While reading the Aleph Blog recently, I was shocked to see an author whom I respect say that Bernanke’s policies “discriminate against the poor, and the lower middle class”, because the poor do not know how to invest, and are leaving their cash in the bank to be eroded by a negative real rate. I think that Bernanke’s policies actually do the opposite, discriminating against the rich and favoring the poor. The typical low/middle-income guy doesn’t care whether the $20k in his bank account is yielding -2% or 5% real interest. Either way, he is not going to able to survive on that income. Way more important to him is that he has a job. A zero Fed funds rate actually makes life harder for the moneyed class, who can no longer live off interest from a safe asset like Treasury bond, and are pushed to acquire real assets to protect themselves from the inflation. In so doing, they increase the demand for real assets in the economy, and more people are hired to produce the goods demanded, and the average poor guy gets a better shake in the employment market. So Bernanke, in my book, is doing the poor guy a favor.

But the more interesting question is : What is the correct “natural” rate of interest that can be expected from safe, liquid, cash-equivalent assets (bank accounts, Treasury bonds etc.)? Is it unfair that Bernanke is “artificially” depressing that rate down to zero?

To answer that question, we would have to lift the veil of money to reveal the fundamental nature of saving. Imagine a world without money, where people exchange goods through bartering. In this moneyless world, people would still want to save, that is, to consume less today so that they can consume more tomorrow. The only difference is that without money, they would have to save real goods. There are two fundamentally different ways to save. The first way is through storage. Simply stash that bushel of wheat in a warehouse, and one year from now, you can eat more wheat. Storage is a form of savings that is intrinsically yields a zero or negative rate. At best, you get back whatever you put in. At worst, your goods gets stolen or burns down. But there is a second way to save, which we’ll term investing. The farmer can, for example, experiment on new strains of wheat on a small portion of his land. During this period, his plot is producing less wheat than usual, because some resources are devoted to experimental strains, some of which can fail, so he is consuming less wheat today. But, assuming that the experiments are successful and he comes up with a wheat strain with greater yields, he reaps more wheat tomorrow. Investing carries the possibility of a positive interest rate; it is entirely possible that you can reap more than you put in. However, it is also a RISKY and ILLIQUID endeavor; it is also possible that you lose all that you put in, and you typically cannot terminate the endeavor without losing all you have already invested.

During normal economic times, with all resources already productively employed with little spare capacity, much of the saving in the economy is actually investing, which has an intrinsic positive yield (assuming risk is handled properly). Resources are simply too expensive to be stashed away in a warehouse somewhere. And that positive interest rate feeds through the entire financial ecosystem, such that even “riskless” financial assets like Treasury bonds and cash yield some small but positive real interest rate. But in a recession, where there is spare capacity and resources, some portion of saving in the economy becomes storing, which intrinsically carries a zero or negative interest rate. And in the financial ecosystem, only those that take risk deserve a positive real return. If you are very risk-averse in a recessionary environment, you should not be shocked to get a zero or negative real interest rate. Banks globally are having problems finding enough credit-worthy people and company to lend to in the midst of a recession, and therefore are stashing their money with central banks or in gold. Some banks are even turning away deposits. In this environment, there is no reason why riskless financial assets should yield anything at all. Bernanke can no more give the risk-averse a positive real rate than he can wave a magic wand and dispel the recession. (Well … actually he can, but not without harming other people.)

From the perspective of society as a whole, risk taking is the only important thing. Without risk taking, any kind of monetary policy is just a zero sum game, dividing the same fixed pie in different ways. Tighten policy to cause deflation, and those with liquid cash assets win. Loosen monetary policy to cause inflation, and those with cash lose while people with hard assets and the working poor win. But in the end, you’re just pushing the same amount of chips to different people. So, why not use a bit of financial coercion to get people to take risks again. Leave your assets in cash, and you lose 2% a year to inflation. But hey, if you take some risk and say buy stock, buy a house, start a company, or heck, even buy gold, you protect yourself against inflation and stimulate the economy at the same time. And I think we can all agree that growing the pie for everyone is a better economic objective than squabbling about who gets a bigger slice of the pie.

P.S. The above is simply a long-winded explanation of the economic concept of the “natural rate of interest”.

