By A. Michael Lipper, CFA
Each week I feel like a one-person research or reconnaissance staff looking through the information clutter trying to avoid Improvised Explosive Devices (IEDs). I hope to dance through the minefield that is out there. Like most destructive forces, IEDs are initially hidden, and like a wary animal I try to sense dangers before they become clear. My search approach is to look for possible analogies that could reveal dangers to all of our portfolios. This week there were four questions that popped up:
- Are there ties between compulsive gambling and ETFs?
- Are there parallels between the collapse of the Weimar Republic and the current condition of the United States?
- Are there amateur real estate winners?
- Is political arithmetic more important than budget math?
Is using ETFs a form of compulsive gambling?
In The Wall Street Journal's Review section this weekend, there is an article titled, "The Real Odds On Gambling." I am pleased that the source of the data for this discouraging article is from scholars in the U.K. supported by gambling business consultants in the U.S. The findings showed that the odds on winning big in casinos were stacked against the players 31 to 1 (31 losers to 1 winner). The scholars found that, among gamblers who bet somewhat continuously over a two-year period, 31 lost money for every one who made money in casino-style games of chance. Poker players playing against other players had slightly better odds, winning about one third of the time. A number of poker players and casino players did win periodically. They kept their winnings by walking away from the tables.
When I wrote the book "Moneywise," I noted that two of my great learning institutions for adult life were the racetrack and the U.S. Marine Corps - apologies to Columbia University, where I started my professional military career through the Naval Reserve Officers Training Corps. I gained a good bit of my racetrack experience while I was enrolled at Columbia full time (in addition to holding an on-campus job and being a member of a world-famous fencing team). When I did the math, I learned that it was virtually impossible to walk away a winner for the racing season by betting on every race. First, there are the obvious issues of racing luck, bad analysis, and not picking winners. Second, the state and the track replaced the casino in terms of the take they took out of every bet. Finally, the New York betting crowd (possibly the same Wall Street players or their cousins with whom I competed later) were too good at juggling most of the track odds and the probabilities at winning.
I concluded that I materially improved my chance of walking away a winner by betting on few races - and in some cases no races - on a given day. Furthermore, I looked for opportunities where most of the attention was focused on predicting the winning horse and the odds on either of the first two or three horses aligned more favorably with my analysis of the probabilities.
What does this have to do with investing in exchange-traded funds? I believe there is a great deal of overlap. Over-simplifying, the bettor using ETFs is in for a fast trade, essentially betting against the market's view of valuation, or else he/she wants to participate for an extended period of time (which is sort of like the horse-betting approach of some of my relatives; they wanted so badly to cash a ticket that they bet virtually every four-legged vehicle in the race). Both the short-term and long-term approaches do not have good odds on winning big, particularly when compared with other opportunities. In truth, I should not be anti-ETF; I own shares in publicly traded investment groups that are the sponsors of various ETFs. I have improved my odds by betting on the house rather than with the crowd. I will admit that I have used index funds in various institutional accounts to balance the concentrated investments of some active funds with broader and cheaper passive funds; I do not, however, use ETFs personally.
Possible parallels between the United States and the collapse of the Weimar Republic
My inspiration for this point (or perhaps more accurately my fear) was generated by The Wall Street Journal, in this case a book review of "The Downfall of Money" by Frederick Taylor. He describes the monetary trap that the post-World War I German government, the Weimar Republic, found itself in when attempting to pay off its high reparations debt calculated in terms of gold. Germany's solution was to inflate the money supply to such an extent that the internal value of their currency collapsed. (In the week of the French invasion of the Ruhr to seize the coal it was owed, the Germans needed 7,260 marks for a U.S. dollar. By October, the purchase of one U.S. dollar required 65 billion marks - and this was not the final quote before the mark became worthless. Under such circumstances, one should have seen that a charismatic leader who would fix things and repair the wounded German pride would arise to take over; and, indeed, Hitler did. This part of the story is well known and should be taught in every school in the world.
What is not nearly as well known is the contention of the author that the economic problems actually started in August 1914. In order to raise the money needed to feed their war machines, each of the soon-to-be combatants of WWI began to inflate its money supply. Between 1914 and 1920, the purchasing power of the U.S. dollar declined by 50%. In reaction to the induced inflation, one after another of the major countries returned to a gold standard, pushing up the value of gold to offset the purchasing value of the internal currencies and thus wiping out arbitrage opportunities and the competitive advantages of various exporting countries. With this background, we can understand the fears that some people have when they consider the problems at the periphery of Europe, potential problems in Japan and China, and clearly the growing deficit of the United States. (At least our debt is all dollar-based for now.) We could see at some time in the future a reversal of Franklin Roosevelt arbitrarily raising the price of gold behind the US dollar and Richard Nixon closing the gold window. (What a strange combination!)
These fears are a good reason that corporations are doing more of their business overseas and, in some cases, in local currencies. Securities investors should follow, remembering that U.S.-listed securities represent less than half of the world's securities.
Investing in residential housing has worked
In an article from the Financial Times, it was noted that the U.K. wealth gap grows as homeowners save more but renters suffer. The article focuses on first-time, well-off buyers of residences. They are intelligently reacting to some remaining softness in home prices, low mortgage rates, and rising rental costs. The same pattern appears to be happening not only in the United Kingdom but other countries as well, including the United States. There may well be political as well as economic implications to this as more people begin to think of themselves as "a little bit wealthy" and change their spending, investing, and possibly their political habits.
The real arithmetic of the partial shutdown
Both the trade press and the general circulation news media are focusing on the size of the current U.S. deficit and the ability to pay the incurred debts. On the surface these are important points, but they are not the motivating drivers of the politicians leading the battle. For them, the key numbers are 17 swing seats in the House of Representatives and 5 seats in the U.S. Senate. If the elections bring additional cover for the Obama administration, more socialist laws and regulations should be expected. If the reverse happens there will be a stalemate on the legislative side, leaving the action to take place mostly on the regulatory front. The battle is being fought through various press releases and interviews on or off the record to influence the relatively small number of swing voters who will make up their minds in terms of local choices one year from now. Largely, the long-term economic impact of what is finally decided in 2013 will have limited dollar impact by October 2014. Thus the keys to watch are the growing changes of perceptions as to which specific local candidates will be considered "less bad" than their opponents. At this point delivery will be more important than wisdom.
The Benjamin Graham Award
Earlier this week, I received the Benjamin Graham Award for Distinguished Service to the New York Society of Security Analysts. I have been active in the Society for more than fifty years, serving the leadership with energy and advice. In a very brief acceptance speech I stated that I was delighted to get an award named after Ben Graham, who was the spiritual godfather of the Society. Having taken Security Analysis under his writing partner David Dodd, I was able to say that Ben taught us (including Warren Buffett) that it's possible to lay out various principles but in the heat of the day do something different. (I believe this is an important realization for all who participate in the market at any level.) I also thanked the audience for the ability to give back to a business that has given so much to me.
How are you looking at the investment world now?