Saturday, May 12, 2012

The Poker Game Of Life

I've recently been playing a lot of a game that I really enjoy: no limit Texas Hold-Em. Through the time that I've spent playing over the past few months, I've begun to see and think about poker concepts that apply to both to the real world and the world of investing.

One in particular that I was thinking about this afternoon was patience. When you are playing poker (correctly) you spend close to 95% of the time just sitting and watching. You fold over 80% of your hands before any cards are even dealt on the table. As a player I spend this time watching other players, listening to them talk, and taking note of the number of chips in their stacks.

For most players, trying to sit back and watch hands is excruciating. I sit next to players that haven't played a hand in a little while and I can feel the tension. This of course, is how some players can win consistently - they can capitalize off this impatience.

This same concept applies to the world of investing. I've held close to 90% of my entire portfolio in the same position since late 2005: silver and silver related assets such as mining stocks. Just the idea of doing this is staggering to most people. I spent about 18 months studying the financial markets intently from the beginning of 2004 through the end of 2005 when I stumbled upon silver as an investment.

When I have had free cash available over the years, I put it into the silver market. Not in savings, stocks, bonds, or real estate. For some of the time (mostly at the beginning), I was told I was insane. Then for some of the time people thought I was a genius, and then during major sell-offs (like this most recent one) people generally think I'm an idiot.

I guess I don't think of it that way. I think of it like a game of poker.

For example, last night in one of my last hands I was dealt Ace - King. The flop (the first three cards that are laid out on the table) were 10 - Jack - Queen. This meant I had "flopped the nuts," a term used when you have the best possible hand.

The correct move at this point, based on the fundamentals of poker, is to get as much money as possible into the pot when you have the best hand. That is what I did. I pushed my entire stack in and I was fortunate enough to get a call. The player that called then caught two straight cards of the same suit (known as a "runner-runner" in poker terms) to beat my straight. I lost over 60% of my entire chip stack.

I called a friend of mine who understands the rules of poker on the ride home and discussed the hand with him. He said that because I was "up so much" before the hand started that I should have bet less.

I told him that if I was in that situation, I would have bet almost 100% of my life savings on the hand if I had the opportunity. Based purely on the statistics, it is a far greater investment than silver, gold, any stock, bond, or piece of real estate in the country. At that point I had over 90% odds of winning the hand.

This concept terrifies most people. Investors first response to this idea would be: what about the 10% chance that you could lose. Before I discuss this let me briefly state that I am both young and I do not have children. I plan on both having children and one day being old so I'm sure my view of the world will be different. However, I'm talking to you about how I see the world today.

Every day when you wake up you are starting with X amount of poker chips in your investment account. What people do not understand is that they are sitting in the world's biggest casino every morning on their way to work. The mutual funds that people invest a certain percentage of their savings into every month has money taken out both when you purchase the fund and every year you hold it in there. These are politely called "fund management fees."

What about investing your money in real estate? Let's say you purchase a home for $200,000 and decide to sell it two years later after it has appreciated 2%. You get to the closing table ready to collect your $4,000 (2% of $200,000 in appreciation) and find out that you must pay a real estate agent 6%. Then you must pay closing costs. When you purchase a $200,000 home you are starting that investment close to $8,000 in the hole.

How about putting your money into a savings account earning 0% or putting money into a bond fund that earns 2%? Inflation is currently running over 3% annually so you lose 3% per year through inflation holding your money in the bank (savings account). The bond fund will take out a percentage, same as the stock mutual funds discussed above.

Can you see the parallels to the casino? The house is going to win whether the market goes up, down, or sideways. They are always raking the pot. Every day, month, and year a large percentage of the investment funds are being funneled into the financial market.

What is the goal of every casino? To keep as many players playing as long as possible. What is the goal of the financial markets? The same exact thing.

Back to silver. Silver faces a premium at purchase just like any other asset. In fact, depending on how you purchase it (I purchased and own the bulk of mine through a company called Goldmoney) you will pay an immediate premium for your metal. This premium can run anywhere between 2% to 6%.

