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  • The Great Debate: Inflation vs. Deflation

    The Great Debate: Inflation vs. Deflation




    Nathan Kawaguchi



    There is no shortage of debate these days regarding the future purchasing power of the dollar—and understandably so.  Not since the early 1980s have we had such strong arguments for either outcome at the same time.  A number of powerful forces will play out in the years to come.  I will discuss some of the main arguments for each, my own conclusion, and what investors (and savers) can do to protect themselves.


    Banana Republic

    With the recent explosion of the Federal Reserve’s balance sheet, it is easy to understand why many are terrified of the possibility of the kind of rampant inflation often found in banana republics.  After all, prices are more or less a product of the money supply and its velocity.  While the Fed has more than doubled the monetary base since September 2008, we have not yet seen high inflation because the velocity, or multiplier, of money has gone down by roughly half over the same period.  However, the potential for high inflation is there.  And this is what folks are rightfully worried about.


    To make matters worse, the U.S. was already heading down a dangerous path in regards to budget deficits and an unmanageable mountain of unfunded Social Security, Medicare, and Medicaid liabilities.  The stimulus response to the financial crisis only added fuel to an already blazing fiscal fire.


    The strongest risk of inflation comes from rapidly increasing government debt that currently carries a low average interest rate and low average maturity.  This is the economic equivalent of an adjustable rate loan because we don’t have the resources to repay principal.  Recent data from the U.S. Treasury show an average maturity of about 4.5 years at an average interest rate of 2.5%.  This equates to about $165 billion in annual debt service (interest only), which is about 7% of total estimated 2010 receipts of $2.381 trillion.  There are three specific factors that could exacerbate this problem and push interest rates higher: 1) Investor fear of dollar devaluation; 2) Rising fear of technical default; and 3) Simple supply and demand forces from ever-increasing debt issuance due to the $1 trillion annual budget deficit that is estimated to persist for at least the next decade.  And the government is notorious for making overly optimistic budget predictions.


    The Great Depression Part Deux

    On the other end of the spectrum, we find another large camp of people who believe that massive deleveraging will lead to a second Great Depression.  This makes sense because we have a debt-based monetary system in which money is born into existence from debt.  And, of course, all debt needs not only to be repaid, but repaid with interest.  As debt is destroyed through repayments and defaults, the money supply is also destroyed.  Lower money supply leads to more defaults and more debt destruction, and the vicious cycle continues.  This was at the heart of the Great Depression.  It is easy to understand why Ben Bernanke, a student of the Great Depression, made the decision to flood the market with liquidity in response to the financial crisis.


    Other strong arguments for deflation are the rising unemployment rate and potentially higher tax rates to pay down ballooning debts at federal, state and local levels.  Both of these would have the effect of lower total discretionary income, which would decrease demand for goods and services.


    So Which Will It Be?

    In a world of self-proclaimed experts, almost everyone with an opinion is firmly in one camp or the other.  In fear of appearing indecisive or incompetent, many overlook the most rational answer: I don’t know.  Since when did it become so shameful to admit that we don’t know what the future holds?  There are very compelling arguments for both inflation and deflation.  The answer will eventually depend on decisions made in Washington and how people react to those decisions.  For now, let’s stop fooling ourselves and admit that we don’t know.  It is a problem that has to be dealt with and there is no easy medicine.  Either path will be painful, but that’s what we get for our two and a half decade debt binge.


    How Can We Protect Ourselves?

    Once we admit that we don’t know what the end result will be, we can focus on how to protect ourselves based on a range of different outcomes.  Investors and savers should focus on the likelihood that different outcomes will materialize and also look at the resulting consequences if they don’t.  And the more uncertainty there is, the more they should diversify.


    Because there are such strong arguments on both sides, it may be wise to diversify your risks and build a portfolio with exposure to both outcomes.  One word of caution here:  Even if we did know the end result, the ability to profit from it is diminished because we don’t know the timing of the end result.  If we are, indeed, heading down the path of a banana republic, it may not come to fruition for another decade or longer.  Conversely, the deflation scenario may be long and drawn out, much like in Japan.


    If you are concerned more about inflation, you may want to favor things such as commodities and other hard assets, real estate, foreign denominated assets, businesses that are paid in foreign currencies, and floating rate debt.  If you are concerned about hyperinflation, you may even consider gold and silver coins.  The problem with these and other commodities is that they produce no cash flows and so value investors cannot estimate their intrinsic value.  The return is completely dependent upon the resale price.  In other words, this would be a form of speculation.  It is a speculation on a bad outcome and a further speculation that these assets will protect you from the bad outcome.


    If, however, you find yourself more concerned about deflation, then the choice is easy.  You will want to hold a lot of cash and invest in U.S. denominated assets.



