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February 04, 2006

Wanted: Excellent Managers, Storm Experience Required
by Doug Wakefield

I watch in amazement the bullish rhetoric that continues to come from the mouths of our political and financial establishments, while the cold hard facts are completely dismissed. Having had a pulse and a set of eyes in 2000 to 2002, which happily I still possess, I wonder how so many individuals could again deny the facts so plainly set before them solely for the comfort that bullish rhetoric brings. Then I remember I am dealing with rationalization, not rationality. The Journal of Behavioral Finance says it this way:

"Rationalization does not mean 'acting rationally.' It means attaching desirable motives to what we have done so that we seem to have acted rationally. In other words, people seek justifications for their behavior. And rationalization, which is largely about perception, often comes post hoc." ¹

So, it all boils down to investors' perceptions. For investors to become willing to hire excellent storm managers, they must encounter something to change there thinking enough to come to the realization that a storm is setting in. Further, to overcome inertia and act, they must perceive that the approaching storm is not a summer rain shower, but a level five hurricane. After all, the umbrella of diversification may be enough to shelter them from the summer rain. But, this same umbrella is an ill-suited tool for a level five.

Chances are that you like hearing bad news about as much as I like the ostracism I receive from its conveyance. The fact is - hurricanes scare us. I get that. I'm human. Yet, if we allow this fear to deter us from preparing for the storm, we will have done ourselves a great disservice. So, for your own benefit, I ask the reader to momentarily close the door on your emotions, and reason with me, with Spock-like logic, to see if we can ascertain our current position, and in so doing, properly prepare for what lays ahead.

First, I would like to touch on an article that I wrote last summer titled, An Asset Allocator's Nightmare. My point in that article was that the dramatic increases in various indices made it less likely, not more, that the indices would continue their upward progress. But, since that time, as evidenced by the charts and stats below, these major markets have moved higher still.

The upper left chart is the Brazilian Bovespa. From August of 2003 to August of 2005, this index increased 92 percent, from 13572 to 26042. At the end of January, it stood at 38382, making its overall gain from August of 2003, 183 percent. Similarly, the upper right chart shows the Russian Trading System Index. From August of '03 to August of '05, it was up 72 percent. From August of '03 to the end of January of '06, it's up 191 percent. Not too shabby.

The German DAX, shown in the upper left, was up 41 percent and 64 percent over the same time periods as above. In the same way, the Japanese Nikkei was up 24 percent and now 74 percent, for the same timeframes.

Again, in the upper left, measured from August of '03, the Dow Jones Transports were up 45 percent to August of '05, and now 67 percent to February of '06. The S&P 600 Small Caps, shown up and to the right, were up 52 percent and now 63 percent for the same dates.

But, what exactly does this prove? Perhaps it proves that I am wrong, that we should go back and listen to the old familiar tunes; "if you miss just a few days out of the markets..." or "market timing is impossible." Yet, if we race into these indices before we "miss out" on the next wave of winnings, in retrospect, we may look back on such a hasty decision with regret.

More likely, it proves that manias can go on longer than expected and that history takes longer to unfold than you or I would like. Throughout history, those who have rationalized that some "new" occurrence is the reason why they should "hurry up and get in" on such rapid price increases, have not fared well at all. They eventually learn that historic and scientific evidence always wins out. This usually proves to be a very costly lesson.

We do not need to look back very far to be reminded of the gravity of this truth. Surely, we all remember the next two charts below.

Though both of these charts should look familiar, the upper left chart of the NASDAQ bears a resemblance to the six charts of the markets we have discussed to this point. Though the chart to the upper right, also of the NASDAQ, may be an unwelcome memory, it is a familiar story, told again and again throughout history.

The lessons of 2000 must have their most valuable application today. Consider the following lesson, told to us from the perspective of John Bogle, the founder of Vanguard Funds, a company which is known for its index funds.

"Not everyone lost money in the stock market 'bubble' of 1997-2000.

The winners , says John C. Bogle, were those who sold . Including thousands of corporate leaders blessed with stock options. And their investment bankers. The losers bought, lulled into thinking a "new economy" changed all the rules of up and down.

The total transfer of income was a shocking $2 trillion, says mutual fund leader Bogle. And don't blame mere "market forces." The trial of Enron officials that started Monday points to one failing of the system: fraud. ² [Emphasis mine]

Rather than list all of the charts or tell all the accounts of manias and there aftermaths in this piece, I refer the reader to the Traits of the System section of our recent paper titled, Riders on the Storm, or to Jeremy Grantham's October 2004 quarterly letter titled, "The Countdown Continues." Instead, here, we will zero in on the Tulip Mania and the Roaring Twenties.

In the sixteen hundreds men believed that a tulip bulb would always gain in value, which, of course, lead to a mania which captured the imagination of the whole of Holland.

"The average annual wage in Holland was between 200 and 400 guilders. A small town house cost around 300 guilders and the best flower paintings sold for no more than a 1,000 guilders. Against these values we can measure the extravagance of tulip prices. According to the Dialogues, a Gouda bulb of four aces rose from 20 to 225 guilders; [and] a Generalissimo of ten aces which had sold for 95 guilders fetched 900 guilders. The Semper Augustus retained its position as the most prized bulb. Gaergoedt relates how 'about three years ago, it was sold for 2,000 guilders,' but at the height of the boom it might sell for 'even 6,000 and possibly more, even if it be a plant of only 200 aces." ³

What was the end of this story, you ask. Well, on February 3, 1637, the tulip market suddenly crashed.

"In the aftermath of the crisis, tulipomania gave way to tulipophobia - a revulsion analogous to the public distaste for common stocks after the Great Crash of 1929." ⁴

Perhaps people were not as rational in the 1600's as the 20th century man and woman. After all they did not have the tools to add "liquidity" to the markets when it was needed. Let's look at the twentieth century.

