I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some energy some healthcare-related names, P&C Insurance and to a lesser extent Reinsurance, particularly those that are strongly capitalized.  I’m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

A word on banks and REITs: the credit cycle has not been repealed, and there are still issues unresolved from the last cycle — I am not interested there even at present levels.  The modest unwind currently happening in the credit markets, if it expands, would imply significant issues for banks and their “regulators.”

I’m looking for undervalued and stable industries.  I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is pretty cyclical at present.  I will be very happy hanging out in dull stocks for a while.

P&C Insurers Look Cheap

After the heavy disaster year of 2011, P&C insurers and reinsurers look cheap.  Many trade below tangible book, and at single-digit P/Es, which has always been a strong area for me, if the companies are well-capitalized, which they are.

I already own a spread of well-run, inexpensive P&C insurers & reinsurers.  Would I increase the overweight here?  Yes, I might, because I view the group as absolutely cheap; it could make me money even in a down market.  Now, I would do my series of analyses such that I would be happy with the reserving and the investing policies of each insurer, but after that, I would be willing to add to my holdings.

Do your own due diligence on this, because I am often wrong.  One more note, I am still not tempted by banks or real estate related stocks.  I am beginning to wonder when the right time to buy them as a sector is.  As for that, I am open to advice.

There is a benefit to reading books on marketing for those that will never be marketers: it will immunize you to sales pitches.  Think of it as studying the strategies of the enemy.  When you talk to salesmen, you can flip their words back at them, or tell them “no,” to the questions that have a guaranteed “yes” attached to them.  Better, if you want, you can tell them, “Stop. I know your tactics.  Cease the sales language and answer these questions I have…” Maybe they will cease.  If not, leave.  There are many places to buy, and some people that will listen to you elsewhere.

Some weeks ago, I was traveling, and heard an ad for a “financial seminar.”  This one sounded better than most, and featured the teachings of a well-known writer.  For fun, I signed up for the free seminar, just to see what would happen.

In reading what little I had before the seminar, I concluded that the only way of doing what they claimed was private ownership of high cash flow properties or businesses.  When I went to the seminar, I was not disappointed — that was the main idea.  Secondarily, they said you could get non-recourse financing easily, or equity limited partnerships to finance you.  (Money grows on trees…)

The first problem is this: mispriced properties are few and far between, and there is competition to buy them, generally.  Second, financing for property investment is scarce, especially for anything where the lender has no recourse to the borrower.

Passive Income

Passive income is an idol in these shows.  It seems like free money, but in practice it is difficult for investors to buy properties cheaply, finance them, and get rents that are far higher.

If it were that easy, they would create a REIT and do it themselves.  I asked the presenter at the end of the presentation: “If there are that many high cash flow properties available, why doesn’t a REIT buy them?  After all, they can finance more cheaply than you.”  Response: “What’s a REIT?”

That’s more than the wrong answer; it means you don’t know what you are doing.

Tactics

There was a lot of framing going on.  The package was worth $5000, but we have a special offer for $600.  Today for you?  $200.  After some people leave — “Yes, $200, but your spouse can some too.”  Oh and if you buy today, we’ll throw in these extras…

I suspect there were shills in the audience, who went back to buy.  I looked back several times, and estimated that 50-60 out of 200 went back to buy.  At the end, only 30 remained to hear the ending advice.

Regardless, the gross revenue of the day was around $6000, which supposedly covered only the cost of the presenter and the hotel room.  I have my doubts.

Other  Notes

Twice the presenter mentioned that the company that the author worked with was publicly traded.  Well, sort of, it deregistered in Spring 2011, and the company is worth less than $10 million today as it trades on the pinks.  What can you say for a company with a negative net worth, normally negative income, and very low trading volume?  (Leave aside the lawsuits…)

The presenter appealed to Buffett on not diversifying, but Buffett tells average investor that they are best invested in mutual funds.  Being undiversified carries with it the idea hat one is incredibly smart, and able to do far better then the averages.

The reason that they put forth a private market strategy is that it can’t be falsified.  That is the great thing about selling people on investing in real estate.  There is no way to put forth an audited track record.  You can tell anecdotes, and people buy your educational materials.