    Although there is such a high probability of extreme outcomes, I will continue to do what I have always done.  There is no better way to protect against both inflation and deflation than to be a value investor.  Buying cheap assets and cheap cash flows can build and protect wealth in any environment.  A large margin of safety protects on the downside and amplifies the upside.  And when no opportunities exist with a sufficient margin of safety, value investors are content to hold cash—and perhaps a little hard cash (gold and silver) as speculative insurance against the unknown.

    For additional insight, visit

    Disclosure: No Positions
    Apr 02 5:28 PM | Link | Comment!
  • Psychological Barriers to Successful Investing


    Nathan Kawaguchi


    Investing is a difficult sport.  It is probably one of the most competitive businesses in the world due to the number of players.  And just like physical sports, talent alone is not enough for long-term success.  Players must have a strong mental game to compete at the highest levels.  This is where psychology comes into the picture—a growing field more commonly known to the investment world as behavioral finance.  Let’s explore a few of the main psychological barriers to investment success.


    Something from Nothing

    Most people are drawn to the financial markets because of the prospect of making money with very little effort.  Unfortunately, it’s just not that simple.  Investing requires a lot of work—a lot of reading and a lot of thinking.  And just like any other profession such as sports, medical, or legal, one should not expect to just walk into the field and enjoy instant success.  What advantage could a newbie expect to have over someone with specialized training and years of experience?  Inevitably, this desire to make something from nothing leads to speculative behavior and financial ruin.


    Fight-Flight Response

    When faced with adversity, we all have instinctive responses.  Sometimes we run for cover and sometimes we face the challenge with brimming confidence.  In investing we often buy something that drops precipitously and we are faced with such a challenge.  A rational investor will reevaluate the situation and make the most logical decision.  However, an emotional investor will either fight (effectively double-down in hopes to recover the loss), or will set flight (sell immediately without regard to fundamentals).  This fight-flight response is especially powerful in market crashes.  Many investors sold in panic from October 2008 through March 2009 when, in fact, this was one of the best buying opportunities in modern times.  Some may argue that this is only known in hindsight, but there is a long list of value investors who have documented this sentiment in conference calls and shareholder letters.  They were being rational.


    Pain-Pleasure Response

    Many psychological studies have shown that people are about twice as receptive to pain stimuli as opposed to pleasure stimuli.  This is similar to a child that touches a hot stove and burns his hand.  The child is highly unlikely to touch a stove again, even if it is not hot.  We also see this with an investor who speculates in stocks and loses a lot of money.  Even though the error was in the speculating and not from stocks in general, the investor may associate the pain with stocks and mistakenly avoid stocks all together in the future.  When faced with potential pleasure (profit) and a repeated painful experience (loss), we are more likely to pass in fear of another painful experience.


    Natural Pattern Seekers

    Let’s face it; we can’t help ourselves from seeking patterns.  Most people think of this in terms of technical analysis, but value investors are pattern seekers as well.  We have found a pattern that shows a high probability of success when buying investments that offer cheap assets or cheap cash flows.  This skill was extremely helpful in ancient times, when humans traveled through the wild.  If there was a rustling in the bushes and then a tiger jumped out and killed someone, the people of ancient times would not hesitate the next time they heard a rustling in the bushes because the pattern told them that rustling in the bushes equaled deadly tiger.  However, this skill is not as helpful in the investing world.  If we enjoy success, we often look for the same quantitative or qualitative pattern rather than looking for the underlying reason why we had success.


    Mistake Correlation and Causation

    Logically, this makes no sense at all, but we do it all the time in the investing world.  This is why we hear things like “the January effect,” which says that the direction of the market in any given year will follow the direction of the market in January.  January is not causing the market to go up or down.  We also see this in other false axioms such as “sell in May and go away,” suggesting that investors should cash out in May and wait for the summer to pass before reinvesting.  And because notable market crashes have occurred in October, many investors mistakenly believe that they should avoid being in the market during October in order to avoid any market crashes.  The only pattern that may be more causation than correlation is the presidential cycle.  This is because late in a presidential term, there is less uncertainty over the direction of policy.  Markets punish uncertainty, which is highest around major political changes.


    Mistake Uncertainty for Risk

    This is also very common.  Many investors will sell securities that have a high level of uncertainty.  However, uncertainty is not the same as risk.  Uncertainty has downside and upside potential, while risk only has downside potential.  There are sometimes investment opportunities that offer low risk, but high uncertainty.  These can be some of the most wonderful investments.


    False Confirmation

    This is probably what created a lot of repeat offenders in the technology and real estate bubbles of the past decade.  Wild bull markets attract novice investors because of the cocktail and neighborhood conversations about easy money.  Often, the novice makes an investment in the latter stages of the bull market and enjoys early profits (on paper).  These early gains give the novice investor a false confirmation of his investing skills because the gains were more of a result from simply being in the market than investing acumen.  Naturally, the novice invests more and more into the final stages of the bull market because he continues to receive further confirmation as the market goes higher.  When the market tops and begins to turn negative, the novice’s early success gives him the confidence to hang on to these losing investments until it is too late and he suffers a permanent impairment.


