A Little More On the Very Complex Financial System

I have finished a first reading of Nassim Taleb's latest book, Antifragile.  It's not an easy read, and it does not tell me what to do in the world of investing, but it's quite thought-provoking.

Bloomberg.com is running today an opinion piece that is more accessible than Antifragile, and is along the same lines.  It argues for more transparency and simplicity in the financial "system".  It's a good read (LINK).  Hint:  the title about embracing complexity is misleading.  Here's a core paragraph:

Complexity also helps financial institutions hide the risks they create. Despite the advertising of the International Swaps and Derivatives Association and others who create and sell derivatives, these products are only sometimes used for hedging and much more frequently for speculation. In the latter case, they are exceedingly useful in obscuring information that would be crucial to the proper judgment of values and risks. Consider the derivatives that helped Italy’s Banca Monte dei Paschi di Siena SpA hide hundreds of millions of dollars in losses as it sought a taxpayer bailout. Anyone making deals with a bank enmeshed in a largely invisible web of contracts with far-flung counterparties does so with a very incomplete view of the risks involved. 

We simply do not know what risks we are, or are not, taking with our investments these days.

Money-Printing Inflationists Get More Media Play, but Nassim Taleb Gets It Right

The L. A. Times purports to make a virtue out of a bad thing, repeating the big lie that "deflation" will cause people to starve themselves to death, fail to buy diapers for their babies, not send their children to college, because they expect that, perhaps, the prices of these goods and services will fall at the rate of perhaps 1% a year as in Japan. Here is a representative sample of the article titled Trashing the dollar to save the economy from today:

If prices of many imports at your local Wal-Mart or Target rise even slightly, or at least don't fall, it could be that much harder for a deflationary spiral to take hold.

We all like paying less, but the Fed is afraid that, amid tepid demand, many consumers will begin to believe that prices can only go down if they wait to buy. That could push the economy back into recession, or worse.

So the theme that the public is supposed to buy is that we all need to buy, buy, buy before prices rise.

And presumably the tooth fairy (aka the Fed) will recharge our credit cards when we buy, buy, buy what we can't collectively afford.

The mainstream generally ignores that it takes productive work and then productively-utilized savings to create true economic growth.

Nassim Taleb gets it right, as usual. Bloomberg reports in Obama Stimulus Made Economic Crisis Worse, 'Black Swan' Author Taleb Says:

U.S. President Barack Obama and his administration weakened the country’s economy by seeking to foster growth instead of paying down the federal debt, said Nassim Nicholas Taleb, author of “The Black Swan.”

“Obama did exactly the opposite of what should have been done,” Taleb said yesterday in Montreal in a speech as part of Canada’s Salon Speakers series. “He surrounded himself with people who exacerbated the problem. You have a person who has cancer and instead of removing the cancer, you give him tranquilizers. When you give tranquilizers to a cancer patient, they feel better but the cancer gets worse.”

Today, Taleb said, “total debt is higher than it was in 2008 and unemployment is worse.”

That last sentence is quite the understatement.

Taleb, no right-winger, "gets it". A free people will produce growth as their available resources and inclinations allow. If people don't want to "grow" and instead want to consolidate their situations, there's nothing wrong with that. Instead we have central planning run amok, and without the Bush/Paulson excuse of a crisis.

The surge in the stock market this month must be related both to easy money and to optimism in some quarters that Obama-ism will be officially neutered after the elections. One gets the impression that just as the Republican Congress devolved into a parody of itself in 2006, a similar thing has been happening in Washington recently. Stephen Colbert? Puh-lease!

From a markets standpoint, the low expectations that people have for either political party admits for upside surprises should one party or the other outperform these low expectations. Or perhaps the economy will turn up of its own accord.

In the meanwhile, what we know is that the President, the Fed and Congress are united in desiring a weak dollar. Unfortunately, more than half the world also wants their own currencies to be weak.

While gold looks technically extended, only now is it getting mention from within the business press that it, and only it, is the one "currency" that can only be diluted ("printed") at the rate of mine production as a % of accumulated supplies that have taken centuries to be mined and saved. It remains the view here that stocks remain in a meandering phase within a structural bear market and only appear cheap in relation to zero interest rates, and that gold remains at least a good ways from the end of its structural bull. It is Treasuries that continue to go Japanese, until one day they may quickly go Grecian and destroy wealthy as rapidly as the NASDAQ did after its implosion. Of course, it is Japan that may in one way or another go Grecian with rapidly rising rates, but since it does not have debt to foreigners, it is plausible that it will find an intra-Japanese solution to its own debt bubble.