A reader recently emailed me regarding a potential investment in a Japanese microcap stock, which set me thinking about Japanese stocks in general. Japanese stocks are really cheap right now. There are many Japanese stocks trading below book value. In fact, some stocks are trading below even the value of cash on their book. Yet Japanese stocks have been trading at depressed levels for close to a decade now, and show no signs of reviving. In a normal stock market, corporate raiders would have long ago taken over these companies and dismantled them for a profit. The problem, of course, is that the Japanese stock market, and indeed Japanese society itself, does not function normally. Foreign hedge funds have tried to shake up Japanese companies, but have been stymied by the Japanese courts. Basically, Japanese companies are not run for the benefit of their owners, but for their employees. In addition to the notoriously shareholder-unfriendly courts, the rapidly aging Japanese population and shrinking economy also puts a damper on valuations. And finally, interest rates have been scraping the bottom of the barrel for a decade now, and companies see no reason to turn to the stock market for capital when loans are so easily available. So really, there is no downside to treating shareholders like dirt.

Can all these obstacles be overcome? In my opinion, yes, but the timing will be tricky. The key to understanding the timing issue is to realize that the root of the Japanese problem is the generational struggle that is currently occurring. In short, Japanese society is run primarily for the elderly. The Japanese culture intrinsically respects the old, the old dominate leadership positions, and increasingly, the old are beginning to outnumber the young. Therefore, it is no surprise that Japanese society enacts policies that favors the old. Despite the demographic problems, the Japanese currency has been a safe haven for investors, because a hard currency favors the old. The Japanese yen has been flirting with deflation for a decade now, and young Japanese employees are used to seeing their wages go down every year rather than up, but this situation is perfectly acceptable to Japanese retirees, who see their expenditures go down while their savings stay up. Bonds are sacrosanct to the elderly, of course, and to protect bonds, companies will happily soak equity holders to keep cash on the books to preserve their credit ratings. Sometimes, of course, a Japanese company is just so badly run that the cash flow that supports the bonds becomes threatened. Nissan faced just this scenario in 1999, and a large foreign investor in the form of Renault had to be brought in. Renault took a controlling stake in Nissan, and its CEO Carlos Ghosn undertook a brutal cost-cutting campaign, laying off many young workers, while paying back its bonds in full within two years, and becoming that rare example of a foreign investor successfully taking over a Japanese company.

Demographic destiny cannot be denied, but it can be delayed. Currently, with the global financial crisis in full swing, Japanese bonds are in demand, and Japanese stocks are likely to continue to languish. It’ll take a sustained bout of inflation to wean the public off Japanese bonds. And when that happens, the pendulum will finally swing in the direction of the equity holders. Demographic trends move incredibly slowly, so I’m not about to invest in Japanese stock for now. But I am keeping an eye out for distressed Japanese companies, aiming to take a stake shorted after a foreign investor has gained a controlling stake.

After jeopardizing the nation’s credit rating, the US Congress is hard at work again with a new idea to destroy nascent recovery, this time from the Democrat side of the aisle. The law I’m referring to is the proposed enactment of tariffs against Chinese goods in retaliation for their currency manipulation. This is one of those measures that sound good on paper and in economic models, but anyone with any sense of realpolitik or history will realize that it is doomed to fail.

In fact, this particular movie has already been played before in the form of the Plaza Accord of 1985. In that instance, major world powers including the US found themselves at the losing end of an industrial race with Japan, and forced Japan to sharply increase the value of the yen. Japan, being dependent on the US for defense, had no choice but to agree, and soon the value of the yen soared more than 50%. To everyone’s surprise, the US-Japan trade deficit did not budge at all. This is due to both political and structural economic reasons. Politically, the Japanese government and public took great pride in their multinational car companies, and did everything they could to maintain their competitiveness. The government used unofficial quotas to protect the domestic car market, while at the same time flooded their economy with low interest rate loans to leverage them up to compensate for the decreased profit margins. Structurally, the Japanese method of assembling cars, using robots instead of humans, was simply a better way of making cars, and one which the Detroit car companies could not imitate due to their unions. Simply put, Japanese cars were superior in initial build quality, lasted longer, and had better resale values. The monetary intervention did nothing at all, except fan an enormous asset bubble in Japan which eventually imploded.