Summary

Be skeptical.  Nothing good is easy.  Anything advertised in investing can’t be that good.  I knew this, and my experience proved it as I reviewed the charlatans.

I wrote about the thoughts of others Wednesday as I took notes on their talks.  I don’t type that fast, so my notes gives synopses of the talks given.

Now for my own thoughts.  I have a sympathy for anyone that wants to take monetary policy out of the hands of the government, because they don’t do it well.  Some sort of hard money standard is necessary, whether gold, silver, or a commodity basket.

Ideals

I have one major ideal here, and I don’t care as much how it is accomplished: get the government out of the monetary policy business.  My secondary ideal is regulating banks properly.

A gold standard could do the job, but I am not wedded to the idea.  Gold standards can be inflationary or deflationary.  It depends on the price at which you link the currency to gold.  Post-WWI, Britain pegged it too high, and got deflation.  France pegged it too low and got inflation. Getting the right level would be important.  Fortunately, we know where it trades now relative to the dollar, and that would be pretty close to the right level, if the stated gold levels of the Fed and the Treasury are accurate.

Practical

A full audit of the Fed is a minimum, as is an audit of the gold at Fort Knox.  Do it once, so that all doubts can be dispelled.

I think that bank regulation for leverage and asset-liability management is more critical than monetary policy itself. Banking crises stem from inadequate asset-liability management.  As James Grant pointed out from the historical example that he gave, deposits should back only self-liquidating assets.  Longer term assets must be backed by matching funding, or equity.

Unseasoned asset classes (i.e., asset classes for which we have no real loss statistics because they have never had failure as a group) should be disallowed as investments for banks except against surplus.  After that, risk based capital should be based off of strict actuarial studies, with a significant provision against adverse deviation, and no credit for diversification.  And, don’t allow banks to score their own riskiness, a la Basel.  That is ridiculous; the fox guards the henhouse.  If a bank has superior risk control, they will earn the results over time; they should not as a result lever up more.

Now, I really don’t care if it makes banks unprofitable, or earn less than their cost of capital.  In that case, we will get fewer banks, the margins of the remainder will rise, and you end up with a genuinely stable system with occasional bank failures that don’t threaten the system as a whole.

There was one idea that I thought could be put into practice immediately, Treasury Trust Bonds optionally backed by gold.  If nothing else, like TIPS, it would give the Fed another indicator on how credible their monetary policy is.

Conference Zeitgeist

The Taylor Rule got some respect.  Many suggested that if it had been followed, we would not have gotten into this crisis.  I’m a little less optimistic there, because bank regulation was co-opted allowing for too much risk to be taken relative to liquidity and capital.

Most felt that the Fed was the major player in causing the crisis, with the GSEs playing a lesser role.  The overpromotion of home ownership, and the constant provision of liquidity to the markets led borrowers to become reckless amid asset price inflation.

Incentives also played a role. Managerial and shareholder liability at banks would help prevent reckless behavior.  Wall Street worked better when it was a bunch of partnerships, rather than limited liability corporations.

Most thought that things are worse now than the ’70s.  The debt levels are higher, which makes demand punk, and businessman more skittish to expand and hire.  Government policy is less predictable as well.

The speakers largely expect more inflation; more debt monetization is the path of least resistance.  Politicians get what they want without a vote being taken.  On the question of where to invest, everyone was an inflationist.  Gold, silver, TBT, were trotted out.  Personally, I’ll stick with my stock investing.

People

Jeffrey Lacker showed courage in coming to the conference.  He made a really good point that the Fed should focus on its liability policies, and limit itself to investing in Treasuries.  The Fed gets bad press and popular dislike when it uses its assets for special lending programs and bailouts, leading to charges of favoritism.

Zoellick was a reasonable guy regarding the problems in the Eurozone.  Germany has to figure out what it wants.  To me, it boils down to this:

1. You can have a suboptimal euro that is not a good store of value, and bail less well-disciplined governments out via the ECB sucking in their debts, or,
2. You can have a smaller Eurozone en route to no Eurozone, or,
3. You can have a Federal Europe, and dissolve Germany into Europe as a state of the whole, as the 13 colonies did after the Articles of Confederation.

Personally, I would choose #2, because people in Europe identify themselves with their nations, not as Europeans.  Political and economic systems must derive from cultural systems or they will not work in the long haul.