America needs to suck it up and cope, as Charles Munger might say. Unfortunately statism has been on the march, with promises that if we just print more money and keep bailing out the banks that lent not wisely but too well, benefits will trickle out to the real economy. If the Taleb view of facing reality and dealing with it actually gains significant traction, the world will get very turbulent for a while and end up a much better place.

Copyright (C) Long Lake LLC 2010

Deflation Theme Getting Too Popular

An increasing number of financial, governmental and academic types are signing on to the idea that (duh!) the economy is entering a slow spot. Jeremy Grantham has joined the crowd (see #1). The deflation argument is getting popular now that Treasuries have surged in price, lowering their yield to ridiculous levels. Where were these deflationists when David Rosenberg was one of the few such proponents 100 basis points of yield higher (10 -30 year bond)?

Supposedly according to this growing alliance of deflationists/economic gloomsters the economy needs more amphetamines, or is it opium? Or is it hopium?

Concomitantly, even the commentators on Kitco.com's commentator site are either bearish for the short term or don't comment at all on the short term, taking a long-term view that paper money devalues (thanks for the insight!).

Mark Hulbert's Gold Sentiment Newsletter Index (HGNSI) was said to be at a contrarianly bullish 9% recommended gold allocation about 2 weeks ago. Given the tone on Kitco and the price action in gold, I wouldn't be surprised if it were below zero now.

In evaluating the main asset classes, certainly cash is the most overvalued. Treasuries are in the late stages of a recovery from a horrible bear market and now are in a Neverland of manipulation. Stocks are looking worse from both a price and earnings momentum standpoint.
Silver is looking like a metal proxy for stocks.

The conditions for the recovery from the multi-year gold bear market that finally ended (for now!) in 2009, when the 1979-80 price range was exceeded for an entire year for the first time since then, are easy money and a desire to fight "deflation".

No matter that the only important deflation is that of houses and stocks, namely assets individuals own. The cost of living is undoubtedly rising in a thousand ways that are uncounted by the Bureau of Labor Statistics. But government statistics are to statistics as military music is to music.

While the Internet was new, tech advances were not new. There was no New Era in the 1990s. There was just a massive stock and investment bubble which extended to property and other lending a few years ago. The sovereign debt bubble is now on the plate in richer countries than the usual defaulters of the past 65 years.

Thus the gold vs. fiat money battle is only now getting going for real. The current fad that deflation is a serious risk is the best argument for gold right now. Short term sentiment amongst gold traders is depressed. Bonds are in fashion. Whatever you own, the financial powers that be want to destroy you if you are leveraged.

As economic activity sputters, Big Finance's potentially insolvent position will make it call once again for money-printing, which aligns with what governments trying to fit a guns and butter agenda generally do. I for one can't come close to timing this. My sense is that once again Nassim Taleb is correct, namely that big-time inflation is the underpriced "fat tail" possibility.

Traders such as Dr. Taleb can take advantage of derivatives such as futures and options, but identifying those opportunities is far beyond my capacity. Gold (and in up-moves silver) is the slow-moving investor's core hedge against these sorts of outcomes. Better to buy when traders are gloomy than when they are ebullient, yes?

And I wouldn't sell gold on a downtick when the trade is into cash yielding nothing. At least not until fiscal sanity is forced upon Washington.

Copyright (C) Long Lake LLC 2010

Common Sense from Nassim Taleb

CNBC reports on an interview it had Wednesday morning with the author of "The Black Swan", Nassim Nicholas Taleb, Ph.D. Here is the text of CNBC's summary of the interview in its entirety:

The Obama administration's attempts to fight the financial crisis with more cash is like treating a bad tooth with Novocain instead of a root canal, Nassim Taleb, author of "The Black Swan," told CNBC Wednesday.

The main problem is the level of debt, and Taleb compared the authorities' efforts with those of a not very skilled pilot who is trying to land a Concorde on a narrow strip, between an ocean of deflation and a mountain of hyperinflation.

"These people failed us, they're going to fail us again," Taleb told "Squawk Box."

"They tell the banks to lend more but have less leverage," and expect people to go out and consume while unemployment is rising, he added.

"The way to restart everything is restructuring, conversion of debt into equity, convince people that debt is not good," Taleb said.