This is why I don't trade it. I buy it and hold it. This avoids both taxes and the cost to re-buy. It's why most of the silver I bought between 2005 and 2007 I still hold today.

This is not a recommendation to purchase silver. It is meant to be a thought experiment and a discussion on the financial markets as a whole.

After spending years studying market history, I believe that they move through long term secular cycles, a topic I have discussed and will continue to discuss in great detail here moving forward. Because I believe this concept, I want to build a position in an asset class that is in a secular bull market and then sell when it reaches the mania stage. I do not get discouraged when the price falls during the process. I just take available cash and buy more. Then I buy more.

At some point I will sell all my silver. Based on where I see the markets in the years ahead, I believe a large portion of the money (and a tremendous amount of borrowed money - leverage) will move into real estate, an investment class that will be severely depressed and beginning its next secular upward move.

While my money is in silver today, I spend most of my working hours preparing myself for being a buyer of real estate. I have spent the past few years working on site as a property manager for a 500 unit apartment community. I could think of no better way to learn how to manage a property than being on site at a community actually doing it. I spend my free time reading books on real estate finance, brokerage, attending seminars, and talking to people in the industry.

Most investors have a hard time thinking of investing this way because they need to see action. They want to trade. They pay a brokerage fee for every trade both buying and selling and then they are hit with capital gains on their short term profits. Wall Street (the casino) loves traders. They make a killing off their moves.

This concept moves beyond the world of investing and applies to decisions you make on how you earn your income. Some people look at starting your own company as risky and choose to work at a job. Other people think working as an employee is risky and believe it is safer to own your own company.

Some people think stocks and bonds are the safest investment. Other people think that stocks and bonds are dangerous investments. Some people think holding cash is the safest investment. Others think that holding cash is extremely dangerous due to possible inflation.

Some people think that being diversified is safer because it will minimize your losses. Other think that being diversified is silly if you believe one investment class is stronger than others.

It goes back to the hand of poker that I had. My friend would not have bet his entire stack because there was a chance the other player might draw out on him. I would have put my car keys on the table if I had the opportunity.

People who think that concept is insane (and most do) are the people that go to sleep at night with 100% of their assets invested in US dollar based investments (stocks, bonds, cash, real estate). All it would take would be a minor dislocation in the financial system and the US dollar could enter free fall. This could occur while they are sleeping.

"That's ridiculous," they would say. "The odds of that happening are less than 10% in my lifetime, therefore I am making the right decision by keeping my money in something that will be safe over 90% of the time." They are correct.

Stop and think about that for a moment. Can you see the correlation?

Sorry for the deeper than usual thoughts on a Saturday night. I'll get back to business discussing the sovereign debt crisis and the market events in coming posts. I just like to take some time every now and then to review some of the bigger picture/psychological ways that I view the world.

Wednesday, May 9, 2012

US Economic Data Meets Spanish Bonds & Gold Pessimism

Spanish bonds, which we have discussed relentlessly during 2012 here on this site, once again today crossed over the important 6% line.

The spread for 5 year Spanish bonds over German bonds (considered the risk free asset of the Eurozone) is now at 4.47%; the highest level since November of 2011.

The stock market has now fallen for six straight sessions. Has the market begun to understand what lies ahead for the global economy or is this just another blip on the road upward toward new bubble highs? Only time will tell but here we will continue to focus on the fundamentals which, like gravity, have always won out over time.

This week we received word that small business optimism was up 2 points in April to 94.5, the highest month over month rise in 18 months. Now doesn't that sound delightful?

An investor who may think that headline sounds peculiar during a depression would be correct, and taking a look at a long term chart makes the headline look ridiculous. Just as with new home sales, which plunged off a cliff and have only rise month over month at the bottom of a canyon, the small business optimism index is only higher off of terribly low levels. The chart below goes back to 1985 and shows the dips in optimism during the 1991 and 2001 recessions. Then it shows the decline of our current depression and the rise off the severe lows.

Small business owners have moved from "wanting to throw themselves off a bridge" to "only wanting to close the store and fire all the employees." The highest month over month rise in 18 months.