"In each decade, the terms and conditions of lending became progressively easier with the passage of years. Auto finance helps to illustrate the tendencies. To start with, cars were financed for a year and with a down payment of one-third to one-half of the purchase price. It was not long before the minimum down payment was lowered to a third or even to a fourth of the selling price of new cars, while the series of monthly payment was increased to eighteen months, and even in some cases to longer periods." ⁵

If we move to 1929, we can see that manias always end in busts. This does not just apply to equities, but to all asset classes, including real estate and bonds.

"The new [New York Real Estate Securities] exchange could not have opened at a worse time. It was the month of the Great Crash. What almost nobody foresaw was the significance of that break to real estate or to the cozy business of real-estate bonds. On February 1, 1930, the number of bonds changing hands on the New York Real Estate Securities Exchange floor was exactly two. Even without active trading, quoted prices fell. The Chrysler Building 6 percent bonds of 1948 fetched 95 cents on the dollar. Two years later, they had fallen to 38." ⁶

Over the last two years, once again we are seeing the signals of a mania. Instead of traders moving tulip bulbs we are flipping condos. Instead of auto loans requiring one third to one half of the purchase price, dealers have come to expect that their will be no down payment. The storm clouds are on the horizon.

For those who are hoping that the umbrella of diversification will protect them, consider the following comments that are outlined in the Seventh Edition of the Investments Planning Textbook used by the College for Financial Planning.

"Diversification and the reduction in unsystematic risk require that asset's returns not be highly positively correlated. When there is a highly positive correlation, there is no risk reduction . When the returns are perfectly negatively correlated, risk is erased. This indicates that combining assets whose returns fluctuate in exactly opposite directions has the effect on the portfolio of completely erasing risk." ⁷ (Emphasis Mine)

The charts from An Asset Allocator's Nightmare and the charts above make one thing perfectly clear. Today, the markets around the world have a high positive correlation - that is, they move (in step) together. Though the tools in the marketplace that are negatively correlated are few, they are there for those who are willing to listen, learn, and act.

* Research Source - Rydex Investments

So, why don't we act? In answering this question, let's again turn to The Journal of Behavioral Finance. The earlier mentioned article states:

"The mathematician, [Blaise] Pascal wrote 'ordinary people have the ability not to think about things they do not want to think about.' In other words, intrinsic laziness often causes individuals to be inefficient, but proper pressure will reduce this kind of inefficiency and boost productivity." ⁸

So basically, it's human nature. Yep, that's it - human nature.

In Heavy Clouds, No Rain, we wrote about this problem. From discussions I have had with numerous individuals, both personally and professionally since last August, this lesson bears repeating.

When we are looking to make a decision, there are three parts of our brain that are called into action. One part, the basal ganglia, "controls the brain functions that are instinctive, such as the desire for security, the reaction to fear, the desire to acquire, [and] the desire for pleasure. More pertinently, this area of the brain controls behaviors such as flocking, schooling, and herding." ⁹ Another part of our brain, the limbic system, "is the seat of emotions and guides behavior required for self preservation. It operates independent of our reasoning capabilities, and therefore, has the capacity to generate out-of-context, affective feelings of conviction that we attach to our beliefs regardless of whether they are true or false." Additionally, this part of the brain has no concept of time and does not learn from experience. ¹⁰ The third part of our brain, the neocortex, "is involved in processing ideas and using reason."

Unfortunately, this third part of our brain is trumped by the other two parts, because the other two parts are faster and control the intensity of our emotions. So, as you can see, when it comes to investing, we are hard-wired to fail.

The reality of our current environment requires us to realize that most investors, investment advisors, and investment managers are set up to sink their ship in the storm that is directly in front of us. I would encourage you to download our research paper, Riders on the Storm: Short Selling in Contrary Winds, in order to gain a better understanding of the systemic risks that are straining our markets, the history of short selling from 1610 to Refco, and the character traits excellent storm managers. Forget the couch potato strategy and the pretty pie charts of the '90s. This is a time to search of the very, very few managers who have already been following John Templeton's maxim for years. "Never follow the crowd."

If you would like a copy of our research paper, Riders on the Storm: Short Selling in Contrary Winds, visit our website. This will also give you access to our new monthly newsletter, which is at no cost, titled The Investors Mind: Anticipating Trends through the Lens of History.

Sources:
¹The Journal of Behavioral Finance (November 2005) "Self is Never Neutral" Lei Gao and Ulrich Schmidt, pg 29
²http://www.pittsburghlive.com/x/tribune-review/business/s_419189.html
³Devil Take the Hindmost: A History of Financial Speculation (1999) Edward Chancellor, pg 18
⁴Ibid, pg 20
⁵Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken (1992) James Grant, pg 162
⁶Ibid, pg 170
⁷Investments: An Introduction, Seventh Edition - Custom Edition for the College for Financial Planning, pg 166
⁸The Journal of Behavioral Finance (November 2005) "Self is Never Neutral" Lei Gao and Ulrich Schmidt, pg 28
⁹The Wave Principal of Human Social Behavior and the New Science of Socionomics (1999) Robert R. Prechter Jr., pg 147-151
¹⁰Ibid

Doug Wakefield,
President
Best Minds Inc., A Registered Investment Advisor

Best Minds, Inc is a registered investment advisor that looks to the best minds in the world of finance and economics to seek a direction for our clients. To be a true advocate to our clients, we have found it necessary to go well beyond the norms in financial planning today. We are avid readers. In our study of the markets, we research general history, financial and economic history, fundamental and technical analysis, and mass and individual psychology.

Copyright © 2005-2009 Best Minds Inc.

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