Why do we do the things we do? How can two people, or even large groups, look at the same set of facts and come to such widely different conclusions? Maybe even more important would be to ask why? Is there some bias involved? Does being a "professional" help you avoid these biases? We will examine these questions and more, and end with a few comments on the important and very strategic sleeper event you probably missed this week. It should be a fascinating letter.
Warning: some of the studies which I discuss can (or at least should) give rise to some serious soul-searching for your own personal biases. This latter activity is best done at night with good friends and your favorite adult beverage. Since the holidays are coming up and we tend to look for reasons to get together with friends anyway, this process will simply help you on your way to finding your own Inner Spock.
And speaking of the Holidays, at the end of this letter, I tell you how to get the perfect Christmas gift for your investor friends and clients: a personally autographed (an individually personalized) copy of my New York Times Best Seller book, Bull's Eye Investing.
But first, a few announcements. As many of you know, my "real" business is researching and finding hedge funds for investors. Investors who are accredited investors (basically $1,000,000 or more net worth - see my web site for more details) can sign up at www.accreditedinvestor.ws and after a process described at that web site can find out more information about the specific hedge funds we represent. I say "we," as I closely work with a firm in California called Altegris Investments who do the actual sales (as well as their own extensive research) and client contact.
In the process of the last few years, we have had a significant number of non-US residents sign up. For regulatory reasons, which is a long story and one into which I will not delve in this letter, we have not contacted those who have signed up residing outside the US. But we are in the process of solving that problem, and it is now my intention to change things over the coming months.
I have just signed an agreement with an outstanding group in England, Absolute Return Partners, which will allow us to work within the current regulatory framework with residents of the European Union. We will soon be contacting those from the EU who have signed up heretofore and ask their permission to forward their names on to Absolute Return Partners. You will, of course, get lots more information, but suffice it to say I have a great deal of confidence in Niels Jensen and his team.
We are diligently working on getting partners who meet the necessary local legal requirements in other parts of the world and who also have a demonstrated expertise in alternative investments. I expect to make announcements of other arrangements over the next year. Canada - have a little more patience!
If you are in the US and an accredited investor, I encourage you to go to www.accreditedinvestor.ws and sign up. I am going to be changing the way I write (I have been woefully lack in writing my free Accredited Investor Letter but that will change) and some of the services we offer which will hopefully make the process of finding alternative investments easier. I will give you more details in a later letter.
(In this regard, I am the owner and a registered representative of Millennium Wave Securities, LLC, an NASD member firm. See more disclosures on the web site and at the end of this letter.)
And now back to our regularly scheduled letter.
Don't Confuse Me With the Facts
Last week, I heard a very disquieting commentary on National Public Radio by Dr. Drew Westen of Emory University. Westen is a well respected psychologist, but he was commenting upon how our feelings can predict our political decision irrespective of the facts. He graciously sent me some of his research and papers. Westen studies the way that psychology and politics intersect, and he says a familiar format in cable TV news works with the way our brains are wired. As I thought about it, there are some real ties to his research and how we also process investment information. Let's look at what Westen said last week on NPR's All Things Considered:
"We've grown accustomed to hearing two versions of every story, one from the left and one from the right, as if the average of two distortions equals the truth. You've seen this on TV. The journalist provides the skeleton of the story; it's then up to partisans to try to graft flesh onto one side or the other of its clanking bones.
"A few weeks ago, for example, I heard a news anchor begin a segment about missing explosives at the al Qaqaa munitions dump in Iraq. He described claims that weapons were missing and then handed it over to a Democrat and a Republican to dress the skeleton in red or blue. In fact, however, the munitions were missing, and the subject of the debate that followed, when they disappeared, was a question of fact, not interpretation, unless, of course, Democrats and Republicans live in different time zones.
"Unfortunately, this format--from the left, from the right--capitalizes on a design flaw in the human brain. We have a tendency to believe what we want to believe. We seek information and draw conclusions consistent with what we want to be true. I've been studying this kind of emotion-driven political thinking over the last several years, and the results are sobering. For example, during the disputed election of 2000, we could predict whether people would believe that manual or machine counts are more accurate just by knowing their feelings towards the two parties and the two candidates.
"When people draw conclusions about political events, they're not just weighing the facts. Without knowing it, they're also weighing what they would feel if they came to one conclusion or another, and they often come to the conclusion that would make them feel better, no matter what the facts are.
