The Bottom Right Hand Corner

John Mauldin | Thoughts from the Frontline
October 22, 2004

What makes one person a pessimist and another an optimist when speculating about the future of the US and the markets? How do we come to our most basic assumptions? This week we look at some insights into human nature I picked up in Tahoe at George Gilder's Telecosm, as optimistic a gathering of bulls I have ever been to. I close with a few quotes from here and there on Fed policy and Muddle Through. I think it will stir your thought processes a little.

Let's set the stage. I am sitting in the back of the rather crowded hall and Rich Karlgaard, the publisher of Forbes asks, "How many people think the market will be up a year from now? How many people think the economy will be better next year?" It was clearly 80-90% in the optimist camp. When asked the opposite question, there were a few lone hands here and there.

George had asked me to this tribute to hopefulness to be the lion in a den of Daniels. My assigned topic was to tell the starry-eyed attendees why the world of the next decade would be somewhat less than they imagined, that we are in a Muddle Through Era.

Those of you who read last week's letter got the gist of my presentation. I listed 9 "Economic Headwinds" the economy faces which I believe will result in below trend growth for the next decade. I raced through them as I had but 25 minutes to present a book worth's of material.

After my presentation, there was a panel of five who had made earlier presentations. I got more than my share of questions, basically in the format of "You are not looking at this piece of data. If you did, you would see Muddle Through is too pessimistic." Trade deficits do not matter. You are looking at the wrong employment data. I was told the establishment survey misses the 500,000 (!) people working out of their homes making a living on EBay. Margin surpluses will make the dollar go up. In fact, the dollar will go up because we are still the best and safest place to invest. (I note the dollar dropped 5% while we were all out of town. Presumably this crowd was not at the trading docks to keep the dollar buoyed. Perhaps this week they will be able to being the dollar back to their way of thinking.)

Now, in an equal opportunity moment, let's go back to Vancouver or New Orleans where I spoke this last year to a room full of gold bugs. No crowd can get as pessimistic as a gold conference in a gold bull market (except about the prospects for their favorite gold stock!). When I suggest that things will not be all that bad, that we are not headed for a depression or worse and that gold is merely a neutral currency I am met with blank stairs. It is only when I aver that gold will go up that am I allowed to peacefully exit the platform.

(As an aside, I am still bullish on gold, not because I think there is anything innately intrinsic in the yellow metal, but because I am bearish on the dollar. Look at a gold chart in terms of the euro and try to convince a German to get bullish. When I at some future point once again become bullish on the dollar [and I will - nothing goes one way forever!], I will become bearish on the dollar denominated prospects for gold. That will upset many of my readers, unless you are a gold bug in Europe or Asia, and then you will be happy.)

It was fun to talk to the attendees after my speech. They broke down into two groups. The first group would come preparing to debate my views that one or the other "headwind" was in fact a true problem. It was as if they could disprove one of my bearish factors, that the rest would disappear. The second faction (and larger than I would have guessed) would come up as individuals, sharing the guilty thought that they agreed I might be right.

Why such extremes at the various conferences? I thought about this a great deal over the last few days and have a few reflections.

First, I think a great deal of your viewpoint has to do with your environment. I sat through many of the presentations, and it is hard not to get excited. One gentleman held up a chip the size of a sugar packet ("if you can't see it in the back that's the point"). His firm is now creating three dimensional chips. They can layer chips one upon another using optics. They can blend silicon with gallium arsenide chips, stacking on memory or processing power. This is not next year's technology. They are doing it now. He showed a 7x2x2 foot rack of servers and boards costing $1,000,000. Within a few years he says they will replace that monster rack of servers with a device the size of my Sony laptop for $1,000.

Foveon talked about its new digital camera which is astounding in its quality. The pictures they showed were nothing short of amazing. You could see the grain in the parchment of a rare manuscript or the facial pores in a beautiful model (which may be too much clarity!). It will yield insanely small and inexpensive cameras, with quality far above what we now have.

Gilder to his solid credit loves a little controversy. Most of the presentations were structured as debates, (especially my panel). Are the large telecoms walking dinosaurs which do not know their lease on existence is limited? Or do they have the critical mass and capital needed once Congress re-writes what all believe was a flawed telecom bill of 1996? (John Rutledge assures us that congress will pass a new bill, finally allowing true broadband to come to our homes). Will copper or fiber optics prevail? (The copper guy made some good points.) What will usher in the age of the all-optical network?