It was fun seeing my old professor, Dr. Steven Hanke.  I reminded him of nine years earlier, when he gave a talk to the (then called) Baltimore Security Analysts Society, and we discussed why we thought the Euro would have a tough time surviving.  Most of that discussion is now taking place.

Ron Paul was Ron Paul.  He doesn’t change much — that’s one of his apolitical virtues.

John A. Allison was entertaining; he argued that capital levels are too low, and regulation too high.  He thinks that you can’t expect much, and don’t get much from regulation.  Especially interesting were the discrimination in lending allegations by the regulators that BB&T fought and won twice.

Conferences like this attract cranks.  Lots of people with odd political agendas hoping to get noticed, others with odd business propositions.

Other

As a final note, the concept of free banking and/or competitive currency issuance, I think invites more problems than it solves.  Think of it this way: people aren’t very good at evaluating financial promises.  The fewer the better, and the lower level of complexity, the better as well.  There has to be some monitoring of financial promises, some intelligent regulation of banks, or things can go badly wrong.  US history backs such an idea up, regardless of whether we have a gold-, silver-, or commodity-backed currency, or a fiat currency as we do now.

Update — thanks to Eddy Elfenbein for catching a typo/thoughtless mistake in paragraph 4.  For France, it was inflation, not deflation.

PANEL 3: TRANSITION TO A NEW MONETARY REGIME

Moderator: Steve H. Hanke
Professor of Economics, Johns Hopkins University

DM: Steve Hanke was a professor of mine when I went to Hopkins.

Targeting NGDP — Cato Institute — 2003 — Nominal Gross Domestic purchases or final sales

Richard H. Timberlake
Emeritus Professor of Economics, University of Georgia

Why did we go off the gold standard?

Dual Mandate is the main problem at the Fed.

Fed very different animal than at its inception.

Legal tender laws — goes back to the Civil war, 2.5x inflation afterward.  Debts paid off with depreciated greenbacks.  Tested by Supreme Court — Salmon Chase, Lincoln’s Treasury Secretary in 1864, was the Chief Justice at the time in 1869, and he changed his mind, on the ability to pay off pre-1862 debts with the greenbacks.

Rankled Grant administration — appointed 2 new justices, and a new case reversed the ruling. 1871

1884 — Congress can issue any currency it likes because it has sovereignty.

1913 — System needed a lender of last resort, thus Fed creation.

1922-1929 — Stabilized the price level, amid a gold standard…

Benjamin Strong dies, and power shifts from the NY Fed to the Board.  New leader opposes speculation; banks needing liquidity could not get it if they had been lending to the stock market. 1929-1933 huge contractions and bank failures.

FDR abandons the gold standard; devalues; collects gold; eliminates gold clauses.

Supreme Court relies on legal tender laws saying that Congress could define money as it chose.  He thinks the precedents should have been re-argued.

Judy Shelton
Author, Money Meltdown

Ruble collapse — Why back to gold standard?

Thinks all candidates should be talking about monetary reforms.

Money should be a stable unit of account and should be liquid.  It should allow us measure value well.  Convey the price signals of the market accurately.

Jefferson wanted a hard currency defined in terms of precious metals.

Offer Treasury Trust Bonds with a an optional conversion feature to gold.  Would receive par back or an ounce of gold.  Priced initially with par of an ounce of gold, no interest paid.

Argues for a balanced budget amendment.

Thinks other nations would mimic the ideas if a US Government gold bond would be issued.

Greenspan proposed this idea 40 years ago.

Lawrence H. White
Professor of Economics, George Mason University

How to go back to the gold standard?

A lot is calculating the proper initial parity with gold.

Treasury owns enough gold to re-establish a gold standard at $1600/ounce.

“At least I assume it is there, Fort Knox hasn’t been audited in a while.”

1) Eliminate excess reserve by eliminating interest paid on reserves.

2) Redeem reserves at Fed with gold.

Back M1 100% with gold — $8000/oz, Inflationary, reduction in wealth, etc.  Warehouse notes w/storage fees.

Central bank?  No monetary policy needed.  People would buy and sell gold daily.

Single mandate has not worked well for the ECB.  Inflation there running at 4% or so.