The Chinese have advantages in 2 types of goods, labor-intensive cheap goods, and surprisingly, capital intensive goods as well. That they have an advantage in labor intensive goods is a natural economic fact stemming from the huge Chinese population, and should not be something that is targeted by US trade policy. They also have an advantage in capital intensive goods as well (such as solar panels, which as Bronte Capital has pointed out, is the economic equivalent of paying for all your fuel costs up front), because the Chinese government is willing to print money to support their domestic green energy companies at non-economic interest rates. Tariffs on Chinese goods of say 25% will most likely affect the labor-intensive goods most severely. Under the best case scenario, assuming that the Chinese do not engage in retaliatory tariffs or measures, there will be a shift of the production of labor intensive goods out of Chinese hands and into another country (say Vietnam), which arguably might be more willing to import American goods, and therefore the US trade deficit will decrease. But notice even in the best case scenario, the effect on US trade deficit will be indirect and slow, and there will likely be an intervening period of adjustment as production ramps up in non-Chinese countries. And most assuredly, the Chinese are not going to stand pat and watch while we export unemployment to their shores. At minimum, you can bet that the stocks of GM and F are going to quickly resume their previous trajectory towards zero. In the worst case scenario, the US becomes the scapegoat as the Chinese asset bubble pops, and the two countries becomes engaged in all-out economic or, god forbid, actual war.

As an alternative to tariffs, I propose a China-America Investment Act, which gives tax breaks and market access to Chinese and other foreign countries who site their capital-intensive industries factories on US soil. This makes natural economic sense, because when you make large capital-intensive pieces of equipment like cars, solar panels and wind turbines, it is often cheaper to manufacture the end product as close as possible to the target market. Politically, the Chinese government wants to transform their large companies into true multinationals with large foreign sales, and also want to stop printing Chinese yuan given that domestic inflation is already topping the charts. Instead, the Chinese can redeploy some US currency from their mountain of US Treasuries into more productive assets, and give the US economy a much needed demand boost. True, when the factories are up and running, they will employ minimal numbers of workers, but they will be quality jobs which pay good wages, and the US is never going to find an edge in labor-intensive industries anyway. And in the meantime, while the factories are getting built, many laid off construction workers will be able to find jobs again. I think this is a more viable win-win strategy. Certainly, this is better than flirting with economic war.

I have been investing on my own for 11 years now. There have been frightening moments, like the 50% decline in 2009, but by and large, I have outperformed the indexes handily, often by huge margins. I have never found a year when I could have done better simply by sticking to an index fund.

I’ve puzzled over why I had been able to do well. I don’t have access to Bloomberg terminals with the latest news and charts, nor am I able to call up management and suppliers and do the scuttlebutt work. My competitors on Wall Street are intelligent and motivated, many with advanced degrees and years of experience. I just read annual reports, and think. By all reason, I should not be able to outperform the professionals. Yet, I apparent do. Over the years, I have come up with some reasons for my outperformance.

Firstly, asset-gathering Wall Street mutual funds are often more concerned with form over substance. In December, funds clear out their holdings of out-of-favor stocks so that they do not have to be reported on year-end statements, and increase their holdings of popular appreciated stocks. Christmas is a busy time for me, as cheap stocks often get cheaper, whereas overvalued stocks tend to become even more overvalued, due to the window-dressing trades of the funds.

Secondly, fund managers are often only as intelligent as their customers. Funds often receive influx of funds after recent outperformance, and are drained of funds after a period of underperformance. While there are fund managers who are talented and hardworking and can handle these fund flows, these flows tend to work against generating good returns. Lazy fund managers who simply plough additional funds into existing names, and forced liquidation of cheap stocks by managers experiencing fund outflows, may be an explanation for the momentum effect in the stock market.

And lastly, of course, Wall Street is decidedly short-term in outlook. From a practical point of view, since being too early is indistinguishable from being wrong, I can sympathize with the short-term orientation that fund managers have. It is relatively easy to outperform in the long-term; Wall Street professionals are paid big bucks because outperforming in the short-term is difficult, and they are expected to deliver. Still, the pervasive long-term blindness among fund managers, where any cash flow beyond the next quarter or next year is discounted beyond reason, does not help returns. For these reasons, I have long ago lost faith in mutual funds and ETFs, and have adopted a DIY approach to managing my finances.

That said, one should also have respect for the Wall Street professionals as opponents. You do not want to go mano-a-mano with them in situations where they have the advantage. I stay well away from investments which depend on how a lawsuit is resolved, how likely a buyout will be consummated, or how a key person will react. Basically, any situation where insider news is likely to be material, or legal considerations are important. I assume that professionals on Wall Street will always have up-to-date gossip and rumors about insiders, and excellent legal help from their army of lawyers. I try to stay in situations where there are uncertainties about how the underlying business will perform. In short, I like investments where developments on Main Street matter much more than developments on Wall Street. Despite my best efforts, once in a while, I am still caught unawares by developments on Wall Street, but by and large, I have done moderately well over the years.

