Credit inflation, Deflation: Prechter Interview

[bart]

Re: Credit inflation, Deflation: Prechter Interview

Thus, in order to sidestep the possibility your forecast of the financial future might not be perfect and to minimize the volatility you will experience in realizing the best possible return, you seek to optimize probabilities.

And here's a chart I found in my archives recently, and added to my investing page. Its simply another way to view the asset allocation approach.



Credit to BCA - http://www.bankcreditanalyst.com/

[Jim Nickerson]

Re: Credit inflation, Deflation: Prechter Interview

geez, Jim, you sure do have a way of asking good questions...

Not quite sure how to explain this without writing a thesis, but mostly it boils down to probability.

Suppose for a minute that you knew with certainty exactly which asset class was going to perform the best over a time frame starting now and ending as some point in the future - which is also known with certainty. If that were the case, naturally the best investment strategy would be to put 100% of your portfolio into that one asset class. And then, when that period was over, move it all into that asset class which would then be the top performer in the next investment period.

Before long, you'd be the richest man in the world.

Alas, the financial markets do not work that way. If they did, everyone would soon be the richest man in the world. You never have certainty as to a specific course of financial future history. The best - the very best - you can do is establish probabilities.

Moreover, consider subperiods of that "next investment period". How long for? A few hours? One day? One week, month, year??? Unless you are prepared to trade second by second, even having your portfolio in the "best" performing asset class will at least temporarily leave you underperforming the rest. This means that you will have losses, if only on a relative basis.

This, in turn, means that even having 100% of your portfolio in the best asset class will leave you underperfoming during at least one subperiod.

Thus, in order to sidestep the possibility your forecast of the financial future might not be perfect and to minimize the volatility you will experience in realizing the best possible return, you seek to optimize probabilities.

Thanks, Finster, and that wasn't a thesis. But it doesn't seem to me that you answered my question (though I expect you see it differently).

If one is invested in TLT, with some reasonable expectation not to lose money, and if the thesis of future inflation (which has generally occurred for most of the past 70 years) is reasonable (is it reasonable?), then it looks to me that betting on the continued increase in long bonds is a poor bet.

Do you think the Fed is just going to keep lowering rates to ZERO as in Japan, or must at some point it defend the bonar, which I think raising rates does? For the sake of asset allocation, one could just as well be short the long bond now. But you didn't make that allocation (why not a short position vs. the long position it would make one more diversified), so might you think rates will go to ZERO before all is said and done?

[Jim Nickerson]

Re: Credit inflation, Deflation: Prechter Interview

And here's a chart I found in my archives recently, and added to my investing page. Its simply another way to view the asset allocation approach.



Credit to BCA - http://www.bankcreditanalyst.com/

That is a good chart, Bart-of-charts, but where do long bonds fit in? Under financials? Were bonds to fit under "Financials", then might we not be closer to the top of the liquidity cycle? I guess we could be at the bottom of the liquidity cycle based on all the spigots that seem to me to be wide open.

[Finster]

Re: Credit inflation, Deflation: Prechter Interview

Thanks, Finster, and that wasn't a thesis. But it doesn't seem to me that you answered my question (though I expect you see it differently).

If one is invested in TLT, with some reasonable expectation not to lose money, and if the thesis of future inflation (which has generally occurred for most of the past 70 years) is reasonable (is it reasonable?), then it looks to me that betting on the continued increase in long bonds is a poor bet.

Do you think the Fed is just going to keep lowering rates to ZERO as in Japan, or must at some point it defend the bonar, which I think raising rates does? For the sake of asset allocation, one could just as well be short the long bond now. But you didn't make that allocation (why not a short position vs. the long position it would make one more diversified), so might you think rates will go to ZERO before all is said and done?

In fact I do not expect long Treasuries to provide great returns from here.

But what if I'm wrong? What if the next ten years did somehow yield up a Japanese-style deflation? Not that that's what I expect, but did you ever run into a financial guru who was always right?

Even Warren Buffett lost a bundle on a currency bet last year. This is the thrust of my point about the probablistic nature of the financial markets. Even at best, you can only say the probabilities favor a certain outcome. Certainty is a fantasy. A risky one at that.

As for taking a short position, I am an investor, not a gambler. I only invest money I have, not money I don't. That policy has not only kept me out of trouble, but added greatly to my returns on the plus side as well.

Basically I have what I consider a "neutral" asset allocation, which represents the apportionment of funds that I would have if I had no opinion on the markets. If I really like something, I "go long" by allocating more to that asset than my neutral allocation. By the same token, if I am skeptical of something, I "go short" by taking a less-than-neutral position.

