First look at this…

Then look at this…

Returns in the stock market are randomly distributed over time.

Let’s say we suddenly start doing everything right according to the Austrian economics playbook. We go on the gold standard and abolish the Federal Reserve. We drastically cut back federal government spending, including all bailouts. We pull back from all overseas engagements. Would it work? Meaning, would we end up more prosperous in the long term than if we stay the current course?

First, can you imagine the immediate shock the the economy? Could anyone really process all of these changes at once, including all of the second-order effects and how they would impact your particular situation? Shocking if done instantaneously. Even shocking if done over the span of one year. But big deal. Get over it. We can be shocked and still survive, right?

Yeah, if the USA were a closed system I think we would be just fine. We would trade our gold for the farmer’s corn. Farmers would trade gold for tractors. Tractor builders would trade gold for houses. On and on. We would employ all the former government workers as road builders. New banks would arise in cities eager to lend us some gold for capital projects. We would do just fine here in the USA.

It is the fact that the USA is not a closed system that complicates the issue. See, in this process we trade dollars for gold. Each dollar is worth 1/900 oz of gold (let’s say). Bring in your pieces of paper, your Federal Reserve Notes, to the bank and they will give you gold coins or a receipt for 100%-reserve gold coin storage.

So now we all have gold in our pockets. And we want to buy a giant LCD TV. With what exactly and from where? Dollars? Ha, they’re gone now. A TV made in the USA? Yeah, right. You gotta give up some gold to some other country. So we load up our Wal-Marts, our Dollar Trees, and our shopping malls with stuff that we trade away our gold for. That represents an outflow of gold from USA. To keep the system in balance, don’t we need a corresponding inflow of gold? Otherwise someday we completely run out of gold, right? Can’t just print more gold can we?

It is the same scenario with any government that is left over. How are they going to pay out Social Security in gold? How are they going to send thousands of troops overseas and build billion-dollar airplanes and pay people to read newspapers in fancy offices? Since they don’t have a gold mine to readily tap into, they either have to take away your gold, or have to borrow gold from China, or they have to stop spending gold. The first option quickly reaches either a point of diminishing returns or reaches a point of torches and pitchforks. The third option is their option of last resort. Which leaves us with the USA borrowing gold from China. Which is kind of making my head spin trying to think of how we are going to come up with the gold to not only pay that back but also to pay the interest.

But maybe that is the point. We would have to figure out some way of getting gold from other countries. We would have to actually make or do things that they want. For example, we could trade our tractors and our corn for their gold. We could build houses for them. We could even help build their roads. Either that or we build our own LCD TVs and stock our Wal-Marts and Dollar Trees ourselves. Shocking isn’t it? Economics does work.

As I ponder this scenario, I realize just how fortunate and prosperous we in the USA have been these past few decades. Being able to "manufacture gold out of thin air," that is, print dollars to trade to foreigners. We are so lucky that they want our fiat dollars. Because that guy reading the newspaper really isn’t a very good road builder.

Read an article by Michael S. Rozeff today in which he describes his approach to investing. The article was called "The Opportunistic Investor ."  He says that a year ago he published two articles on buying a diversified portfolio and holding it. That portfolio is down 34 percent. Better than most. He says he actually did not invest according to his advice in that column. Instead, he was in cash.

He goes on to say that buy and hold is not the right approach. And I think the reason might have to do with the notion of "Austrian Investing," though he does not use those words.  Here is what he does say about buy and hold:

The problem with that approach was and is government. Government alters currency values, and this alters the value of different kinds of investments. Government creates booms and busts, and that alters investment values. The presence of government forces us to speculate.

Then he goes on to talk about how we need to find value and buy it, be it stocks, real estate, or even timber.

I am on the hunt for more information about Austrian Investing. They’ve been right about the economy, maybe they would be right about investing too.

Oh, and BTW: Mish does a pretty good destruction of Peter Schiff’s approach to Austrian Investing. Good read.