Baruch at Ultimi Barbarorum has sparked a debate in the blogosphere about whether the average guy should invest on his own. The detractors, such as David Merkel at the Aleph blog, say that investing is hard and not for amateurs (although I should point out that Merkel’s mother is apparently an excellent amateur investor, as is Merkel himself). In this debate, unsurprisingly, I am on the side of Baruch. I could cite my own investment record, and probably many of my readers could cite their own outperformance as well, but I have a much more compelling argument. A regular Joe has no appealing options when outsourcing portfolio management. If you don’t invest on your own, you’re basically doomed to underperformance.

First, let’s look at the most popular way to outsource portfolio management, the good-old mutual fund. Numerous studies show that the vast majority of mutual funds underperform, with only a teeny tiny proportion of the funds outperforming. Certainly, the funds that outperform are not the ones you see on television and magazine ads. You’ll be hard pressed to find these outperforming funds. Recent outperformance and Morningstar ratings are most assuredly not the way to find good funds. Most funds are primarily interested in asset gathering and not performance. My advice is to shun all mutual funds. They are the chumps that other market participants feed on.

Then, there are the index funds, many easily available as ETFs. Index funds are less bad. They have low expenses, but are susceptible to front running strategies. So basically, you’ll still underperform the market, but not by much. This can be an acceptable option for those who really hate reading and numbers and want to put zero time into research.

Hedge funds and investment partnerships are better, because the 20+2 compensation structure aligns the interests of the management and investors. A larger percentage of hedge funds outperform the market compared to mutual funds. But the point is moot, since the SEC in its infinite wisdom has deemed these investment vehicles off-limits to the general public. And in any event, the minimum investment for these vehicles is stratospheric. Hedge fund managers have only 99 slots to fill before they become mutual funds and have to be regulated by the SEC, so understandably, they require enormous minimum investments.

Then there is a passive investing approach for those who is willing to spend a little time reading, but don’t want to crunch financial reports. This is my preferred passive investing approach. That is, to look for situations where the management has a huge stake in same investment vehicle that the public has access to, and therefore can be counted on to be a responsible steward of the investment. Fairholme Funds, Microsoft, Berkshire Hathaway, and Apple are several names that come to mind. With a modest amount of research, you can acquire a diversified portfolio of such names, which is likely to outperform the market if held for a period of years.

At the end of the day, by definition, some segment of the population must underperform the market. Like at the poker table, if you don’t know who the patsy is, you’re the patsy. If you’re okay with underperformance, then so be it. If you have only modest sums to invest, then the time spent in thinking about investments may be better spent enjoying your life and your work. But I believe that if you actually enjoy stock picking and watching your investments grow, and if you are willing to put in 5-10 hrs weekly on research, there are reasons why a retail investor may indeed outperform Wall Street professionals, which I’ll touch on in my next post.

In my last post, I described how, in my initial foray into the stock market, I was tripped up by my emotions. An emotional response to the market is one of the worst things a value investor can do. Over the years, I have come up with a few cognitive tricks which help me combat these emotions.

Dissociation. I dissociate myself as much as possible from my stock portfolio, despite having much of my net worth invested in it. Firstly, I never depend on my portfolio for any of my living expenses. For my living expenses, I depend on my salary from my day job. Therefore, there is no immediate existential threat every time a dip occurs. Secondly, I do not have the value of my portfolio up on my screen all the time. Usually, I check my portfolio on Saturdays. Less frequent checking means I am less tempted by emotional responses. And checking my portfolio on Saturdays means that I cannot act on my emotions immediately, and I have at least one more day to cool down and think about matters rationally.

Reframing. In my mind, my portfolio is an import-export business. I import some goods (stocks), which I try to export at a profit. I adopt many of the practices of a full-fledged business, like double entry accounting, and annual compilation of balance sheets and operating statements. All businesses fluctuate according to macroeconomic and seasonal cycles, so I do not fold up shop every time business dips. I treat the stock market like my customers who are constantly bidding for my goods. I do not get mad when they lowball my wares, nor do I get fearful. I try to find out what the problem is. Perhaps I had imported a batch of bad goods (i.e. there was a mistake with my initial stock analysis). Maybe some goods were damaged during shipment (i.e. a new event has occurred that impaired stock value). I try to determine whether the problem is temporary or permanent, and then decide whether to cut my losses or hold onto the stock.