    Good Driver

    When people are asked whether they are above-average drivers or below-average drivers, an overwhelming majority say they are above-average.  Obviously, this can’t be.  This tendency to overstate our abilities is found in investing as well.  After all, why would someone continue to invest while admitting they are below-average?  While most people believe they are better investors than the average, studies have shown that over long periods of time (10+ years), less than 25% of all investors are able to beat the market index, which is essentially the average before expenses.


    Home Town Bias

    Very similar to the good driver problem, many investors suffer from home town bias.  Everyone thinks that their home town is the best, their state is the best and their country is the best.  This directly translates to investing as well.  A domestic small cap manager may believe that domestic small cap stocks are always the best investment.  Most investors (especially value investors) know that this is simply not true.  Good investments are a function of risk-reward, which is dependent upon the price paid.  Domestic small cap stocks are not always the cheapest.  Sometimes it’s real estate, or emerging markets, or corporate bonds, or cash, or whatever.  It’s easy to believe that the best opportunities are always in the area in which we have special expertise, but good investors know better.


    This is only a short list of the potential psychological pitfalls that get investors into trouble.  By simply overcoming these barriers investors will be ahead of the game.  Talented prospects in professional sports are exciting because of their great potential, but only those who master the mental game go on to be superstars in their respective sports.  Master the mental game and turn your potential into success.


    For more information, visit

    Disclosure: No positions
    Mar 24 12:46 PM | Link | Comment!
  • Betting the House (of Cards) on Interest Rate Derivatives

    Betting the House (of Cards) on Interest Rate Derivatives




    Nathan Kawaguchi


    Previously, we wrote a piece called, “Interest Rate Derivatives – A $437 Trillion Time Bomb?”  In that article, we gave an overview of our basic points of concern.  The sheer size of the interest rate derivative market caught our attention, especially since the $62 trillion credit default swap (CDS) market was a major factor in our recent financial crisis.  In this follow-up article, we will examine some of our specific concerns and begin to offer some suggestions on how to mitigate the risk.

                As we stated in our previous article, there were approximately $605 trillion outstanding notional amount of over-the-counter (OTC) derivatives as of June 2009.  $437 trillion of this amount was interest rate derivatives.  In conversations and email exchanges with people who have considerably more knowledge and experience with derivatives, we are told by some that our concerns over the staggering notional amounts are overdone.  This is explained because, unlike credit default swaps, no one is on the hook for the actual notional amounts.  Notional amounts are really more of a reference point for the amount of the cash flow being exchanged.  Fair enough.  We are also told that derivative books are marked to market daily and sometimes multiple times daily, if needed.  This is supposed to ensure control of risk through collateral requirements and real-time credit risk evaluation.  This is fine for small incremental movements.  But what happens if there are dramatic unexpected movements?  Considering the large notional amounts and currently low interest rates, could counterparties come up with the collateral without dislocating global markets as in the recent crisis?

                Before we express our more specific concerns about interest rate derivatives, we want to make something very clear.  We have no conflict of interest in expressing our negative opinions on the matter.  We are not big enough in size or name to access or influence this market directly.  Nor do we have any directly correlated hedges or bets from which to gain financially in the event of a collapse.  In fact, we hope we are dead wrong and that our concerns stem from our rather elementary understanding of derivatives.

                There are a few specific features of the interest rate derivatives market that are particularly troubling to us.  First, does $437 trillion in notional debt even exist?  After all, isn’t an interest rate swap really just an interest rate hedge—a form of insurance?  The whole concept of insurance requires an insurable financial interest.  Anything beyond an insurable interest is a speculation on an outcome. 

    According to the Federal Reserve Board’s December 10, 2009 Statistical Release, there was approximately $53 trillion in total U.S. credit market debt outstanding at the end of the third quarter 2009.  Let’s assume that every single U.S. debtor was unhappy with their original loans and entered into interest rate contracts such as swaps.  What’s the other $384 trillion of interest rate derivatives insuring?  Sure, the $53 trillion only includes debt of people, companies and governments of the United States.  While we could not find reliable figures for total worldwide debt, we find it hard to believe that the rest of the world accounts for the remainder (We did find unverified estimations of total worldwide credit market debt around $100 trillion).  Even if we include all other liabilities (bank deposits, money markets, repos, insurance, pensions, etc.), total U.S. liabilities add up to approximately $111 trillion.  Again, assuming every single penny of notional is swapped, that still leaves $326 trillion to be absorbed outside the U.S. or by speculative interests.