Another way to gauge the health of the economy is to look at the all important consumer credit. We found out this week that consumer borrowing rose by $21.4 billion in the month of April. $16.2 billion of this rise came from non-revolving credit (student and car loans) and the remaining $5.2 billion came from revolving credit (credit cards).

A closer look at this particular economic "beacon of light" shows something equally disturbing.

The following three graphs show the total growth in consumer credit during our "recovery" (blue line). It is assumed that consumers will borrow when they become more confident. Consumer borrowing means spending and spending means growth.

The second graph looks at one particular part of this credit growth: student loans (red line). The third and final graph shows what consumer credit looks like when student loans are removed (green line). It is collapsing.

Who is providing all this money for these privileged children to attend school?

In the following graph the blue line shows all student loans, and the red line shows the government owned student loans. Why does it only look like one line? The government owns all the loans.

You can see that the chart goes parabolic in July of 2009. Why? It was at this point, 6 months into our current depression, that young American began to realize that there were no jobs available. They turned toward school as a play to "ride out" the recession and get an education during the process. A student loan provides room, board, books, meals, and drinking money for the weekend. It was and is a direct transfer from the government to keep the youth off the streets. Other countries have tried a different path:

The blue line in the graph below shows non-government backed loans since the depression began in 2007. The red line shows government backed loans during this period. Can you spot the difference?

All this small business "confidence" and consumer credit "growth" must be leading to new record highs in the consumer confidence index, right? The following chart lays the just discussed small business confidence (red) over the consumer confidence index (blue). Just as with new home sales, any uptick is only coming off of massively depressed levels.

Funding consumer credit through student loans has been one of the largest fiscal boosts over the last three years. College tuition is soaring, real estate prices in college towns are rising, and students are getting free money to party. In a world where deficits don't matter, and the government can stimulate.....everything, life is pretty good.

What if deficits did matter? What if gravity became real not just outside the United States in "less fortunate" places like Europe, but in the US as well?

Imagine the graphic below represents the financial overview for a family that lives on your street. They are friends of yours. The family spends $73,319 per year (total bar on the left), and they earn $51,360 per year (blue section of bar on left). Not bad, only a $21,959 deficit per year (orange section of bar on left) . How do they cover this deficit? With credit cards, which now total $325,781 (orange block on right).

The credit card companies only charge this couple 2% interest per year because they have confidence the money will be paid back. However, if the credit card company began to lose faith in that ability they would begin to raise rates on the debt to cover the risk. They have an "adjustable" rate loan.

This family comes over to your house one night and asks if they can borrow money. They are "good for it" they tell you. They have even gone to the rating agencies and now proudly own a AAA debt rating.

Would you lend money to this family?

Of course not. The couple will obviously never have the ability to pay the money back. This graphic was created to represent the current financial standing of the United States. It is an exact replica, only the United States makes more income and owes more debt.

This afternoon the government held an auction for 10 year treasury bonds, which priced at an all time record low interest rate of 1.85%. This means that investors are willing to look at the financial situation above and lend the government money for 10 years at 1.85%? Doesn't that sound insane?

The following graphic from the Wall Street Journal shows mutual fund flows over the past ten weeks. The light green bars at the top shows money pouring into bond funds, and the bottom (dark green) bars show money simultaneously pouring out of stock funds. The American public, month after month, is piling into the next bubble asset class.

This afternoon, after this graphic was published, we found out that this most recent week saw an additional $6.6 billion move out of stock funds (piling more money into bond funds).

In today's trading session the daily sentiment index for gold reached 10% bullish. This means 90% of investors now believe that gold is going lower. Investors are running scared, and the media has once again (for the 12th year in a row) declared the bull market over.

As no one is paying attention to the millions of lemmings sitting passively on a mountain of toxic bonds, it is up to you to decide which asset class looks more like a bubble.

h/t The Big Picture, Zero Hedge, Wall Street Journal

Achuthan: US Will Be In Recession Next Month

The ECRI institute made the call last fall that the US would enter recession the second half of 2012. They have been roundly ridiculed over the call over the past 6 months. Achuthan came back on CNBC this morning to confirm their outlook and discuss where we stand today.