Rules-based investing. I have adopted some rules that tend to slow down my investing pace and hence blunt any emotional responses. Most of these rules operate at the portfolio level, thus giving me maximum flexibility at the level of individual stocks to choose my investments. For example, I have a maximum investment per stock rule that limits my exposure to any one stock, and thus limits the effect of any single stock dip on my portfolio. I also have “no more than 10% cash” rule that means that every time I need to liquidate a substantial position, I have to find some other investment to enter into, and vice versa. This tends to curb any impetuous entry and exit trades, and means that to make a portfolio change, I have to do 2 analyses, one of the current investment, and the other of the new impending investment. Basically, by adopting some reasonable rules and sticking to the rules religiously, I am constrained by the rules and cannot react emotionally even if I become panicked.

Do you have any tips or tricks to help you avoid bad behavior as an investment? If you found the above tips helpful, perhaps you could leave a comment and share some of your own tips and tricks.

I first started dipping my toes into value investing in 2001, shortly after I had purchased my first index fund after reading “A Random Walk down Wall Street” by Malkiel. I had saved a modest sum, and wanted to create a nest egg so that I would be able to do what I wanted, rather than do what other people wanted of me for a living. I was looking for financial freedom and autonomy. These hopes were dashed 3 months later, when the index fund plunged 20% in the midst of the stock market crash, and I bailed out of the fund in a panic. I started reading many other investment books in the search for a better investment strategy than an index fund approach, stumbled upon value investing, and saw the light.

Interestingly, modern neuroscience research has begun to reveal the neural underpinnings of my initial investment foray. It turned out that the human brain has evolved as a prediction machine, driven mainly by the prefrontal cortex. The human prefrontal cortex has arisen relatively recently in evolution as a brain region that processes data and uncovers patterns, and during evolution, it had formed an especially rich set of connections with the limbic system, the seat of emotion and motivation in the brain. While prediction is the primary function of the human brain, we are driven mainly by our emotions to perform this function. The human brain has an actual hunger for information and certainty, similar to our hunger for food, water and sex, but less intense. Our brains actually receive a little squirt of dopamine each time the world gets a little more certain, which we interpret as pleasure. Hence, many people spend hours compulsively reading the internet in the quest for information, or solving Sudoku or crossword puzzles. Each time a puzzle is solved, a little uncertain piece of the world has been made more certain, and we receive a shot of happiness. Entire industries exist to satisfy our cravings for certainty, including psychics, palm readers, and black boxes that predict stock market movements. We can also channel this hunger for certainty and autonomy in more productive ways. Many entrepreneurs have started their own businesses in the pursuit of autonomy and certainty. Although many entrepreneurs work longer hours and at lower pay compared to when they were employed, many also report being happier and more fulfilled because of the autonomy they now enjoy. And of course, once in a while, an entrepreneur’s business actually makes it big, fulfilling their dreams of financial freedom.

Unfortunately, the flip side of our hunger for certainty is our fear of uncertainty. The same limbic system that provides pleasure for certainty also causes fear and pain when we perceive an uncertain situation. As anyone who has been paralyzed by fear when trying to ask someone out on a date can attest, the limbic-system based fear emotion is far stronger than any other thought process. While we can cognitively recognize that in many situations, the upside is substantially higher than the downside, the introduction of an uncertainty element simply swamps out rational thought. For example, in this experiment, participants were willing to pay $45 for a $100 Barnes and Noble gift voucher, and $26 for a $50 gift voucher. However, when they were asked how much they were willing to pay to take part in a game in which they had a 50% chance of winning the $50 voucher, and a 50% chance of winning the $100 voucher, they were willing to pay only $16. The mere injection of uncertainty into a situation can lead to irrational decision making. As value investors, we try to take advantage of this kind of irrationality. More importantly, we have to properly control and channel the fear reaction that arises in us whenever our own holdings plunge. In future posts, I will outline several of the cognitive tricks I use to properly manage the fear in my investing life.

Yesterday, I read with amazement the James Grant op-ed in the New York Times advocating for a return to the gold standard. Why a publication as august as the New York Times allowed an op-ed which heaped undeserved abuse on Fed economists I do not understand. As a way of venting, I now list some arguments why Grant is a moron.