"An experiment completed right before the election shows just how powerful these emotional pulls can be. Here's what we told the participants. A soldier at Abu Ghraib prison was charged with torturing prisoners. He wanted the right to subpoena senior administration officials. He claimed he'd been informed the administration had suspended the Geneva Conventions. We gave different people different amounts of evidence supporting his claims. For some, the evidence was minimal; for others, it was overwhelming.
"In fact, the evidence barely mattered. 84% of the time, we could predict whether people believed the evidence was sufficient to subpoena Donald Rumsfeld based on just three things: the extent to which they liked Republicans, the extent to which they liked the US military, and the extent to which they liked human rights groups like Amnesty International. Adding the evidence into the equation allowed us to increase the prediction from 84% to 85%.
"A readiness to believe what we want to believe makes it all the more important for journalists to distinguish what's debatable from what's not. The line between facts and interpretations isn't always easy to draw, but presenting fact as opinion is not objective reporting. It isn't objective to preface news that's unflattering to one side or the other with phrases like 'critics claim' when it doesn't take a critic to claim it. There's nothing like a healthy debate, but there's nothing as unhealthy as a debate about the undebatable." (NPR Radio)
Let's look at one sentence which is stunning. "Adding the evidence into the equation allowed us to increase the prediction from 84% to 85%." In his study he sent to me, the actual number was on 84.5%. The old joke is, "Don't confuse me with the facts. My mind is made up!" This study, and others he and his team have done over the years shows that it is no joke.
They did studies on Clinton and Lewinsky, on impeachment and on whether Clinton actually molested Kathleen Willey. What you felt about several emotional issues reliably predicted how you felt about the above topics.
But even when it was not an emotional issue as above, and one subject to facts and potentially rational thought, it made no difference. The subject of whether or not machine counts or hand counts was accurately split along party lines.
The clear implication of the study suggests that if Gore had won the state by some 500 votes, the opinions about which method of counting votes would have been reversed. The "facts" would be the same, of course, but the emotions surrounding the facts would have been opposite. We believe what we want to believe because to do otherwise would upset our world. The potential emotional stress of a contrary opinion is too much for us to deal with, so we go along with the (personally) least stressful emotional choice.
The Emotional Contrarian
This is the reason why contrarian investing can be so profitable, and at the same time why it is so hard. Our emotions help dictate our investment decisions. We are long the market because we need the market to go up so we can retire. Even thinking about a bear market and it consequences is so upsetting that we do not contemplate it until it is too late.
Do you think investors, with hard money on the line, don't make emotional decisions? Not you and me, of course, gentle reader. We are virtual Spocks, without the pointed ears, radiant in our rational decision making processes. I am talking about those other hormone driven, adrenaline addicted, fearful and stressed-out guys and gals.
James Montier brought a study to my attention done on exchange rates in 2000 by Menzie Chinn. While having no short term relevance on exchange rates, over the long term fundamentals determine almost 90% of the value of a currency according to the traders surveyed. OK, that sounds rational. But it seems that the perception of those traders as to what was important as a "fundamental" changed over time.
For instance, in 1995, some 37.5% of those surveyed said the trade deficit was important. By 2000 only 10% thought it was important. What happened in that time? The trade deficit was going up and the dollar continued to rise. How can trade deficits be so important if the dollar was rising? Traders therefore changed their views of fundamentals to square with their trading positions.
Today, however, I think it is fairly obvious that a much larger number, perhaps back to that 37.5% (or more), would say that trade deficits matter. Times change, and we change our interpretation of the facts to meet our current views.
We are lying to ourselves, maintains Montier. "Why the sudden switch in investor attitudes? Why have investors suddenly dropped the suspension of disbelief over the current account that has been the mantra for the last few years? I suspect that it has a lot to do with our inherent need to justify our actions to ourselves. We see the dollar declining, and then need to explain it.
"There is a long history of self-deception and justification in psychology. For instance, Nisbett and Wilson laid out many pairs of stockings, and asked ladies to select which pair they liked the most. When the women were questioned as to the reasons for their selection, they volunteered all sorts of wonderful excuses about texture and sheerness. Sadly, however, all the pairs of stockings were actually identical!"
In one of my favorite chapters in Bull's Eye Investing (shameless plug), which Montier and I co-authored, we talked about the deep-seated need for humans to make up reasons for their actions. We all know that we have right and left parts of our brain. For whatever reason known only to God, most functions of the sensory inputs to the brain are cross-wired. For instance, our right eyes are wired to the left side of our brain, and vice-versa with the left eyes. In a famous study by Gazzaniga, people whose right and left brains do not communicate (either by accident or for some surgical reason) were given instructions "...such as 'walk' or 'laugh' to the left eye and thus the right hand side of the brain (with the right eyed covered up) and they dutifully followed the instruction.