This works because the assets in my "neutral" allocation include only those investments which over time tend to produce positive returns. So even if I haven't a clue on the financial landscape and just plopped everything into my neutral allocation and rebalanced occasionally, I'd still have positive returns over time. And have virtually no risk to boot.

To the extent my assessment of the financial environment is correct, however, the returns are outsized. So to speak - icing on the cake.

Not only that, but if something in which I am invested falls, having a target allocation tells me I should add to my position. And vice-versa - if it rises greatly, my allocation rises above my target. Due to this phenomenon, I tend to buy low and sell high.

Kind of the idea, huh?

[Jim Nickerson]

Re: Credit inflation, Deflation: Prechter Interview

Thanks, Finster, you make some very good points.

Just in case you have yet to figure out my level of investment expertise, I have shorted one stock once in 20 years. Having no knowledge regarding shorting bonds, I read somewhere it is for "professionals" only.

It is true you could lose unendingly being short a stock that goes up unendingly, but if one is short a benchmark via a "bear" type mutual fund, then one cannot lose more than one invested, right? You could lose no more in it that you could lose in an ETF such as TLT. So if one is of the opinion

In fact I do not expect long Treasuries to provide great returns from here.

why would you not allocate to the bear-type bond fund. It would still allow you to maintain the discipline you discussed above I think.

[bart]

Re: Credit inflation, Deflation: Prechter Interview

That is a good chart, Bart-of-charts, but where do long bonds fit in? Under financials? Were bonds to fit under "Financials", then might we not be closer to the top of the liquidity cycle? I guess we could be at the bottom of the liquidity cycle based on all the spigots that seem to me to be wide open.

Pretty much like all attempts to boil something complex down to one chart, there are lots of issues with it and bonds being missing is one. Its actually referenced on my investing page in the context of mutual funds... but that said, it sure does seem that bonds belong with the Financials.

I think we are at least approaching a relative bottom in the liqudiity cycle, and the key is "relative". It could not only be another year or more (or just a month) before it truly bottoms and effects start to show, but also showing the curves as evenly spaced sine waves can be deceptive.

I'd prefer that they be shown as ascending sine waves at least, and that would address your spigots view. It would also highlight that inflation is pretty much continuous, and that its also changes at the edges that drive markets. Even at the bottom of the last recession, bank credit growth was running around 3%.

[Finster]

Re: Credit inflation, Deflation: Prechter Interview

Thanks, Finster, you make some very good points.

Just in case you have yet to figure out my level of investment expertise, I have shorted one stock once in 20 years. Having no knowledge regarding shorting bonds, I read somewhere it is for "professionals" only.

It is true you could lose unendingly being short a stock that goes up unendingly, but if one is short a benchmark via a "bear" type mutual fund, then one cannot lose more than one invested, right? You could lose no more in it that you could lose in an ETF such as TLT. So if one is of the opinion why would you not allocate to the bear-type bond fund. It would still allow you to maintain the discipline you discussed above I think.

The questions get tougher and tougher ... ;-)

In fact I don't see a simple symmetry being being long and short. The investment proposition starts with the assumption that you have assets. You need to do something with them. (There is no such thing as having assets invested in nothing). That being the case, why complicate things by taking on debt and investing someone else's assets?

That would be speculation. I suppose if you want to be a speculator, that's fine, but that's just a whole different ball game than investing. When you're investing, you have no choice but to have your assets in something. The only alternative is to take a vow of poverty and join the brotherhood. Speculating is attempting to profit from changes in asset prices that are unrelated to the investment merit of the assets. Arbitrage. This is a full time occupation, and there is no assumption you have assets to invest in the first instance. So from the point of view of the investor, it is solving a problem that doesn't exist in the first place.

One exception. And that is taxes. You may have a position in the stock market that if sold, would generate a sizable tax bill. Yet you want to reduce your stock market exposure temporarily. A bear fund is wonderful for this purpose. You can buy a position and offset your long exposure for a pretdetermined time period without making a mess of your Schedule D or paying for a basis upstep you didn't want or need.

Also, being short bonds is an extremely crowded trade. Think about it. If you lend money, you are in a similar position to someone who has bought a bond. If you borrow money, you have in effect sold a bond. Selling a bond, or selling short a bond, then, is putting yourself in the same position vis-a-vis the bond market as about 200,000,000 financially reckless Americans. Not a crowd a savvy investor would think of himself keeping company in ...

[Jim Nickerson]

Re: Credit inflation, Deflation: Prechter Interview

The questions get tougher and tougher ... ;-)

In fact I don't see a simple symmetry being being long and short. The investment proposition starts with the assumption that you have assets. You need to do something with them. (There is no such thing as having assets invested in nothing). That being the case, why complicate things by taking on debt and investing someone else's assets?