The promise of nano-technology is just around the corner. Analog is back and is now the cutting edge of research. The event closed with professor Carver Mead of Cal Tech, the godfather of the information age, giving us a riveting speech on the future.

Even in the debates, there was no question of whether or not technology will change our world. It was a debate about which technology or company. These are all truly amazing things. They are real and happening and will change our lives at some point.

Visiting the opposite extreme, if you only read Kurt Richebacher, Marc Faber, Gary North or Bill Bonner (his essay today was excellent) plus a dozen of their Austrian economic cohorts, you might want to move to the French countryside, buy some gold and wait for fall of western civilization. Those @#$% commie Chinese are going to overwhelm us all.

And by and large they are pointing out real economic truths. There are limits. Bubbles will always burst. Too much debt is not good. Governments will in most cases and in most places make things worse. It takes two new laws to correct the problems of the original law, and will cost twice as much as the problem they were created to fix.

The Bottom Right Hand Corner

So who is right? While each may appear to be right at some point in time, over the long run it is somewhere in the middle that we find a balance.

The optimists are looking at the asset side of the ledger. The pessimists look at the liabilities. I would encourage you to look at the bottom right corner of the balance sheet. Sometimes the number is positive and sometimes it is negative, but it is rarely at the extremes. If you focus on the balance, you have a much greater chance of being right in the long run, and keeping your investments balanced as well.

My view is simple. AS I look out over the horizon, I notice a lot of problems. I could have added several more headwinds to my list of nine last week. I did not mention demographics, government deficits, under-funded pensions, or dependency ratios. Nor did I mention Iraq and other global concerns. Once can get quite pessimistic.

How then, can I be so, well, Muddle Through? Because there are lots of good things happening as well. There are in fact assets in the ledger. It is a little easier to see them right now than it will be in the middle of the next recession, but they will still be there. The bottom right hand number (the net balance) may have turned negative, the assets may not outweigh the liabilities for awhile, but that is just part of the cycle. The dollar will not always go down, the markets will not always go sideways nor will any economic activity stay in balance. "Things" go up and down.

The one trend in place is the overall advance of mankind. That trend will stay in place, in fits and starts, as long as the trend in freedom is in place.

Bringing Out Your Inner Spock

There is a reason I write so much about the psychological aspects of investing. Unless we can "Find Our Inner Spock," we tend to go on our emotions and most recent input. And those emotions can well and truly be influenced by the crowd we run in and the investments we already have. How easy is it to be bullish about the future if you are creating it, literally designing the building blocks which will allow the human race to advance into the next brave new world? If you have a large gold or short position, and only read and run with the bears, it is easy to see things through a shaded lens.

That is why it is so important to read those who disagree with you. I find that when I disagree with someone, it is almost always because of their basic presuppositions - their premises and assumptions that they bring to the table before they start looking at the facts. Most people are logical. If you give them their presuppositions, you will probably end up logically with their conclusions. (That's why a good demagogue can lead a crowd, but that's another subject.)

(This is the reason I have started my new letter, Outside the Box, which brings you the thinking of other writers. I am working through a historical piece now by Andy Kessler on the problem with a gold standard. It will drive gold bugs to distraction. In fact, I do not agree with some of his conclusions. But it is forcing me to think a great deal and to re-visit my presuppositions on the nature of money. I will get someone to reply with the other side. If you do not frequently challenge your assumptions and presuppositions, you mind will calcify and your investments will suffer.)

As human beings, we tend to extrapolate from recent experience. We let our views on one part of the investment scene leak into other, maybe totally unrelated parts. One can be bullish on certain aspects of technology and stocks, but what does that have to do with the total market which represents all sorts of non-tech companies? We can be bullish on oil and energy, but that does not mean that other companies will prosper along with them. Nor does it mean that the world will come to an end at $60 or $70 oil. And not all energy stocks are the same, just as all non-US currencies are not equal. I can be bearish on the US dollar, but that does not mean I want to own the Mexican peso.

We have to keep our enthusiasm controlled. The following short selection is from Chapter 17 of my book, Bull's Eye Investing. The chapter is one of several which deals with the psychology of investing. This particular section is about how we deal with growth versus value stocks, but the principal is the same for all investments.

Addicted to Growth

"Why is it that investors are repeatedly drawn to growth investment styles when the research and our experience so clearly show that value investing is the long-term winner and even the less risky investment? It doesn't matter whether it is the latest technology innovation, the fascination with the power of all things Chinese, the belief that Internet stocks can grow at incredible rates forever, or the belief that "this time it is really different," investors seem drawn to growth stories like sailors to the sirens.

