Archive for November, 2008

Reconciling the experts

Thursday, November 20th, 2008

Buffett is buying.  Soros is gloomy.  Who is right?  Probably both.

Schiller’s 125-year historical record suggests the broad index reverts to a long-term mean P/E ratio of about 16.5.  Today, it’s 32% below that, about 11.  So there is no question the market is cheap by historical measure.

But when will it turn?  There is the rub.

There is historical precedent to go much lower (in the 1970s, broad index P/E bottomed out at only 6 or 7 albeit while competing against much higher interest rates), so it would not be surprising to see a further market decline of as much as 40% — particularly if the Fed loses control of long-term interest rates.  

But for a very long holding period (15 years), mean reversion alone argues for buying now.  

Thus your strategy now depends upon your holding period.  This reconciles the conflicting public statements of famous investors.  Buffett holds forever, so he is buying.  Soros, Rogers et al play much shorter time frames, so they are staying out.  Both are rational, given their specialization.

Fewer, Nicer Things

Tuesday, November 18th, 2008

The Last Viridian Note has it exactly right, but is ironically wordy for a minimalist treatise.

Massively paraphrasing:  ”fewer, nicer things.”  

I chose Evernote and GrandCentral precisely because they radically simplify. One phone number for life, one searchable repository for all documents.  Both detached from any particular hardware.  Also 1Password, which automates password storage and data entry. Another 100 fewer things to remember.

The specific experiment is to refit the business to run simply and securely from anywhere.  Nearly there. Slicehost is the last piece of the puzzle.

Simplification is relaxing.  Example:  gave away 80% of my wardrobe this spring.  The rest –  less than I had in high school — is high quality, aesthetic and unusual.  I like it, spouse gently horrified.

Office now little more than a laptop, California plein-air watercolors, and a cellphone.  The emotional barrier is with books.  I could and should eliminate hundreds, but there is irrational attachment. 

The Game of Capital

Wednesday, November 5th, 2008

American capitalism has been so stable, for so long, that everyone has apparently forgotten what it is.  Capitalism is presumed by both liberals and conservatives to be an ideology of total deregulation.  That’s mistaken.

Capitalism is, and has always been, a game whose rules are designed and enforced by government to maximize the efficiency of capital allocation.  

“What?”  my laissez-faire readers argue.  ”Capitalism has inherent rules?”  No, they argue, capitalism is the totally free, utterly unfettered flow of capital.  The rules are what get in the way.

“What?”  my Bay Area friends argue.  ”Capitalism has inherent rules?”  No, they argue, capitalism is the unrestrained excess of the greedy.  The rules are what keep them at bay.

These positions both misunderstand the history and definition of capitalism.  Basic regulation — the rules that define incentives in the capital allocation game — are central.  Capitalism cannot function without them.  The objective is not to increase or decrease regulation, but rather to design a legal structure that maximizes the efficiency of capital allocation at minimum cost.

Consider:  capitalism depends upon private ownership.  But what does “ownership” mean?  Property is, at its core, a form of monopoly granted and enforced by government.  When you buy a house, what are you paying for?  Exclusive use.  Who protects that exclusivity?  What stops your neighbor from crashing on your couch whenever he wants?  Laws and police, paid for by tax.  Private ownership cannot exist without this government sanction and enforcement.  Thus regulation is inherent to capitalism.

This is a special case of the most general function of government:  to assign individual costs and benefits to externalities, in a way that makes most people better off.

The cost of such assignment can easily exceed the benefits, which is why so much of the regulation of the 1960s and 1970s was wasteful and counterproductive.  This set the stage for a conservative backlash that is only now running out of steam, as it hits the problems that exist at the other end of the regulatory scale.  As posted here years ago, Baja California demonstrates how poorly under-regulated capitalism works.

In the US, wasteful regulation and counterproductive deregulation are both driven mainly by politicians born before 1960, who, as posted here previously, grew up in conditions of essentially unlimited American power, stability and financial resources, and thus never developed the judgment necessary to make decisions under conditions of limited resources.  

With the passing of the torch to a new generation that grew up with declining living standards and American balkanization, we may reasonably hope for better cost/benefit analysis.

Investor's Edge

Monday, November 3rd, 2008

Investing does require a competitive edge, but the “information edge” set forth by rational-agent economists is not the only kind of edge that emerges in the real world. Other kinds of edges:

1. Temporal — willingness to hold one type of instrument, such as stocks or cash, for a very long time, i.e. years, until conditions are right to switch.
2. Emotional — ability to sleep at night while holding a highly volatile instruments.

These sound trivial on paper, but are actually rare and valuable enough to confer a big advantage. Illustrative example:

Since the 1870s, a simple rule to outperform the market has been to buy 100% into the index when its P/E ratio falls below 9, then sell 100% (go all cash) whenever the index P/E ratio is above 22. This rule outperformed the index by a factor of 7.

But this is so simple. What critical edge could be involved? The discipline of inaction. The temporal and emotional wherewithal to make only 9 trades in 125 years. This rule would have had you sitting on the sidelines since May 1995. It might require making no investment moves for most of your adult life. It would be impossible to be an investment adviser, or to hire one: who would pay a fee to a manager who did nothing for 15 years?

This strategy is impossible to execute unless you are currently very young, and prove to be exceptionally long-lived. Thus almost no one has the necessary edge to pursue it.

In a way the investing edge is like marketing strategy: there are many different paths to advantage, but they all involve being unique in a significant and sustainable way.