"Do not delay a root canal," he added. "Don't do piecemeal solutions to a problem that is fundamental."

"The solution is there, convert debt to equity. Usually it happens with Chapter 11, let's do it faster, and across the board," Taleb said.

Dr. Taleb is my number one man in this crisis. One reason is that he looks at matters in a system-wide fashion.
No one knows whether the recession/depression/banana will end this month, next quarter, etc., and no one really needs to know. How does the long-term value of, for example, IBM or McDonald's, or a medical technology company, change if the abstraction called the "economy" bottoms in one quarter or another?

What really matters is risk-reward, which Taleb has been top-notch at.

There's no doubt at Econblog Review that the U. S. needs to move to equity rather than debt. Piling debt upon debt will fail. When? No one knows. But it will fail. Is the President or Congress listening to this advice? No.

More's the pity.

Copyright (C) Long Lake LLC 2009

Getting It Right But Still Getting It Wrong

A writer named David Carr, who covers the media, has turned his attention to the media coverage of the financial mess. Glory be, he referred to the interview on CNBC between its anchors and two of the best "bears" around, Dr. Nouriel Roubini and Dr. Nassim Nicholas Taleb. The article, This just in: The market is still dead, has a choice part:

The two guests — known as Dr. Doom and the Black Swan, nicknames that usually land on people who do their best work with chain saws and thumb screws — were fresh off their appearance in Davos, Switzerland, where they were hailed as visionaries for having foreseen the financial crisis.

Griffeth started things out briskly by saying, "What would it take to make you bearish on this economy right now?"

You mean bullish, his co-host, Michelle Caruso-Cabrera, interjected. They cracked wise about Freudian slips, but the entire segment, it turned out, was about trying to somehow find the horns of a bull on two ferocious bears.

Roubini quickly pointed out that many big banks were insolvent — something that became more apparent as the week wore on — and went on to predict a brutal, U-shaped recession with no quick end. "It's ugly," he concluded, using the same term of art, minus a few oaths, that I use when it's my turn at home to open the latest update on our retirement fund.

"But that's not the end of the world, is it?" Griffeth asked plaintively. Roubini indicated it was sort of getting there, with a recession that will be three times as long and three times as deep as the previous two.

Sensing the thickening gloom, Griffeth pivoted away to Taleb and said, "You're not as bearish as Nouriel, are you?" Well yes, as a matter of fact he was. "We have the same people in charge, those who did not see the crisis coming," he said.

In studio, Dennis Kneale of CNBC broke in and said, "Let's get back to the real purpose of doing this, because we know the forecast is dark and continuing dark," and then when on to fish for one metric, any measurement, that suggested the economy was "turning the corner."

His guests did not play ball, and later they looked slightly aghast when asked what they would invest in and what was in their portfolios.

You may enjoy the interview at http://www.cnbc.com//id/29103328.

To me, here's the punch line that prompted this blog: the author's conclusion that the first of the "fundamental lessons" of this crisis is to "have a diversified portfolio".

As did Betty Boop in the eponymous cartoon (1935): No! No! A thousand times no!!

Just as she rejected the villain, people should reject the idea that they should have a "diversified portfolio". Different situations call for different asset allocations. People in their 80's perhaps should no money in common stocks most of the time. Young people without many assets do not have much to lose, and can take more chances. People like yours truly who follow markets closely like to identify a major theme and maximize risk-reward rather than just having the financial assets move like the average asset in a diversified portfolio.

Nassim Taleb, for example, recommends that most people should have 85-90% of their assets in ultra-safe Government securities. Perhaps the diversification would be between Treasury bonds and bills, and Ginnie Mae bonds!

Getting back to Mr. Carr, he reported on Drs. Roubini and Taleb, and undoubtedly watched the interview at least twice, but he obviously did not hear what they were saying.

If a market falls 50%, then it must double to get back where it was. The Great Crash of 1929-32 had a number of 30% down, 28% up sort of moves, but the catch was the up-moves never got back to where the down-move started from. What Dr. Taleb preaches is that one should avoid big losses. Dr. Roubini has been screaming for some time that the risks in the real economy were horrendous, and he still states that there is a probability that the news on the economy will keep being worse than expected.

In that case, Mr. Carr picked the right topic on which to focus, but he missed the point completely. How many other Americans are focusing on the risks but are continuing to miss the point?

Copyright (C) Long Lake LLC 2009