"However, the right hand side of the brain in most cases has no language skills. When the patient was asked why they walked out of the room, or started laughing, the left hemisphere starts to make up motives (remember the information was only seen by the right hemisphere). The 'honest' answer from the left hand side of the brain would be 'I have no idea'. However, this wasn't the answer that was found."
The patient, feeling the need for a reason, and not knowing that his right brain had seen an instruction to walk, simply made one up. The investor, whether amateur or professional, needing a reason for the current dollar drop if he is short the dollar, now becomes a trade deficit hawk.
That Most Emotional of Metals
And it's not just the dollar. For over 20 years, from the peak in 1980 until the nadir in 2002, gold was not a good investment. But that did not keep die-hards from proclaiming that the next gold bull was just around the corner. When it didn't appear, the reason was some conspiracy. Central banks were selling and wanted to keep gold down. Or forward selling by gold producers. If it was not one thing, it was another.
Of course, central banks are still net sellers of gold, but gold is rising. Have central banks lost their power to hold down gold? Or is it as I have maintained for years that it is simply a function of the falling dollar?
There is no gold bull market in Europe and in other countries where the dollar is falling. Certainly in countries like China there has been a gold bull in terms of Renminbi, but that is because the Renminbi and the dollar are pegged.
Gold has acted just like a neutral currency, which is what I believe it is. Thus owning some insurance gold made sense even in its bear market days, as it provided diversification. But if you wanted it to be an investment with returns even close to simple government bonds, you were often disappointed. If you were emotional about gold, you looked for reasons why it did not rise. Rather than face the fact that it was simply in a bear market, it had to be someone's (typically a central bank's) fault.
The dollar will not fall forever, although it still has a way to go, in my opinion (see more later). At some point it finds a bottom and begins to rise. My deep suspicion is that gold, that most emotional of all metals, will overshoot the nadir of the dollar. Emotions will keep it going past whatever that future natural level will eventually be. Panicked investors, fearing they will be left on the sidelines, will jump on what they feel is the last train out, and we will see another bubble in gold.
What that "bubble" number is, I will let other speculate. But it will be too high and will come back. But those who are emotionally tied to their gold will be writing about how this time it is different. It won't be. It is the same phenomena as the first gold bubble in then 80's, the recent Internet bubble, the Japanese real estate bubble and the coming Chinese bubble sometime in the next decade or so.
The Dollar - Oversold or Overwrought?
Is there anyone left who is bullish on the dollar? Even Greenspan and other Fed governors openly suggest the dollar and the trade deficit are too high. If the United States is borrowing to finance its trade deficit, then somebody must be lending, which means someone is saving. Everyone knows that the United States trade deficit, at 6% of GDP, takes around 83% of total world savings to finance (International Monetary Fund). The US government deficit soaks up a huge amount of our own national savings.
The reality is that the trade deficit cannot go much higher because the world is running out of the ability to lend more money. Someone somewhere must start to save more or the deficit must begin to come down. The classic ways are for the dollar to drop or for a recession to appear. What politician or Fed governor in his right mind would deliberately induce a recession? The answer that is left is for the dollar to drop, and that is clearly the way the Fed and the Treasury are leaning.
That also means the US must ultimately finance its own deficit. Thus we will be forced to save more and spend less. Given the boomer retirement coming all too rapidly down the road, it is hard to imagine a longer term scenario which yields growth in consumer spending, increased savings and a stable dollar, all at the same time.
So, the open short position on the dollar continues to climb. If everyone is on the same side of a trade, who is on the other side? Is the dollar extremely oversold? Maybe. I can paint a scenario either way.
Fundamentally, the dollar has not dropped all that much on a trade weighted real basis, and given the trade deficit, government debt and other factors, it still has a way to go, in my opinion. Further, the current short position of traders is a small percentage of the huge ($1 trillion a day) currency markets. There is still plenty of room for more short-selling.
On the other hand, the traders who move the market from day to day are all on one side of the trade. It is quite crowded. It feels a lot like this time last year when again everyone was short. The dollar stopped its slide and actually began to rise with a significant correction. Now we can see that correction was a buying opportunity. At the time, many said the dollar had reached its bottom. That scenario could, and likely will, play out again. Very few markets have ever gone down (or up) without significant corrections along the way.