With the stock market down some 40% last year, many people are asking, "Where did the money go?" Sure there are some stock market losers. But remember the winners, those who sold their stocks in October 2007? They got their money. Remember also that for every share of stock sold, there was a share of that stock bought. But Fannie Mae used to trade for $80 a share and is now just pennies a share. Is the money just totally gone? Where did that market capitalization go? Furthermore, we need to push deeper, past the issues of money and valuations and ask, "Have we really lost wealth?" The answer may surprise. We will get to that last question in a moment. But first, let’s follow the money.

Where did the money go?

The USA Today ran a story that read, "$2 trillion wiped out of retirement funds " so far in 2008. Really? Two trillion dollars is wiped out? Lost? This is a fascinating notion. You wake up one day and wealth is suddenly gone. Vanished. Like some ice cube that has melted on a hot street. Here one moment and gone the next. As we shall see, the ice cube metaphor may be even better than it first appears. Stocks have melted.

The NPR Planet Money podcast a few weeks ago sought to answer the question "What is money?" and recently asked "Where did the money go?" To help us visualize the "loss" of money, they acted out a little skit with three market participants. At the start of the skit it was noted that among them the sum total of money was $400. Russ had $200, Alex had $200, and Lois had a house. (It was a little green Monopoly game piece house.) Russ Roberts (of EconTalk fame) decided he wanted a house. So he offered Lois $200 for hers and she accepted. Russ has the house, Lois has $200. Some time passed and then Russ wanted to sell his house. Alex was the only one who made an offer and it was for $100. Russ took the offer but was obviously unhappy about "losing" $100. At the end of the skit, Alex owned the house and $100, Lois had $200, and Russ had $100. The sum total of money was $400. Therefore, the net amount of money remained unchanged although some of the market participants had varying emotions about their transactions.

Lois was happy to receive the $200 for her house because she said she had originally purchased the house for $100. But she said that she still had to live somewhere and would now have to go and buy another house. Russ was obviously unhappy because he has $100 less than when he started. And still no house. Alex was probably the happiest because he has a nice house and still has $100 of his original $200 remaining. But with the net amount of money remaining the same, they didn’t really ask the question, "Why did the house only get an offer of $100?"  Why not a $300 offer? Don’t house prices continuously rise and never fall?  It was a fun exercise to walk through, but it still left me unsatisfied. What’s behind the rise and fall of prices? Let’s try to figure that out. But instead of houses, let’s switch over and talk about gold for a moment.

Gold and the Market

Gold is different than houses. We can’t live in gold. Instead, gold is money. Ancient money. Gold would still be money today if the governments would stop prohibiting it from being money. Consider these characteristics of money: money must be marketable, easily transportable, relatively scarce, relatively imperishable, easy to store, easily divisible, and uniform in quality. Gold meets all of these characteristics and has been used as money by default through the ages. Ironically the dollar, the world’s reserve currency, doesn’t meet all of these characteristics. It misses the scarcity test.

So let’s trade two things: dollars and gold. It used to be that a dollar represented a fixed amount of gold, but today we can trade one for the other at different amounts. If you have dollars and I have a one ounce gold coin, you can make me an offer to trade some of your dollars for my coin. I can accept or refuse. If you offer me $200, I will refuse. If you offer me $2000 I will accept. Somewhere in between these two ranges we may reach an agreement (or we may not). The more people there are around to offer bids and ask for bids, the greater the chance that someone can reach an agreement on a fair trade. As an example, say your bid for my gold coin is $600 but Troy bids $800. You may consider increasing your bid to $850 in light of his bid. But before you do, Bill next to me accepts Troy’s $800 bid for his coin. You witness that and decide to limit your bid to me to $800 also. Why pay more, right? Or if you are really trying to game me, you may hold your bid at $600 thinking that no one else is around now that will bid something higher.

This is the workings of the market. Bidding and asking is how we reach agreed-upon prices. This is why stock prices are what they are: dynamic. It is a continuous mixture of people wanting to sell at the highest asking price and people wanting to buy at the lowest bid price. But they know they are competing with other sellers and buyers for those same shares.

Motivated Sellers

Competition is the heart of the market. It is the heart of the gold market and the heart of the real estate market and the heart of the stock market and even the heart of the currency market.