That would be speculation. I suppose if you want to be a speculator, that's fine, but that's just a whole different ball game than investing. When you're investing, you have no choice but to have your assets in something. The only alternative is to take a vow of poverty and join the brotherhood. Speculating is attempting to profit from changes in asset prices that are unrelated to the investment merit of the assets. Arbitrage. This is a full time occupation, and there is no assumption you have assets to invest in the first instance. So from the point of view of the investor, it is solving a problem that doesn't exist in the first place.

One exception. And that is taxes. You may have a position in the stock market that if sold, would generate a sizable tax bill. Yet you want to reduce your stock market exposure temporarily. A bear fund is wonderful for this purpose. You can buy a position and offset your long exposure for a pretdetermined time period without making a mess of your Schedule D or paying for a basis upstep you didn't want or need.

Also, being short bonds is an extremely crowded trade. Think about it. If you lend money, you are in a similar position to someone who has bought a bond. If you borrow money, you have in effect sold a bond. Selling a bond, or selling short a bond, then, is putting yourself in the same position vis-a-vis the bond market as about 200,000,000 financially reckless Americans. Not a crowd a savvy investor would think of himself keeping company in ...

Finster, I promise I am not picking at you. I could go on, but lack of time prohibits that right now. I am seeing your points and appreciate your time to put them down, I really do. You are enabling me to define myself an a "speculative investor" perhaps that is oxymoronic, probably is.

[Finster]

Re: Credit inflation, Deflation: Prechter Interview

Finster, I promise I am not picking at you. I could go on, but lack of time prohibits that right now. I am seeing your points and appreciate your time to put them down, I really do. You are enabling me to define myself an a "speculative investor" perhaps that is oxymoronic, probably is.

Well nobody can tell you what your goals are. If, for example, you goal was to lose money, we could argue all day about what the best way to go about it might be, but the goal of losing money is still a decision, not a fact.

Facts, logic and methods are where the debating come in. Concerning what I'm calling "speculation" here though, I have some advice. Before you consider any speculation, first picture yourself having lost the money that you risked on your speculation. Is the picture one you can live with? If so, then weigh the odds and place your bet. If not, stick to investing.

[Jim Nickerson]

Re: Credit inflation, Deflation: Prechter Interview

Well nobody can tell you what your goals are. If, for example, you goal was to lose money, we could argue all day about what the best way to go about it might be, but the goal of losing money is still a decision, not a fact.

Facts, logic and methods are where the debating come in. Concerning what I'm calling "speculation" here though, I have some advice. Before you consider any speculation, first picture yourself having lost the money that you risked on your speculation. Is the picture one you can live with? If so, then weigh the odds and place your bet. If not, stick to investing.

Finster, since my last note here, I have been ruminating (and trying to get my computer working) over your method of buying the group of ETF's and CTF's. I think you said something like "this is a sleep like a baby" or "walk away from it for a couple of years" type investment allocation.

25% in US bonds, 25% in commodities and gold and silver, and 50% in equities, a bit larger portion of the equities in the US and smaller internationally. Your method of taking from the winners and rebalancing to the loosers to keep the allocation percentages near the same as time goes forth seems very reasonable when something in the allocation does in fact go up. But what if nothing goes up very much if at all, while others sustain significant losses?

It seems to me that in 1987 crash everything went down (and I would check this out, except for finding charts back that far, probably something didn't go down), and from top in 2K to 2002 bottom, it seems everything went down. After writing that, I went and checked how your present allocation might have done from top to bottom in the last significant downturn. I guess I realize, that if this were 10/1999, and if you thought then as you appear to think now, your allocation might have been different. Even thought now is now, let us assume it turns out to be as things went on to develop between 10/99 and 10/02. Still the basic question of how would your "sleep like a bady" portfolio do in similar conditions if that is even remotely possible.



I hope that table will stay with this post. It shows the prices from about the end of March 2000 to the prices around 10/10/2003. I am sure it is not exact, the data were gleaned using annotated stockcharts.com. I could not locate short note prices, so I have assumed SHY might have performed somewhat similarly to TLT. I used the CRB versus the "basket" of your commodity picks, and "baskets" of ETF's for your EFA and EEM choices. I chose the prices without any conscious bias; hopefully I was objective and did not "jigger" any choices.

The bottom line in the table raises the question that I hoped it would.

What do you do in a widespread down market, if the winners are not covering the losers? Whether investing or speculating, stop-loss levels seem to me logical, so how do you see that? And if this were two years from now and you are down 18-20%, are you going to stick with it or what?