The Sleeper Dollar Issue
Did you feel the ground shake? The epicenter of the economic quake happened in Laos last Tuesday. Southeast Asian nations and China signed an accord to create the world's biggest free trade area by removing tariffs for two billion people by the end of the decade. In macro-economic terms, that is tomorrow. Leaders in the 10-member Association of Southeast Asian Nations (ASEAN) also signed a pact to create an ASEAN Community along the lines of a unified Europe by 2020. It aims to create a common market with common security goals. ASEAN members are actively talking of creating their own "reserve currency" to compete with the dollar and the euro.
On an even larger note, Japan, South Korea, Australia and New Zealand have all agreed to start free-trade talks with the ASEAN countries. (Just for the record, the Association of Southeast Asian Nations consists of Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand and Vietnam.)
Now, let's couple that with another fact or two. The Wall Street Journal reports: "Total flows of Foreign Direct investment (FDI) have collapsed since 2000 - from a peak of $314 billion in 2000 to [a mere! - JM] $29.8 billion in 2003. That's down 90%. No doubt some of that decline is a cyclical response to the giant surge in the late 1990's. But some of that falloff might be structural. In 2003, for the first time, China attracted more FDI than the US ($53 billion). This comes as the US share of world FDI inflows fell to only 5.3% in 2003, from 22.6% in 2000."
Where is the US International Trade Commission? We are still putzing around with a Caribbean free trade agreement, which we cannot get done because of sugar subsidies to the Florida Fanful family, let alone a Central American agreement or a southern hemisphere agreement.
Right now, the world and especially Asia needs the US consumer. But we cannot always count on that. Asia is working hard on creating its own internal consumer demand. A free trade territory the size of the one developing is huge, and we should be driving the talks, not watching them.
The Balance of Financial Terror
Right now, the world and largely Asia, finances our deficits. It is a kind of vendor financing, where a company arranges the financing of its products so it can stay in business and grow. But there are limits.
"However, such a large deficit leaves the US effectively relying on what Larry Summers so aptly refers to as the 'balance of financial terror.' In fact, Summers' recent speeches are amongst the best arguments I have seen over the current account for ages. As Summers notes:
"'Inevitably, dependence on foreign governments for short-term financing has to raise questions and create vulnerabilities in both the economic and political realms. The question can fairly be asked: How long should the world's greatest debtor remain the world's largest borrower? I have previously used the term "balance of financial terror" to refer to a situation where we rely on the costs to others of not financing our current account deficit as assurance that financing will continue.'" (Global Equity Strategy, DKWR)
Free trade, whether in Europe or Asia is good for the world at large, and should be applauded and encouraged at every instance. But if the United States is to remain a major world power through this century, we must participate in that trade or be left behind.
Falling foreign direct investment, huge trade deficits, a world working actively to no longer be forced to rely on the American consumer for growth - these are all bearish on the dollar over the very long term. These are all events and facts which can change. Certainly the trade deficit is reaching its limit, but the longer we delay in creating balance, the worse the correction is likely to be.
One final thought. In 1971, the yen was at roughly 350. (Today it is at 102). In the 80's, Lee Iaccoco, the CEO of Chrysler, stated something to the effect that "Give me a 150 yen [to the dollar] and we can beat the Japanese." It fell soon after to 120. Japan and Toyota are still taking market share from Ford, GM and Chrsyler.
Those who take comfort that a falling dollar will make our companies more competitive, who yearn for a floating Chinese Renminbi, should be careful for what they wish. They might get it.
Your Personally Autographed Bull's Eye Investing
As noted at the beginning of this letter, we are going to do a Christmas Special Offer. For those of you looking for that perfect Christmas gift for that investor in your life, or for your clients and customers, I will personally autograph a copy of Bull's Eye Investing, the book that some call the most important investing book of 2004! Just click on the link (http://www.2000wave.com/pdf/christmasform.pdf), fill out the form and fax it back (or mail it) to us along with the name of the person you want me to personalize it to. Go to www.absolutereturns.net for more info and reviews on the book. (Note: some international readers may have to pay extra shipping. We will work with you to get the best rates, but with a cheap dollar, you can afford it! Splurge a little.)
Or, you can always go to www.amazon.com/bullseye and get a 34% discount. Either way, it will make a great gift that will keep on paying dividends for years.
The time goes by too fast on writing days. It's already time to hit the send button. Is this a great time of the year or what? I love the crispness of the air, the little extra feeling that accompanies Christmas, as everyone decorates and spruces up, the lights on the houses, the whole sheer magic as well as the Importance of the time.
Have a great week.
Your not going to worry about the dollar tonight analyst,