"There is reason to suspect the answer lies in the very way in which our minds are structured. One of the most exciting developments in cognitive psychology over recent years has been the development of dual process theories of thought. That is the academic way of saying that we tend to have two ways of thinking embedded in our minds. There may be in fact a real reason that you feel schizophrenic on some days.

"Psychologists posit two different systems called Experiential and Rational. Experiential is essentially the emotional part of the brain. It is automatic and effortless in the way that it processes information. That is to say, the Experiential prescreens information before we are consciously aware that it even made an impact on our minds. Hence, the Experiential is effectively the default option.

"Experiential deals with information in an associative way. Its judgments tend to be based on similarity (of appearance) and closeness in time. Because of the way the Experiential deals with information, it can handle vast amounts of data simultaneously. To computer nerds it is a rapid parallel processing unit. In order for the Experiential to believe something is valid it may simply need to wish that it were so.

"Rational is the "Vulcan" part of the brain. For non-science fiction fans, this refers to the character Spock on the early Star Trek , who was from the planet Vulcan, where emotion had been banished and all decisions were made based on logic. To use Rational requires deliberate effort. It is logical and deductive in the way in which it handles information. Because it is logical, it can follow only one step at a time, and hence in computing terms it is a slow serial processing unit. In order to convince the Rational that something is true, logical argument and empirical evidence will be required....

"Do not misunderstand: One system is not better than the other. In fact, neuropsychologists have found that if the emotional decision-making areas of the brain are extremely damaged then decision making becomes impossible. Effectively, the unfortunate individuals afflicted by this problem make endless plans but seem to be incapable of choosing which they wish to follow.

"Tasks may also migrate between the systems. We have all had the experience of driving to and from work. When the route is new to us, we need to concentrate. However, after driving exactly the same roads for a year, we find that the task largely appears to have transferred from being a Rational function to being an Experiential function. How many times have we arrived home not realizing how we got there? Or even more to the point, how many times do you find yourself on the way to a meeting and deep in thought and catch yourself actually making the turns to take you to home? When the Rational is busy, the Experiential can take over.

"Just in case you think this is all just a pleasant psychological theory, neuropsychologists have started to work out the neural correlates of the two systems called X and C systems. Decisions that are made using X-system seem to use very different parts of the brain from those that are active when C-system decisions are being made. (Researchers use all sorts of brain imaging systems to determine this.) [X-system correlates to Experiential and C-System to Rational]

"By now you might just be wondering, not without reason, what on earth any of this has to do with investment. The answer lies in the fact that the X-system has a strong influence over many of the decisions we make, including those relating to investment.

"Dr. Gary Klein has identified some of the conditions under which we are likely to see decisions be made by the X-system. The X-system is more likely to dominate when:

The problem is ill structured and complex. Information is incomplete, ambiguous, and changing. Goals are ill defined, shifting, or competing. Stress is high because of time constraints and/or because high stakes are involved. Decisions involve multiple participants.

"We would assert that pretty much every decision of any consequence that we make falls into one or more of those categories. It certainly characterizes many of the decisions that we make when faced with an investment proposition.

"However, we are not powerless in the face of X-system influence. We can force the C-system into action. And this brings us to our eleventh guideline:

Focus on the Facts, Not Stories

"We all love a good story. In fact, we are hardwired to focus on stories. However, good stories aren't the best foundation for investment. The best company in the world won't be a good investment if everything is already in the price.

"Think about the CEOs of companies. Do we not admire the ones who can tell good stories about their companies? How many times have we invested in a company or fund solely on the basis of the story we were given by the broker or manager? How many knives or pots and pans have we bought on the Home Shopping Network because of those incredible stories?

"As human beings, we learned to communicate by stories even long before the written word. The love of a story is deeply embedded in our brains. Our greatest religious leaders of yore and the current preachers of today use parables and stories to communicate their teachings and principles.

"In order to beat the love of the story bias we need to focus on the facts rather than the stories. This is the easiest way of forcing the Rational to handle the problem. But the Experiential doesn't handle facts. By their nature, facts are generally characterized by low valence (emotion/affect) and thus the Experiential doesn't react. Instead the Rational is called up to logically assess the situation."

(You can order your own copy of Bull's Eye Investing and read about the other ten guidelines to bring out "Your Inner Spock" at http://www.amazon.com/bullsye. They have the book now at a 32% discount).