Advocating for the gold standard is class warfare in disguise

According to Grant, under a gold standard, “If you didn’t like the currency you could exchange it for shiny coins”. Isn’t that the current situation? Are not the citizens of most countries now free to exchange their paper currency for gold just by visiting the closest jeweler? Presumably, he meant that under a gold standard, one could rely on the central bank to store gold, thereby making it cheaper to own gold by socializing the storage and security costs. In fact, hard currencies in general has the effect of subsidizing the moneyed classes, making sure that the store of wealth they have built up does not erode with time, and allowing them the luxury of not having to tend to their vast stores of wealth and outsourcing that expense to the central bank. While I think that the rich are entitled to their wealth because they have worked hard to obtain it, I do not think that the costs of preserving the real purchasing power of that wealth should fall on the shoulders of the public. The rich should pay their own portfolio managers and build their own security vaults at their expense to safeguard their wealth.

A gold standard is also an under-handed way to shift economic power into the hands of the moneyed classes. Advocating for a gold standard is basically advocating for deflation. Almost all of the major gold deposits in the world has been mined, and by Grant’s own admission, negligible increases to the world gold supply occurs each year through mining, while increasing amounts of gold are consumed in industrial applications as more uses are found for gold. In the meantime, the amount of goods and services in the economy constant rises due to improvements in technology and efficiency. Committing to a gold standard means committing to a declining monetary base and deflation, making debts heavier in real terms, and shifting the balance of power towards those with the money to lend, and away from the people who need to borrow.

And if you’ll permit me one last look at the motivations behind people who call for a gold standard. What are the main obstacles against the preservation of wealth? They are 1) being on the losing end of a war, 2) erosion of property rights, and 3) inflation. Reason one is why there are no longer any rich descendants of Venetian merchant princes around today; the periodic wars that sweep through the European continent has resulted in the appropriation of all their wealth. If you are a loser in a war, all your property is essentially controlled by the victorious party, so the rich are generally in favor of a strong military. Secondly, strong property rights and lack of the threat of state confiscation is conducive to wealth accumulation. Hence, the rich tend to favor the weakening of government power as much as possible. And lastly, of course, inflation is bad for wealth preservation. While I certainly do not hate the rich so much as to advocate for wars or abrogation of property rights to punish them (although I might make an exception in the case of the fat cat bankers that precipitated the current economic recession), I do think that gunning for deflation to complete the trifecta of wealth preservation is beyond the pale.

A gold standard discourages risk-taking

A gold standard is often cited as having the beneficial effects of discouraging debt and promoting saving. Now, I have nothing against saving. I fully subscribe to the “all things in moderation” and “save for a rainy day” philosophy of life. However, there are 2 ways to save. At its root, to save is to consume less today so that one can consume more tomorrow. Fungible commodities, such as oil and wheat, can be saved simply by putting them in a warehouse today, paying the costs of storage and security, and then consuming them tomorrow. However, for non-fungible commodities such as eggs, one cannot simply stick them in a warehouse for a year, and then expect to consume fresh eggs one year later. However, one can “save” eggs if resources are devoted to research on egg production and distribution, so that we can produce more and waste less eggs with the same inputs, and thereby achieving the same objective of consuming more eggs tomorrow. This second form of saving is known as investment, and is the only way for structural economic growth, so that we can all consume more, rather than just redistributing the same amount consumption in space and time. Today, the constant slow erosion of the purchasing power of capital through inflation encourages the use of capital in productive investment, which in itself is a way to preserve the real purchasing power of capital. If the real purchasing power of money is guaranteed, there would be less need to actually invest in and invent new sources of income to offset the constant drag of inflation. In essence, a gold standard makes it easier to be conservative and encourages people to shun risky ventures, but society as a whole requires some level of risk-taking to produce rising living standards.

Deflation is bad, and inflation is a fair price to pay to avoid it

Many empirical economic studies have shown that for psychological reasons, prices are sticky, especially for wage levels. People hate to see their wages go down, and businesses hate to cut prices on goods and services. So, if you are a business-owner in a recession facing price pressure on the goods you sell, you cannot simply increase sales by lowering the prices you charge, and then preserve employment by cutting the wages you pay. What generally happens is that you stick to your original price, sales fall, and you lay off workers to cut costs and maintain profitability. Finally, the inevitable cannot be postponed, and you are forced to cut prices on your goods to regain market share. Your customers see that your prices are going down, and then choose to postpone their orders in anticipation of further cuts. So a waiting game ensues, with economic activity stagnating until customers are convinced that prices have gone as low as they will go, and workers face up to the reality that they need to accept lower wages, especially since goods and services now cost less. Once that core lesson has been learnt by the vast majority of the population, price stability is achieved, and normal economic growth resumes. The problem is that most studies have shown that it takes YEARS for people to accept lower wage and price levels. This delayed acceptance has been credited with trapping the US in the Great Depression for nearly a decade, and even now trapping Japan in its economic malaise. Make no mistake, price stability is required for productive economic functioning, and both deflation and high rates of inflation are very bad for the economy. The problem is, both deflation and hyperinflation are self-reinforcing, and most economists agree that a low inflation rate is the best place to be to avoid both specters. And you cannot engineer a low inflation rate if you are on the gold standard.