In the NPR skit, Alex was able to buy the house from Russ for only $100 because there were no other offers higher and Russ really wanted to sell. A motivated seller they say. Perhaps he needed to move because of a job relocation. There are motivated sellers in all markets just as there are motivated buyers. Are there more motivated sellers than motivated buyers? Prices will fall as bids dry up. Prices will fall as the number of offers rise and the amount asked for sinks. Are there more motivated buyers? Prices will rise as bidders compete. Prices will rise as owners hold tight.

Presently in our global stock markets our global real estate markets and our global commodity markets we have not just a boatload of motivated sellers but a whole fleet of cruise ships full of motivated sellers. We have banks, brokers, hedge funds rushing for the exits at the same time, needing to sell just to get the dollars to pay off debts and client redemptions. We even have investors motivated to sell simply because they see so many other motivated sellers selling.

As naturally happens when motivated sellers outnumber motivated buyers, prices drop. We might call this an asking war , the opposite of a bidding war. Sellers lowering their asking prices in the face of other low asking prices. Asking prices for stocks go lower. Asking prices for houses go lower. Asking prices for copper goes lower. But motivation in a particular market is only part of the story. We need to also consider motivation across markets. I may want to sell my house not because of physical reasons but because of economic reasons. Perhaps I want to trade house wealth for stock wealth. I may prefer at present to rent and hold 10,000 shares of an index fund rather than owning a house. I probably will not find the exact trade I’m looking for; that is, someone to offer to trade me their 10,000 shares for my house. Instead, I’ll have to trade through money. I sell the house for dollars and then sell the dollars for the index funds.

But the net amount of money in the system doesn’t change as a result of motivations. The buyer gets to keep the net amount that the seller loses out on. Alex has the $100 instead of Russ. When prices kept going up, did anyone ask, "Where did that money come from?" Not likely. We don’t care how we got it. Yet we darn sure want to know how we lost it. But both answers are the same. The net amount of money remains constant among the total pool of buyers and sellers.

[Note that I am for purposes of this discussion ignoring the effect of fractional reserve banking and the creation of money when lent and the destruction of money when a loan is paid back. This effect is indeed serious and makes an enormous impact to the economy as a whole.]

Lost Wealth?

Now we know where the money went. It is still there. Not a satisfying answer to owners of stock mutual funds in their 401K plans who say, "Oh great, more motivated sellers means any bids I seek for my shares will be lower if I were to try to sell today." Penny’s 401K plan may have a cost basis of $100,000. And last year when she checked the bids on her portfolio it may have fetched nearly $300,000. But based upon recent offers, it may only receive bids for $150,000. That seems like lost wealth to Penny. Is it?

It depends. It might not be lost wealth to Penny. We need to look at what Penny would have wished to trade her shares of stock for? A house? If so, Penny is in luck because houses she liked that used to fetch $300,000 bids are now asking only $150,000. So Penny’s 401K plan would buy the same amount of house even though its dollar value has fallen in half. Similarly, Penny may have wished to use her 401K to travel or to eat or to pay her gas bill. Dollar values for each of these things may have fallen, but their values may have stayed relatively close to the value of her stocks over that time.

We are living in a world where bids for practically every asset are lower in comparison to bids for dollars. Many motivated sellers of stuff, many motivated buyers of dollars.

So the problem is the thing we are using as money, which itself is becoming more "valuable." The banks, brokerages, and hedge funds that need to get dollars are not just motivated sellers of stocks and commodities, but they are also motivated buyers of dollars. There are lots of motivated dollar buyers. Prices of dollars rise. Everything else seems more expensive compared to dollars as a result.

But we the investing public with 401K plans are typically not motivated buyers of dollars. We are more typically motivated buyers of the things that dollars buy. Food, travel, cars, shelter, heat, etc. When we trade one of these for the other, we might expect roughly the same item-for-item transaction this year as we did last year. The thing in the middle is what has changed: the money. The demand for the dollar by banks, brokers, and hedge funds has skewed the monetary valuations of both the things that we need to sell and the things that we want to buy. But in the end, it might possibly be that our wealth remains somewhat unchanged just like the amount of money remains unchanged among buyers and sellers.