Competing private banks worked better than with central banks.

Or, the Fed could become a currency board in the short run.

Q&A

Taxation of Tsy Trust Bonds?

Shelton: Would confuse some of the issues.  Just get this out there so it can be tried.

Will the gov’t take action?  Guesses as to when?

Shelton, White: No idea.

Would would trust the Treasury w/Treasury Trust bonds?

Shelton: They would be collateralized.

Why is monetary reform important?

Hanke: because the Fed ran a reckless monetary policy, and did not regulate leverage of banks well.

PANEL 2: FED POLICY AND THE ALLOCATION OF CREDIT

Moderator: Mark A. Calabria
Director of Financial Regulation Studies, Cato Institute

Malinvestment vs capital flowing to most productive sectors of the economy.

Jeffrey M. Lacker
President, Federal Reserve Bank of Richmond

Fed’s response led to misallocation of capital.

Monetary expansion was needed to prevent a collapse.

Initial Fed lending was sterilized — equivalent to issuing Treasuries, and lending the proceeds.

Fed could have just bought Treasuries, and not MBS or other securities.  To do otherwise distorts credit incentives.  It creates an appearance of unfairness.

Many contend as a result that credit allocation should not be an aspect of Fed policy. May compromise the independence of the Fed to do so.

Cornerstone of CB independence is control of liabilities.  Assets are more open to choice.  Thus it becomes a path of least resistance in a crisis.  Creates moral hazard, and probabilities of future economic distress.  Threatens CB independence.

Contain the willingness to intervene either by CB habit or law.  Would conflict with lender of last resort, which was more a product of a commodity money era.  Not elastic credit needed but elastic currency.

CB asset policy is an unfinished aspect of Central Banking.  This should be a top priority for action.

Allan H. Meltzer
University Professor of Economics, Carnegie-Mellon University,
and Distinguished Visiting Scholar, Hoover Institution.

Bailing out Bear Stearns was a mistake, and other non-commercial banks, including AIG.  Added to uncertainty of the situation, Fed then increased supply of credit, bought MBS and long-term Treasuries.  Fed acted too soon, if they had waited, they might have been able to do less.

Speculators front-run the Fed.

Fed doesn’t care about exchange rates except in a crisis — US Dollar down 15% recently.

Operation Twist not needed because they acted too soon, economy expanding rapidly now (?!)

Fed is too short-term oriented.

Believes that things will only normalize when housing values fall to their eventual equilibrium levels.

Chart on base velocity vs LT AAA Corp Bond yields.  Current conditions consistent w/ ’20s and ’60s.  Here’s my version, really only consistent with 1932-33 at present.

Greater centralization of the Fed and US Government control over the Fed.

Thinks higher future inflation is highly likely.

Fed has done well when it has followed the Taylor Rule.  Flip-flopping from one aspect of the dual mandate to another has not worked well.

Phillips Curve does not work, and the present Fed uses it for erroneous forecasts.

Fed kept monetary policy too low for too long and created the crisis.

Fed needs to be more accountable for its actions.

George Selgin
Professor of Economics, University of Georgia

Jokes that the Federal Reserve should be done away with, or that it should be significantly modified.

Describes how monetary policy works.  Little need for a discount window a common topic before.

Fed channels liquidity through soundest counterparties — primary dealers.  But if primary dealers are impaired, they become liquidity sponges.  Happened in 2008, so they worked to rescue primary dealers, excluding Lehman. [PDCF?]

Discount window didn’t help because of stigma, and thus the TAF was created.

1) End primary dealer system.  Not needed anymore with modern technology for auctions.

2) End Treasuries only.  Original Fed was not that way; avoid monetization of US debt. Let many parties bid for credit from the FOMC.

Eventual disbanding of FOMC, let a computer do it.

Roger Garrison
Professor of Economics, Auburn University

Natural rates of Interest and Economic Growth

The Fed attempts to expand growth beyond the natural rate of growth, and accelerates it beyond, setting up the conditions for a slump.

FOMC actions every eight weeks; learns once a decade when a crisis occurs.

Taylor Rule has no concept of the natural rate of interest.

Concludes that the Fed oversupplied credit, creating a boom and then the bust we are currently in.

Q&A

Opinions on Nominal GDP targeting?

Meltzer: easy to say, hard to do.  Follow Taylor Rule.  Lacker agrees.

Selgin thinks it is a much better idea.

Garrison: target a zero growth rate. Prices would fall.

PANEL 1: RETHINKING THE GLOBAL FIAT MONEY SYSTEM

Moderator: Mary Anastasia O’Grady
Member, Editorial Board, Wall Street Journal

Comments that the Fed buying MBS reminds her of the Latin American countries that she covers.

Benn Steil
Director of International Economics
Council on Foreign Relations

Central bankers as Churchillian war leaders, rather than dull technocrats.

Y = C + I + G  Economists treat C, I, and G as easy substitutes but they have different effects over time.

Krugman advocated creating a housing bubble, to replace the NASDAQ bubble.  (DM: They are trying to create new bubbles now via QE.)

Sweden and Australian central banks sold foreign assets to buy dollars and euros during their financial crises.

Central banking effective when governments can borrow near the policy rate of the central bank w/a tight correlation.  Implies that the ECB is no longer an effective CB for the fringe.

Central Bankers not particularly effective with fiscal policy.

Can Central Banks act without capital?  Will German taxpayers recapitalize the ECB? Doubtful.

On the Fed:

If the Fed got into trouble (negative net worth), the Treasury would back up, recapitalize it.

Suggests that the Fed should exchange MBS with the US Treasury for Treasuries.  Suggests that MBS will produce significant losses.

George Melloan
Former Deputy Editor, Wall Street Journal

Jokes about what a nickel could buy during the (big Baby Ruth bar) Depression and now (a jellybean).

Talks about post-WWII monetary policy in Britain, and how British Socialism led them astray.  War in Vietnam did much the same thing in the US, leading Nixon to end Bretton Woods.

Dollar’s primacy increasingly questioned.

Inflation coming as the Fed creates credit to fund the US government.

Doubts that multilateral currencies like the SDRs of the IMF would work. The Euro proves that.

The US needs monetary reform, but we might need to fail before that comes.  Gold, bitcoins, scrips, barter if things break down.  Fiat currencies are liquid, barter is inefficient.

If the US dollar goes, a lot else will go down as well. (DM: think about Chinese banks.)

Gerald P. O’Driscoll Jr.
Senior Fellow, Cato Institute

Gold standards can be done if the currencies reflect the fair values of the currencies.  I.e. France made its currency too cheap post-WWI, and Britain too expensive.

Gold standards are not always associated with deflationary periods with low growth.

No monetary system survives big wars.

Nixon went off the gold standard when the CPI was at a high 4.2%.  Monetary policy run by the seat of the pants then.

Argues that classical liberalism requires a gold standard.

Q&A

Fiat currencies even larger proportionately in Africa.  Give seniorage as foreign aid to Africa?

O’Driscoll: dollarization is faux gold.  Gold would be better.  Seniorage can’t be given away.  We need it.

Steil: Helps the African countries get along fine.  Dollarization of Panama has not hurt them; they know the US won’t send help.

O’Grady: Argentines tried to find a way to use US Dollars, but wanted seniorage, thus but devalued instead.

Question to Steil on Operation Twist, duration risk to Fed?

Steil: Operation Twist worked for several nations.  40 bp move would wipe out Fed capital.  ECB purchases of PIIGS debt an alternative to Eurobonds, bailouts, etc.

Isn’t fractional reserve lending the problem?

O’Driscoll: leverage would come from other sources.  MMMFs?

Melloan: Politicization of monetary policy is the problem.

DM: misses the concept that asset-liability mismatches with leverage produces failures.

O’Grady: Wouldn’t a single mandate solve things?

All of the panel expressed doubts on this point.  The Fed needs it to hide, but they would find other ways to do it.

This is the first book that I have reviewed twice.  I reviewed the third edition of the book previously, but I am reviewing the sixth edition now.