10/29/06, the table disappeared and I put it back. If it is not there and one wishes to see it, try http://0201.netclime.net/1_5/D/B/I/finster_table.jpg

[bart]

Re: Credit inflation, Deflation: Prechter Interview

...
I would check this out, except for finding charts back that far
...

Bigcharts will display a lot more data than stockcharts in free mode.

http://bigcharts.marketwatch.com/def...seen&dist=ctbc

[Jim Nickerson]

Re: Credit inflation, Deflation: Prechter Interview

Bigcharts will display a lot more data than stockcharts in free mode.

http://bigcharts.marketwatch.com/def...seen&dist=ctbc

Yes, but I think you can only zoom-in on the java charts that never go back more than 10 years, and then if one is estimating on the longer charts, the estimates are fuzzier. Thank you for pointing me.

Incidentally, my Mozilla on two different computers started working differently in the last couple of days on bigcharts. Is it just me, or did anyone else notice?

[bart]

Re: Credit inflation, Deflation: Prechter Interview

Incidentally, my Mozilla on two different computers started working differently in the last couple of days on bigcharts. Is it just me, or did anyone else notice?

Firefox 2.0 has come out. Perhaps one has it and one doesn't?



edit/add

Yes, but I think you can only zoom-in on the java charts that never go back more than 10 years, and then if one is estimating on the longer charts, the estimates are fuzzier. Thank you for pointing me.

There's also finance.yahoo.com, downloading all the data on a given stock into Excel and then making your own chart(s).

[Finster]

Re: Credit inflation, Deflation: Prechter Interview

Finster, since my last note here, I have been ruminating (and trying to get my computer working) over your method of buying the group of ETF's and CTF's. I think you said something like "this is a sleep like a baby" or "walk away from it for a couple of years" type investment allocation.

25% in US bonds, 25% in commodities and gold and silver, and 50% in equities, a bit larger portion of the equities in the US and smaller internationally. Your method of taking from the winners and rebalancing to the loosers to keep the allocation percentages near the same as time goes forth seems very reasonable when something in the allocation does in fact go up. But what if nothing goes up very much if at all, while others sustain significant losses?

It seems to me that in 1987 crash everything went down (and I would check this out, except for finding charts back that far, probably something didn't go down), and from top in 2K to 2002 bottom, it seems everything went down. After writing that, I went and checked how your present allocation might have done from top to bottom in the last significant downturn. I guess I realize, that if this were 10/1999, and if you thought then as you appear to think now, your allocation might have been different. Even thought now is now, let us assume it turns out to be as things went on to develop between 10/99 and 10/02. Still the basic question of how would your "sleep like a bady" portfolio do in similar conditions if that is even remotely possible.

...

I hope that table will stay with this post. It shows the prices from about the end of March 2000 to the prices around 10/10/2003. I am sure it is not exact, the data were gleaned using annotated stockcharts.com. I could not locate short note prices, so I have assumed SHY might have performed somewhat similarly to TLT. I used the CRB versus the "basket" of your commodity picks, and "baskets" of ETF's for your EFA and EEM choices. I chose the prices without any conscious bias; hopefully I was objective and did not "jigger" any choices.

The bottom line in the table raises the question that I hoped it would.

What do you do in a widespread down market, if the winners are not covering the losers? Whether investing or speculating, stop-loss levels seem to me logical, so how do you see that? And if this were two years from now and you are down 18-20%, are you going to stick with it or what?

Wow Jim, you are in top form here! Okay, let’s roll up our sleeves and really dig into the issue.

I’m going to address your points on several fronts. Let me know if I’m losing you at any point along the way.

1) The basic concept here is a takeoff on the "Permanent Portfolio" as set forth in Harry Browne’s excellent book, Fail Safe Investing. In it Browne advocates an all-season asset allocation of 25% cash, 25% bonds, 25% stocks, and 25% gold, along with a rebalancing algorithm. Rather than attempt to lay out the case for his model, I recommend reading the book. It is a short book, easy to read, and elegantly simple in concept and application. Harry Browne, by the way, also wrote the book How You Can Profit In A Monetary Crisis over 25 years earlier, which despite its title is one of the best economics texts ever written and which formed the basis of my conception of finance and economics as a teenager. Browne, who just passed away a few months ago, was a master investor and also was twice the Libertarian Party nominee for President of the United States. He is also well known for his book How I Found Freedom In An Unfree World.

In an act of unpardonable hubris, I’ve modified Browne’s recommendations somewhat. His is really the true "sleep like a baby" portfolio. The overall volatility and risk of loss is practically minuscule, even over time frames as short as a year or two. My version is more oriented towards longer time frames and aims to provide greater returns at the expense of somewhat higher short term volatility and risk.