Monday, May 7, 2012

The New Market Cycle: Waiting For The Sell Off

Since 2008, after the financial system collapsed in a mountain of debt, our economy has been run on life support through federal spending and quantitative easing (printed money injections). This has created a new form of the business cycle that can be seen in the graph below.

Money is injected into the system (federal stimulus or QE), the market rallies, the outlook improves, policy makers take their foot off the gas, and then we have another sell off.

The arrow above points to where I believe we are in this current cycle. The stimulus from the Federal Reserve's operation twist and the European Central Bank's LTRO programs are beginning to wear off.

The chart below shows the adrenaline shot the stock market received during QE1, QE2, and the most recent combination of LTRO and operation twist.

During this time last year we began to see the economic surprise index turn down sharply meaning that economic data was beginning to "surprise" to the downside or under perform. What has happened this year? Almost the same exact process has taken place as can see see in the graph below.

The jobs data has followed an almost identical path as well. A strong spring of hiring followed by months of very weak data - confirmed by the dramatic fall off in Friday's jobs report.

Just as it did during the spring of 2011, when the market was marching to new highs the first week of May, optimism is soaring. Barron's big money poll released last month showed that 84% of money managers expected to be buyers over the next 6 to 12 months. 55% were bullish or very bullish, while only 14% were bearish.

While stocks, particularly the financials, in Europe have continued to drag lower the American market has "decoupled;" investors in American stocks believe that Europe's issues have no impact on the American economy. A topic I have come back to time and time again is the interconnected nature of our financial system and economy.

The following graph shows that almost 50% of the trade in global goods runs through Europe. As their economies slow down it is going to impact every business from Australia to Hong Kong to Brazil.

11 European countries are now in recession; Belgium, Greece, Ireland, Italy, The Netherlands, Portugal, Slovenia, the UK, Denmark, Czech Republic, and everyone's favorite conversation piece: Spain.

At the end of 2011 over 50% of Spanish government bonds were held outside the country. At the end of March this number had fallen to only 37.54%. Who was the major buyer within Spain?  The banks. Government debt on the bank's balance sheet rose from only 16.93% of the total exposure to 29.16%.

The LTRO program provided a get out of jail free card for those holding toxic Spanish debt outside the country. The Spanish banks took the free cash and loaded up on bonds while investors gladly dumped everything they could. While never announced publicly, there was obviously a behind closed doors handshake with the banks and government where the banks were promised full backing should the bonds run into trouble. While I don't need to explain to you how this process makes absolutely no sense, I think the following picture helps sum it up nicely:

European unemployment continues to surge higher with youth unemployment moving toward the stratosphere. The following chart shows youth unemployment for Greece and Spain (over 50%), Portugal (over 35%), and the Eurozone as a whole (over 22%).

The US stock market has charged higher led by the darling of the universe: Apple. The following excellent chart shows recent parabolic moves in the market and what followed. Usually a parabolic move upward ends in an even more rapid decline. Will AAPL be different?

Another great chart below shows the value of our stock market in comparison to the total size of our economy. When stocks are in favor they are bid up to extreme price levels vs. the general size of the economy. The red arrow shows when Greenspan gave his "Irrational Exuberance" speech back in 1996, just as the market was crossing over 100% of GDP. Today we still find ourselves far above Greenspan's definition of irrational exuberance although he recently proclaimed that "stocks were cheap."

We will see everything possible through the remainder of the year to keep stocks elevated and optimism running high into the election. The last thing the American people need is to look down at their 401k statement and be disappointed.

Should that happen they may look for someone to blame, and an election year is not a good time for that to occur. At least we know that should the 401k's fall there is always social security ready to stand as a safety net for the 10,000 baby boomers that are retiring every single day.

h/t Jim Sinclair, The Big Picture, Zero Hedge, Bloomberg

Jim Rogers: The Next Slowdown Will Be Worse Than 2008