I used Apple’s Keynote presentation software from their iWork package to create a video that goes along with the IFA Quote of the Week Issue #44. The episode talks about the rise and fall of fund manager Bill Miller. Have a look and give me suggestions for improvement. Get these videos delivered to your iPod or iPhone automatically by subscribing through iTunes.

Got Feedback: Try any one of these methods:

• email: feedback AT MadMoneyMachine DOT com
• voicemail: 571-366-7121
• Comment here on this blog
• Comment at drop.io/MadMoneyMachine
• Twitter me at Twitter.com/MadMoneyMachine
• Skype me at MadMoneyMachine

Check this out. NYTimes, with its unlimited budget (ha) has gone and done my pitiful "Table of What it Takes to Get Back to Even " several times better. Theirs is an interactive graphic (in Flash no less) where you can enter what you once HAD, what you now HAVE, and your expected return rate (ha again!). It will tell you how long you’ll have to wait to see that same amount of money again.

http://www.nytimes.com/interactive/2009/01/06/business/20090106-comeback-graphic.html

What’s neat is that if you put in a negative inflation rate, say -3%, you can get your money back in a few years even at 0% Annual return!

I was talking with Mark Hebner today about this idea of Black Swan investing. As I mentioned in show 141, I read an article entitled “Is There Such a Thing as Austrian Investing?” by  Sterling T. Terrell. He talks about the differences between passive and active investing. But then he talks about their similarity: they both realize small gains most of the time and large gains very rarely. He says an Austrian approach would embrace the fact that the future is unknowable. He says the way to invest in the unknowable is to do Taleb’s approach of putting most of one’s net worth in low risk assets, perhaps money markets or short term bonds, and then with a small amount invest in options. The idea is that most of the time one would lose a little amount of money but on rare occasions, when there is a shock to the market, the strategy would make a large amount of money.

My comment upon his article is that it needs to be fleshed out more. Simply saying that one would follow this approach because the future is uncertain leaves a lot of arguments untouched. For instance, the article does not show how one would implement it, how it would have performed in the past, and what mathematical basis it has upon reality. Show me how such a strategy would have performed over the last 10 years. 20 years. Rolling periods. What amount of one’s investment would be eaten by fees and bid/ask spreads on these options? Can an individual actually implement such a plan or must one be a hedge fund with millions rolling around?

Wouldn’t investing in capitalism be closer to the Austrian ideal rather than speculating in financial derivatives? And particularly investing in ALL of capitalism and taking out the “controlling” decisions of some fund manager to select which companies may do better than others. This means investing in index funds. This means buying baskets of as many companies as possible, with some rational due diligence hopefully embedded in the process. By this I mean, if a company comes out and says, “We intend to close our business in the next couple of years” then by all means the index manager could have leeway to pull out of that stock.

Perhaps an important aspect of Austrian Investing was something else Terrell mentioned, 

To further explore Austrian investing, one might look at the nature of Austrian Business Cycle Theory: how can the role of the Federal Reserve in setting interest rates, causing shortages and surpluses in the market for loanable funds, the nature of malinvestment, and the inevitable boom and bust that follow, be formulated into a successful investment process?

That’s definitely something to take into consideration. Peter Schiff, Nouriel Roubini, Ron Paul, James Grant, Jim Rogers and many, many others are trying to do this too. Still, applying it to investing is akin to licking one’s finger and sticking it up to the wind. I need something more scientific, more measurable, more definitive so that I can take the belief factor out of the equation and instead invest rationally. In fact, maybe rationality is the real key to Austrian Investing after all.

By now you’ve heard about the alleged multi-billion, multi-year Ponzi scheme by Bernard Madoff and how so many other hedge funds were invested with him and how they lost money. Here’s the question: Are we sure those hedge funds lost their money by investing with Madoff? Maybe they did lose some money but maybe they are inflating their losses. Were they running a Ponzi scheme of their own and simply used the Madoff scandal as a scapegoat? