The Rules, Part VI

History has a nasty tendency to not repeat, when everyone is relying on it to repeat.

History has a nasty tendency to repeat, when everyone is relying on it not to repeat.  Thus another Great Depression is possible, if not likely eventually.

When people rely on the idea that a Great Depression cannot occur again, they tend to overbuild capacity, raising the odds of another Great Depression.

I think I wrote those between 1999 and 2002.  I kept a MS-Word file at work and home, and when ideas would strike me, prior to my time of being asked to write at RealMoney, I would write them down, and later revise them, until I had something that I thought was worth keeping.  I eventually ended up with 6 pages.  At some point in time, I concluded that my musings needed to be more structured, and I reorganized them so that similar thought were near each other.  I am fairly certain I wrote the three phrases above at different times.

I have sometimes said that to be a good contrarian, you don’t analyze opinion, you analyze reliance.  How much have people invested in an idea?  Are those that have invested in an idea long-term holders with a strong balance sheet, or short term holders that are reliant on total returns?  Do those who have invested in an idea have to get returns in the short run in order to survive?

The idea may be right or wrong, in the long run or the short run.  But near turning points, short-term money seems to be near-unanimous in its opinion that “this is the best way to make money.”  Seemingly free money brings out the worst in us.  We were created to work, but we would rather speculate, if given the opportunity.  I criticize myself here as much as anyone else; maybe I should have been a Mathematician or a Chemist.  That’s what I started out as in College, before being seduced by the simple beauty of Economics 1 & 2, which hid the complexity, and lack of ability to estimate their models.

It’s Different this Time.”  So say many investors during booms.  Following momentum is a great strategy when few are doing it, less good when many are doing it, and troublesome near market breaks.

The same is true of governments.  They happily accept credit for a good economy, and then during busts, they borrow from the future in order to make the present better.  The first few times they do it, is works amazingly well, and so they assume that it is a rule: let the government borrow, and let the central bank lower rates a lot, and voila! the recession ends.  They don’t notice the increases in debt, public and private, and that useless economic capacity is not disappearing, because it gets financed at lower and lower rates.  We tend to be lazy, and not think of better uses for resources until there is financial failure forcing us to do so.

The cost of eliminating recessions too quickly and prolonging boom cycles, is that the debts build up.  Consumers and investors lose fear, and take on more debts than is prudent.  Debt-based economies are more complex and fragile than economies with lower leverage.  Particularly when financial entities are highly levered, the odds of a crisis are high.

As my wise former boss once said, “We don’t make the mistakes of our parents, we make the mistakes of our grandparents.”  Our parents typically warn us of the problems they survived, but not those that their parents did.  Thus we fall into the forgotten problem, and why big busts tend to recur about once every two generations.

The knowledge is out there, but culturally, we don’t use it.  The past is irrelevant; this is a new era.  It’s different this time.  Alas, the hubris of man is one of the few infinite things that he has.  Few study economic history, particularly most economists.

As such, we build up productive capacity using debt, assuming that high compound growth will make it work, and fall into another bout of debt deflation.  It may not be the Great Depression, it might be like Japan for the last two decades, or, maybe… it could be another Depression.  Or, something entirely different… the US Government builds up so much debt, and is constrained politically from inflation or higher interest rates, that it decides to default on external obligations.  Not likely, I know, but hey, there are a lot of unusual things going on, and unusual tends to beget unusual, at least in the short run.

But, how many are truly invested for total disaster?  And which total disaster?

  • Depression.  Buy long Treasury bonds, sell gold.
  • High inflation.  Buy TIPS, foreign bonds, and commodities. Sell long bonds.
  • Hyperinflation. Buy Gold and Silver.  Sell bonds short, if it is still legal.  Look for alternatives for practical currency.
  • Civil unrest? Choose your home with care.  There is nothing to buy or sell here.  Survivalism would work for short periods, but almost all long-term solutions rely on a stable civil government.

My estimate is that few are invested for a crisis.  That does not mean that a crisis is coming, but that if a crisis comes, since most are not prepared, the selloff would be hard.

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Moving to the short run, there are many who say that the current rally is tapped out, and will fail soon.  That may be, but there is a lot of liquidity generated by the Fed’s low short rate policy, and many in the short run will borrow short to fund a long term asset, like a stock, which has a higher yield.  Eventually that will fail, but in the short run it is temporarily self-reinforcing.

My view: favor the momentum in the short run, but realize that most of this rally is anticipating profit margins in the economy that have never been obtained in the past.  Trim exposure, or be ready to do so.  Remember, bond yields are proving to be greater competition day by day.