Kindleberger places the manias, panics, and crashes on a common grid, to see their similarities,  In it he draws on a number of common factors:

• Loose monetary policy
• People chase the performance of the speculative asset
• Speculators make fixed commitments buying the speculative asset
• The speculative asset’s price gets bid up to the point where it costs money to hold the positions
• A shock hits the system, a default occurs, or monetary policy starts contracting
• The system unwinds, and the price of the speculative asset falls leading to
• Insolvencies with those that borrowed to finance the assets
• A lender of last resort appears to end the cycle

The advantage over the third edition is that you get to hear about the Asian crisis LTCM, the tech bubble, Madoff, and the present crisis (banking & housing, soon to be sovereigns).

The main point for readers is to beware when monetary policy is easy, banking regulation is lax, and many seem to favor buying the asset du jour, often with leverage.  What is self-reinforcing on the way up will be self-reinforcing on the way down, but with greater speed and ferocity, as bad debts have to be liquidated.

Quibbles

Hindsight is 20-20.  If the US Government had rescued Lehman, something else might have proven to be “too big to rescue,” that the government might allow to fail, but miss the connectedness of the institution.  I do think the US Government should have been a DIP lender to troubled firms, but not a buyer of equity.

Who would benefit from this book: Most investors would benefit from this book.  It will make you more skeptical of assets that seems to be doing unnaturally well; it will also make you more skeptical about catching falling knives in the market.  If you want to, you can buy it here: Manias, Panics and Crashes: A History of Financial Crises.

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Bubbles are easy to spot.  Wait, don’t most people say that bubbles are impossible to spot?

I’ll say that again: bubbles are easy to spot.  Why?  People have the wrong theory on bubbles.  They listen to those that don’t understand the efficient markets hypothesis, and think, “Prices are always fair predictors of the future.  I don’t have to think about the future as a result.” (It would be better to say that current prices are the short-term neutral line against which bets are placed.)

Don’t listen to academics on bubbles.  There have been booms and busts as far back as we can see.  If markets tend toward equilibrium, that is very well hidden — please require economists to take courses in history.  I mean this; I am not joking.  Neoclassical economics is not  a science; it is a religion, and with much less historical evidence to support it than Christianity has to support the historicity of the resurrection.

Why do I write on this? Partly because of Jason Zweig’s piece in the WSJ.  I ordinarily like what Jason writes; this is a rare exception.

Spotting bubbles gets easier when you don’t simply look at rising prices.  It is better to look at what is driving the rising prices.  How are players financing the purchase of assets is more important to view than even price trends.

It is hard to get a bubble without having an increase in debt-finance.  Financing with debt is cheaper, and riskier than financing with equity.  Financing long-term assets with short-term debt is even cheaper and riskier than financing with debt that matches the term of the asset.  Most bubbles end with some sort of financing time-mismatch, where the inability to renew short-term indebtedness in order to hold the asset leads to a panic, which leads some to say, “This is a liquidity crisis, not a solvency crisis.”  When you hear that leaden phrase, ordinarily, it is a solvency crisis, with long-dated assets of uncertain worth, and near-term liabilities requiring cash.

This is why the simplest way of looking for bubbles is to look for where debt is increasing most rapidily, and where the terms and conditions of lending have deteriorated.

But where do we have these issues today?  Let me offer a few areas:

• We have a chain of financing arrangements in the Eurozone where many banks might have a hard time surviving the failure of Greece, Italy, Portugal, and perhaps some other nations as well.  Failure of those banks might lead to bailouts by national governments and/or a significant recession.  Anytime financial firms as a group would have a hard time with the failure of a company, industry, government, etc., that is a sign of a lending bubble.
• There is a major imbalance in the world.  China trades goods to the US in exchange for promises to pay later.  Creditor-debtor relationships are meant to be temporary, not permanent as far as governments are concerned.  There may never be a panic here, but so long as the US retains control of its own currency, it is safe to say that they will never get paid back in equivalent purchasing power terms as when they exported the goods.
• China itself, though opaque, has a great deal of lending going on internally through its banks, pseudo-banks, and municipalities, a decent amount of which seems to be for dubious purpose at the behest of party members.  The government of China has always been able in the past to socialize those credit losses.  The question is whether covering those losses could be so large that the government follows an inflationary policy to eliminate the debts amid public discomfort.
• AAA and near-AAA government debt has been the most rapidly growing class of debt of late.  Maybe AAA governments that are unwilling to cut spending or raise taxes are a bubble all their own.  Remember, when you are AAA, the rating agencies let you make tons of financial promises — think of MBIA, Ambac, FGIC, AIG, etc.  Only when its is dreadfully obvious do the rating agencies cut a AAA rating, but once they do, it is often followed by many more cuts as the leverage collapses.

