. After the fact they will be very visible and will derive precise and well-sounding explanations about why they made it. It is difficult to argue with them; ‘nothing succeeds like success.’ All these retrospective explanations are pervasive, but there are scientific methods to correct for the bias. This has not filtered through to the business world or the news media; researchers have evidence that professional fund managers are just no better than random and cost money to society (the total revenues from these transaction costs is in the hundreds of billion of dollars) but the public will remain convinced that “some” of these investors have skills…”

Again, I’d read the book – this is a sub-cliff notes version. But to answer your question, “You expect me to spend more time on validating your point than you do?” My answer is no. I don’t expect you to spend any time validating my point. If you want to live your life in ignorance, that’s your problem, not mine. I was giving you some free worthwhile advice. Whether you decide to benefit from taking it is up to you.

[davelj]

Two primary issues: survivorship bias and (again) mistaking correlation for causation. (Btw, I’ve read both books – they’re not bad books, just not to be taken too seriously – some of the conclusions drawn are overly simplistic.)

Unfortunately, this is complicated and I don’t have the time or patience to type it all out.

Read Taleb’s book and then you’ll understand. Trust me. It’s a great book regardless of how you feel about his damning critique of the other two books, their methodologies and conclusions. Taleb’s forgotten more about investing and statistical research in the last 30 seconds than Kiyosaki, Stanley, etc. know cumulatively.

I guarantee you that there are quite a few things that “appear” to make sense to you when in fact they do not make any sense at all when put under the microscope of more rigorous logical analysis. That’s human nature.

[davelj]

There is an important difference between correlation and causation. The only reason that higher test scores are correlated with stay-at-home mothers is that this condition tends to be associated with a husband that went to college, has a higher income and can afford to support the family as a single wage earner. Such families tend to value education. However, the issue of causation is NOT that the mother stays home but rather that there is an emphasis on education. In fact, when adjusting for the education of the parents alone, there is very little difference between the education of kids with working mothers and those with moms that stay at home. And, taking it a step further, when adjusting for parents that are actively involved in their kids’ education (through PTA, etc.), even the prior education of the parents drops off in importance. The critical issue of causation is: To what extent do the parents actually value education? (See first and second generation Asians in the US for a good example of this phenomenon.)

My parents got divorced when I was 8 and my brother was 9. She went to work full-time after the divorce. I didn’t see either of them very much growing up after that, but they valued education. My brother ultimately went to a top law school and I’ve got two graduate degrees. It’s anecdotal, but I really don’t think a mom’s staying at home has anything at all to do with success in education or life, for that matter, from a causation standpoint. And the data supports that. Although there is probably a correlation due to the reason stated above.

[davelj]

I personally know a woman who bought a “premium” downtown condo unit for north of $800K about two years ago. She put it on the market several months back for about what she paid for it and got zero offers. She’s already moved to another city to take another job and she lowered the price within the last couple of weeks to $100K less than what she paid for it and still no offers. I’ll keep tabs on the situation and report back accordingly. I think this will become the norm over the next year or so except that places will be on the market for $200K+ less than the original purchase prices.

[davelj]

This is in desperate need of clarification:

“My brother who has studied this more, said if 3% of Fannie Mae’s loans become insolvent, they become insolvent too and it would set off a derivatives and banking crisis.”

Fannie Mae is levered about 33 to 1, such that if 3% of its loans are “charged off” then its equity will evaporate (and it will be insolvent). Hopefully that’s what your brother meant. Mortgages don’t become insolvent; they become “delinquent” and eventually go into “foreclosure.” Insolvency relates to businesses and individuals, not mortgages.

Now, the only way Fannie Mae’s equity disappears is if 10% or more of its loans move into foreclosure AND a third of the foreclosure balances get charged off. Highly unlikely even considering today’s craziness. (But we could still see a derivatives crisis related to Fannie even if it remains solvent.)

Now, dont’ get me wrong, I’m very bearish on Fannie Mae’s equity and long-term debt. But there’s no way that the government or investors will let Fannie Mae disappear – it will survive via new equity and debt if it runs into serious trouble, which brings us to Fannie’s short-term debt, which is held by lots of money market funds…

If you look at Fannie’s balance sheet, you’ll see over $900 billion of long-term debt (plus its equity) that lies below the short-term debt in terms of liquidation preference. Consequently, you can be very bearish on Fannie’s equity and long-term debt and still be bullish on its short-term debt. Bottom line: I wouldn’t worry about money market funds with Fannie’s short-term paper… but I’d be very worried about owning its equity.

[davelj]

Hussman hits on two of the three critical issues: profit margins (which will mean revert negatively) and the distinction between reported earnings and operating earnings (use of the latter makes the P/E appear lower than it really is). (Although Hussman doesn’t mention the more pervasive use of stock options these days as compared to decades ago which dilutes the real P/E.) I think there’s one more issue to think about (with respect to the S&P specifically): dividends.

Prior to the late-1980s, dividends comprised almost half of the 10% annualized long-term return on the S&P. Well, the current dividend yield is about 1.5%. If you assume 6% nominal long-term earnings growth (3% inflation + 1.5% population growth + 1.5% productivity growth), that gets you to a return of 7.5% annually on the S&P over the long term IF MARGINS AND VALUATIONS REMAIN HIGH, as they are currently, which has historically been a bad bet. The other issue is that the risk-free return on the 10-year treasury is about 5.25%. If you’re willing to accept the volatility of the S&P (standard deviation of about 20% per year) to get a 2.25% premium over risk-free treasuries (standard deviation of about 5% per year), then you’ve got a very unusual appetite for risk. And, again, that 7.5% is a very optimistic projection.

Assuming some mean reversion on margins, the S&P probably won’t return more than about 5% or so over the next decade. That’s not particularly exciting considering that you can get 5.25% risk free owning treasuries. Stocks generically are a sucker’s bet right now.

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