A gold standard economy is more vulnerable to foreign interference

There are multiple ways a country with a gold standard or a fixed currency can be subject to foreign attack and interference, both intentionally and accidentally. Firstly, international financiers can simply mount a speculative attack on your currency if they detect that you have mis-pegged your currency to gold, or for that matter, to any other harder currency. Examples in history abound, and the end result is a dramatic flight of gold (or hard currency) from the country under attack, followed by an economic contraction caused by the decrease in monetary base, at least until the leaders come to their senses and begin to print more money (i.e. devalue their currency) to compensate for the capital flight. Secondly, a gold standard opens your country to economic warfare from mercantilist nations. Any country can adopt a policy of systematically hoarding gold, refusing to part with gold at all costs, demanding that all its needs for goods and services be fulfilled domestically if at all possible, so that minimal gold flows to other nations. At the same time, it freely sells its own goods and services to other nations in return for gold. In time, a huge gold hoard is accumulated, allowing the leaders of the mercantilist nation to wield greater influence on the world stage due to their wealth, and at the same time impoverishing their trading partners by draining them of gold, and hence decreasing their monetary base. If you have a currency without a gold peg, you can print your currency to give to the mercantilist nation without parting with an ounce of gold, thereby severely blunting their economic attack (which essentially is what the Fed is currently doing with QE2). Lastly, if the world is truly united in a global gold standard, any economic disturbance in any country, say a bank run in Europe, will affect the money supply in other countries, and hence the chances of economic contagion is dramatically increased. For an example of the dangers of monetary union, one need look no further than the European Union and its recent travails. In a nutshell, by going on a gold standard, a country is voluntarily abandoning the tool of monetary policy, which can be used defensively against a number of economic attacks by foreign powers.

A gold standard is not a guard against human fallibility

Let’s leave aside the fact that a certain segment of the population see no problem with delegating the power to rain nuclear holocaust on countries to a single individual, yet object vociferously when the power to reduce the purchasing power of their wealth is involved. Grant implies that if only we remove the tool of monetary policy from the government, we will abolish the chances of a failed state intervention in the economy. However, most countries who have tried the gold standard in practice have found it impossible to stick to a single currency-gold conversion rate. They have found that it necessary to tweak the conversion rate, and in fact, that global coordination in the adjustment of conversion rates was necessary. The US government itself has gone on and off the gold standard multiple times in its history. In other words, if your government is not a credible steward of currency, it won’t be able to stay on the gold standard for long. It just enables the more economically cognizant (i.e. rich people) to cash in their soft currency for a harder one just before the government is forced to devalue the currency dramatically, thereby robbing the rest of the people still holding onto the soft currency. Grant should recognize the fact that the economy is a human construct, and requires human intervention to counter the inherent boom-bust cycles that is a result of human psychology. Non-interference does not guarantee a better result. In fact, history would suggest the exact opposite.

In summary, to function optimally, the amount of money in the economy must match the amount of goods and services, leading to price stability. To allow the amount of money in the system to be determined by some arbitrary factor, like the amount of above-ground gold, leads to sub-optimal economic functioning and growth.

A steady drumbeat of articles proclaiming the death of the equity cult has cited many reasons, including loss of faith in equities due to various reasons, new alternative investments, baby boomers retiring and shifting from stocks to bonds, and projected anemic growth in the US vs other countries. Let’s take a look at some of these reasons with an analytical eye.

Straight off the bat, we can dispense with all the psychology-based reasons. Yes, the public is currently burnt by a decade of equity underperformance, scared by the flash crash in May, disgusted with bankers on Wall Street, and convinced that the investment game is rigged against them. But no, this will not be a permanent situation. Psychology changes, and fads and fashions come and go like clockwork.