Now, my view here is both qualitative and quantitative.  To find bubbles there are indicators to watch, such as:

• Low credit spreads and equity volatility
• Low TED spreads
• High explicit/implicit leverage at the banks
• High levels of short term lending/borrowing (asset/liability term mismatches)
• Credit complexity and interconnectedness
• Poor Credit Underwriting
• Carry trades are common (many seek free money through seemingly riskless abritrages)
• Accommodative monetary/credit policy

All manner of things showing that caution has been thrown to the winds and lending is done on an expedited/casual basis is a sign that a bubble may be present.  Kick the tires, look around, analyze the psychology to see if you can find a self-reinforcing cycle of debt  that is forcing the prices of a group of assets above where they would normally be priced without such favorable terms.

Not that this analysis is perfect, but it follows the broad outlines of Kindleberger and Chancellor.  Speculative manias are normal to capitalism; don’t be surprised that they show up.  Rather, be of sane mind, and learn to avoid participating in manias, long before they become panics or crashes.

This book grew on me. Think of it as “How I hit a home run in investing.”  Who are the sluggers that earned outsized returns?

But, there is a problem here, and the book would have been better if it had recognized the problem.  In a few cases, the “greatest” made one (or a few) good decisions.  In more cases, they made many good decisions that compounded over time.

Was the first group lucky? Maybe, but when things work out for the reasons that you specify in advance, I think not.  The problem of the first group is repeatability, which for John Paulson, is proving to be an issue for his asset management shop at present.

The investment markets are cruel.  No matter what you have done in the past, the question comes, “What have you done for me lately?” The pressure is high, so no wonder that one of the investors that the book mentioned has gone into hiding.

There are two more dimensions here.  Imagine an investor that made some amazing gains , but then craters.  There are some brilliant investors for which that has been true: Livermore, Niederhoffer, Keynes, and more… how much credit should we give to the gains, if the price is flameouts?

Second, imagine someone who is the best in class at a low-return area of the asset markets, like Jim Chanos in short-selling, or Bill Gross at Pimco.  They may not earn that much, but the skill level is really high.  But is the skill level so high when they chose areas of the market to work in that are low -return?

Maybe the book should have featured private equity players, or real estate investors, or those that have managed university endowments well… there are other investors that would be comparable or better to the returns of some in this book.

Or ask, where is Buffett?  He would deserve a spot here, not for any one trade, but for the multitude of clever trades and mergers he has done over the years.

Quibbles

The book needed a better editor.  Information on Templeton is repeated.  Beyond that, most of the ideas on how an average investor could try to replicate the strategies of the great investors are akin to drinking near-beer.  They are too weak, but on the other hand, without the brilliance of the investors, an average person would not know when to but and sell.

With those caveats, I recommend the book highly.  It is well-written, and it will fill out knowledge gaps in amateur investors.

Who would benefit from this book: Most investors would benefit from this book.  If you want to, you can buy it here: The Greatest Trades of All Time: Top Traders Making Big Profits from the Crash of 1929 to Today (Wiley Trading).

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent it to me.

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Comments

• This release of the FOMC statement was really kind of a nothing-burger, aside from the hawks going with the majority, and Evans arguing for looser policy.
• The main shift in the FOMC’s economic reasoning is that GDP growth is improving.  One quarter on the GDP data should not get us that definite.
• In my opinion, I don’t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located.
• Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
• The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.
• The Fed is out of good policy tools, so it will use bad policy tools instead.

Questions for Dr. Bernanke:

• Why do you think that holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located?
• Why will reinvestment in Agency MBS help the economy significantly?  Doesn’t that only help solvent borrowers on the low end of housing, who don’t really need the help?
• Couldn’t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
• Isn’t stagflation a possibility here?  I mean, no one expected it in the ‘70s either.
• Could we end up with another debt bubble from keeping short rates so low?
• If the Fed ever does shrink its balance sheet, what effect will it have on the banks?
• Is it possible that you don’t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?