The people at Telecosm told great stories. So do the people at gold conferences. I have yet to meet a money or hedge fund manager who does not think his story merits my clients' money. If you are in the business of running money you are in the story telling business. I must confess I am not a bad story teller.

Of course, we all too often find "facts" to fit our stories rather than letting our stories be dictated by the facts. Your job as an investor is to wade through the stories and try to find the facts. Read and talk with as many people as you can to help you decide how to weight them.

I cannot tell you how many times I meet people who show me their portfolios and I can immediately know they are "story" people. Their portfolios are peppered with "stories." There is no logical pattern and perhaps a frightening lack of diversification. They are generally characterized by simply taking too much risk. Often, the stories run counter to where they should be (or at least where I think they should be). The riskier an investment is, the better story it takes to sell it. Talking in-depth with them, you begin to hear the stories. Sometimes they can be quite emotional about them. I find they are not looking for advice, but for confirmation that they were right. Sometimes they are, and sometimes they are not (again, in my opinion).

Muddling Along

Before we go, let me quote two brief passages from letters I read. The first is from Doug Greenig of Greenwich Capital Markets

"...When you have a bubble, when you have an enormous misallocation of resources, you cannot escape paying the price - no matter how you conduct countercyclical policy. Policy decisions can shape the timing and distribution of pain, but not eliminate it.

"The watchword for our economy is 'Muddling.' Muddling is not exciting to observe. No one aspires to muddle when they grow up. The economy muddles now because we avoided the painful cleansing of a real recession in 2001 and 2002. Most economists consider recessions to be bad things because resources are underutilized. A more dynamic view holds that economies make mistakes (e.g. develop excess capacity) and recessions both cause and are caused by a reallocation of resources. A recession destroys excess capacity, restores pricing power, and paves the way for higher expected returns to investment. This adjustment has occurred, in part, but low interest rates and a surge in leverage economy-wide propped up both business profits and consumer spending. (A simple calculation shows that declining interest expenses account for a large majority of the increase in corporate profits since 2001.) Through our policy decisions, we avoided a sharp, stabbing pain in return for a prolonged, dull ache - an extended period of lackluster growth and low expected returns. As the impact of prior stimulus passes, the lack of forward momentum in our economy will be quite apparent. Indeed, the recent rally in bonds reflects a growing awareness that 2005 will be slow.

"While we muddle, China and other emerging economies ... many with undervalued currencies ... continue to flood the world with manufactured goods, and, to an increasing extent, services. The build-out of infrastructure there and the high rate of economic growth cause inflation in commodity prices, at the same time that they depress inflation in finished goods. Political considerations in these exporting countries dictate a policy of maintaining an undervalued currency - providing real goods and services in return for American IOU's and other pieces of paper."

I should note that the Index of Leading Economic Indicators is starting to suggest we should go on recession watch. There are other warning signs. The next quote echoes the above and my belief that things are looking soft. It is from the very influential Bank Credit Analyst:

"The Fed during Chairman Greenspan's era has tended to listen to signals from the marketplace as a key input in guiding policy. The bond market is signaling that inflation is not a problem, with yields steadily receding since the Fed started to tighten at the end of June.

"The same benign inflation message is being sent by inflation-indexed bonds. Meanwhile, the equity market has performed poorly despite falling bond yields and is showing signs of breaking down, suggesting that the economic soft spot could get worse. The relentless rise in oil prices has spread throughout the energy market, with huge price gains in refined products lately, not to mention an explosive run-up in natural gas prices (even before cold weather hits!). Implication: the Fed needs to pause for an extended period or the economy could stumble - stay tuned."

Birthdays and Belize

It is time to hit the send button. I have kids coming in from here and yon to be with #2 son, who is celebrating his 16th birthday this weekend. Somehow he has managed to extend it into three nights. It is a special time. They grow up so fast.

My bride and I are thinking of taking a late December vacation in Belize or some other warm tropical spot easy to get to from Dallas. If any readers have suggestions or comments we would be interested.

Next week I will return to my series where I look at my basic investment themes or presuppositions. We have explored the concepts of a secular bear market and the Muddle Through Economy. Next week we look at the dollar.

It is good to be at home for a few weeks. Tahoe was a beautiful winter wonderland after a foot of snow hit after we arrived, but it took a full day to get back. I have been traveling a lot more than usual lately, and after the next few trips, it should slow down. But something always seems to come up. At least next week people are coming to me. Economist Gary Shilling is in town, followed by Jon Sundt of Altegris.

Have a great weekend,

Your wondering what's around the corner analyst,

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