Then, there is the proliferation of ways to invest in alternative asset classes, and the fact that an aging population should theoretically hold more bonds and less stocks. This explanation has a large kernel of truth. There are now more ways than ever for the retail investors to dabble in commodities, forex, and options. But these alternative asset classes have historically gone nowhere or declined over long periods of time, and for a good fundamental reason, because they are not productive assets with a cash flow. That leaves bonds, the traditional safer alternative to stocks, with positive cash flow. Bonds are less volatile and have a more certain cash flow than stocks, and should indeed make up a large portion of a retiree’s portfolio, especially one who relies on cash flow from his portfolio for living expenses. However, current bond yields are at historic lows, which is another way of saying that bonds are over-valued. Surviving on 1-2% bond yields is going to be difficult for many retirees, especially those who have under-saved for decades. In comparison, stocks are cheap, with many solid large cap companies selling at high earnings yields. A stock portfolio can be managed to generate cash flow through dividends and liquidating stocks which have appreciated, although this is admittedly more uncertain and less straightforward then simply holding a bond portfolio with a defined cash flow. Still, many retirees may have little choice as they are unable to survive on the low bond yields.

Lastly, there is the question of future US growth and its impact on domestic stocks. Certainly, the US economy is mature, and greater economic growth can be expected in overseas emerging economies. There is a strong case to be made for diversification into foreign stocks. However, with looser regulations and much less available information about stocks, it is not clear that the value that can be expected from stronger economic growth will flow into the pockets of minority shareholders (as opposed to, say, majority owners and management), nor will it be easy to find enough accurate information to judge the companies. I have dabbled in foreign stocks, and in practice, I found that the language barrier is formidable, and the only foreign stocks which have trusted annual reports written in English are in mature European economies with limited growth prospects anyway. In the end, I think that for the average retail investor, the US stock market presents many investment opportunities and a portfolio of twenty carefully chosen stocks will give the greatest return for the lowest risk over the long term.

Commodity ETFs are financial instruments that are supposed to enable small retail investors to invest in commodities such as oil and gold. Now normally, commodities are bad assets to invest in. They do not have any cash flow, incur storage costs, and will not grow. At first sight, then, commodity ETFs appear to be miraculous instruments. They are marketed as perfect proxies for physical commodities, but with no storage costs.

Futures-based ETFs, which includes all the oil ETFs such as USO, OIL, and DBO, all employ the strategy of buying (say) the 6 month futures for oil, and then selling the same futures 3 months later (when it is a 3 month futures), and reinvesting the money in a new 6 month futures. In this way, the oil is always “coming”, but never actually arrives, hence there is no need to pay for storage.

However, this buying of long-dated futures and selling of short dated futures by USO has an effect in the oil futures market. Normally, long-dated oil futures are priced slightly higher than short-dated futures, a phenomenon known as contango. Contango occurs because it costs money to store oil for delivery later. The contango curve is usually quite shallow, amounting to perhaps 2-3% over 3 months. Since the entry of USO into the oil futures market, its activity has caused contango to sharply increase, to as much as 10% over 3 months. Contango is now so severe that it has spawned a brand new hedge fund trading strategy known as the contango trade. Basically, traders in large firms such as Goldman Sachs buy oil on the spot market, store the oil in oil tankers for 6 months, at the same time selling 6 month oil futures at a higher price, reaping the difference. Because this is a perfectly hedged trade (the oil is sitting in tankers, so no matter what the oil price is in 6 months, the oil can be delivered), traders are able to lever up the trade with borrowed money at wholesale rates of 1-2%, making huge profits even after deducting oil storage costs. The loser in this trade is the USO ETF, which loses money each time it sells its short-dated 3 month futures to buy long-dated 6 month futures.

How has the USO ETF performed with respect to crude oil prices? On Aug 4 2009, the spot oil price is $71.78 per barrel, and on Aug 4 2010, spot oil is $82.39, a rise of approximately 15%. USO, on the other hand, has gone from $38.20 on Aug 4 2009 to $36.48 on Aug 4 2010, a LOSS of 4.5%. This is a tracking error of nearly 20%, due largely to its constant contango losses in the futures market. It is important to note that long-term investors are especially penalized, as the longer you hold USO, the larger are the contango losses.

In short, financial engineering cannot produce a commodity ETF that is free of storage costs, just like it cannot turn subprime mortgages into true triple A securities. USO has merely outsourced its storage requirements to traders at Goldman Sachs and other trading outfits, and has done so at an exorbitant price far above the true costs of storage. The real losers are the small investors who invest in these commodity ETFs believing that they can escape storage costs. Commodity investments will always carry a negative yield due to storage costs, and are unsuitable long-term investments.