                The second observation that gives us concern is the amount of interest rate derivatives handled over-the-counter.  The $437 trillion OTC market dwarfs the $69 trillion of exchange-traded notional amount (as of September 2009).  OTC markets are sometimes opaque and more difficult in which to implement and enforce prudent risk controls.  If so much is done OTC, how can we be sure there are proper controls to mitigate systemic risk?

                Another cause of concern is the concentration of counterparty risk.  While “too big to fail” is often cited as a key reason for the financial collapse, one would think we’d make an effort to change that.  The reality is the situation has not gotten any better.  In fact, it has become worse in some respects.  The Bank for International Settlements (NASDAQ:BIS) publishes the Herfindahl index, which is a measure of market share concentration.  Since the peak of the credit crisis, the Herfindahl index for interest rate swaps has actually increased for markets in every major currency except for the Euro, which saw a modest decline.  In many currencies, the index climbed significantly.  This indicates a further concentration of risk, which increases systemic risk and moral hazard under the paradoxical “too big too fail.”

                The other major area of our concern is the use of Value-at-Risk (VaR) in capital adequacy calculations.  As David Einhorn pointed out in his debate with Aaron Brown in the June/July 2008 issue of Global Association of Risk Professionals, risk models such as VaR are flawed because they disregard long-tailed events.  In a common VaR calculation, a firm may figure its daily VaR at a 99% threshold.  If a firm expected a disruptive change in interest rates that historically occurred once every 10 years, the odds of that change on any given day are 1-in-3650.  In other words, it would have a 0.03% chance of occurring, which is outside even a 99.5% threshold.  The VaR model renders this probability statistically insignificant.  The trouble here is that our financial world is growing increasingly complex and these multiple-sigma events seem to pop up more frequently than historically-charged statistics would suggest.  What if you were very confident that a “perfect storm” would strike once every 15 years (1-in-5475 days)?  You wouldn’t disregard it because it only has a 0.02% chance of occurring on any given day.  You would prepare for something like a 50% or 75% chance of occurring over any given 15-year period, or at least a 6.67% chance in any given year.

                The last major concern we have is related to asymmetric interest rate risk.  Interest rate swaps have a zero value at inception because they are based upon future interest rate projections implied by the swap yield curve.  Interest rates, as far as we know, can only go to zero.  However, they can theoretically go infinitely higher.  While it’s not highly probable, it’s neither inconceivable to envision interest rates similar to those of the early 1980s.  Even having rates return to historical norms would place a tremendous burden on the counterparties holding the variable legs of long-dated interest rate swaps.  Most swaps are based on the London Interbank Offered Rate (LIBOR).  One- to 12-month LIBOR rates were recently 0.23% to 0.85%.  In October 2008, these rates were around 3.80% (There is also some controversy surrounding the reliability of LIBOR rates as reported by the participating 16-bank panel during the credit crisis).  Even a return to pre-crisis levels of around 5.00% could spell danger for the receiver (who pays the floating rate).  If we take an average current LIBOR rate of 0.50%, that is a 10-fold increase!  Additionally, LIBOR rates incorporate the perceived creditworthiness of participating banks.  We wonder whether or not these assumptions are considered when risk managers look at their VaR models, especially when considering thin capital ratios.

                Some readers must be thinking by now, “Okay, if you’re so smart, then what’s the solution?”  We would be foolish to presume we have all of the right answers.  We have neither adequate knowledge nor experience in this field.  But we do have enough common sense to examine our major concerns. 

    We need to address systemic risk and break up firms that are “too big to fail.”  Bringing back something similar to Glass-Steagall would be a good place to start.  We need to further address systemic risk by encouraging more competition, which would spread the concentration of counterparty risk.  We suspect that swap dealers could effectively be “sleeping around” by entering into offsetting contracts with each other—similar to the monoline insurers reinsuring each others’ exposures.  Worse yet, we also suspect that swap dealers could be entering into offsetting contracts with their own subsidiaries—very similar to the offloading of illiquid assets into Special Purpose Vehicles (SIV) and the like.  Of course, this is merely speculation on our part.

                We also recommend implementing some uniform standards for “plain vanilla” interest rate swaps that could be cleared centrally through various participating clearing firms.  This would provide much-needed transparency to this market and create standard products that parties could more readily understand.  With central clearing, it would also be much easier to institute uniform margin and/or capital requirements similar to those of more traditional securities dealers.  And there would still be a need and place for more customized contracts to trade OTC.

                We are sure to have more bones to pick with the interest rate derivatives issue, but we run the risk of losing our readers’ attention continuing this particular article any further.  Look for more in the near future.  Similar to our first article, we welcome any additional input or insight that would help us refine our understanding of this market.

    For more information, visit us at

    Disclosure: No Positions
    Mar 11 10:43 AM | Link | Comment!
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