2) I’m not sure I fully understand your historical interpretation of my recommendation. You are using other funds or indexes as surrogates for the ETFs I cite before they became available? In any case, the deviations from the actual funds could be quite significant.

3) As far as I can tell, you are looking exclusively at price performance, and not taking total return - including interest and dividends - in account.

4) In addition, it appears you have not allowed for rebalancing during the time frame in question. Since the rebalancing regimen is an integral part of the concept, it is not a realistic test.

5) My allocation targets are dynamic. See the chart I posted way back on Page 2 of this thread (#28). The fixed targets themselves would give you better performance than most investors, due to the common tendency to buy after something has already risen greatly and sell after it’s already fallen greatly, but in my view it is possible to improve further on that with an intelligent dynamic asset allocation target. Note for example that the allocation target swung rather dramatically from stocks toward bonds in 1999-2001.

6) You have selected as your control time frame a truly extraordinary period in financial history. The deepest bear market in stocks since the Great Depression. This is surely a very tough hurdle for any investment program … a once in three generations, six standard deviations, event! If you are expecting it to be repeated in the next few years, then you are surely placing an outlier of a wager.

I would simply urge you to consider that the nature of your argument is highly analogous to someone making a similar argument in 1936. He bases his analysis on the time frame extending from the top in stocks in October 1929 to the bottom in July 1932. Quite logically, he concludes that one should never, ever, own stocks. Of course, such logic would also keep him out of the single best performing investment for the next seven decades!

7) This final point may be the most subtle of all, and yet the most important. You have erroneously assumed that cash is constant. It most certainly is not!

This error is tantamount to taking any of the other components as constant; for example, assuming that the S&P 500 is fixed. If you were to then use that as the unit of measure for your portfolio performance you would see cash rising dramatically in value during the time period in question. But as Einstein might say, it’s all relative. Your error is very common - practically universal - due simply to the fact that we use our currency, the US dollar, as our unit of account. But aside from sheer force of habit, I would challenge you to defend your tacit assumption. Just try and justify a position that the value of the US dollar never changes!

On what grounds, for example, do you assert that in fact the real value of cash did not change and that it remained fixed as in stone as the stock market declined, rather than rising as the stock market remained fixed as in stone?

The real truth is neither.

But this is not merely an academic point. In fact, in the 1929-1932 experience, a great deal of the apparent losses in the stock market were in fact a phenomenon of a rising value of dollars. That’s why we call it a deflation. Not only did cash rise against stocks, but it also rose against real estate, commodities, groceries, and just about everything else. If you held a portfolio of 50% stocks and 50% cash, and the stock portion declined by 90%, by your logic you would conclude that your overall loss was 45%. I strenuously object, however, countering that your cash gained in value - you just failed to acknowledge that fact by assuming cash to be constant and using the cash as your unit of measure.

It happened again in 2000-2002. Of course this time the Federal Reserve intervened with a massive, historic, inflationary effort before the slow-to-respond consumer prices went deep into the negative. We did briefly dip into CPI deflation in during that period, but the underlying deflation was cut short before it could really affect consumer prices to an extent resembling 1929-1932. Nevertheless, the assumption of constant cash value is unjustified.

This is a crucial point behind my FDI work. In fact, the main application I use it for is as the unit of account for my own portfolio performance. If the value of cash rises, I see it happening in my spreadsheets. If it falls (the more normal circumstance!) I see it declining. And if stock prices are merely reflecting inflation, the declining value of the dollar, then I am not lulled into thinking I am turning a real profit when in fact I’m just treading water. If you were to do the same with the portfolio I cited - and include dividends and interest, the effects of rebalancing, etceteras, you would find that even in this historical outlier of a financial environment, you would have done far better than the vast majority of investors and then gone on to do so in the subsequent environment as well.

Do you now see the fallacy inherent in your question about a financial environment when almost everything is going down? When you examine the historical record, and evaluate the performance of a portfolio such Browne’s in real terms, you simply do not find any protracted period where such a thing happens. Something is always going up. It’s just that when it happens to be cash, your use of cash as a unit of account leads you to fail to notice.

[Jim Nickerson]

Re: Credit inflation, Deflation: Prechter Interview

Finster,

I am glad I asked the question, and I cannot be more sincere in saying "Thank you" for your time to explain your perceptions. I need to read several more times all you wrote in order to better digest it. Clearly you appreciate this is not an argument, but rather an attempt for me, and any others wishing to advantage themselves, of gaining more insight, becoming a bit smarter, or a bit less dumb. Your shoulder must be improving. Good.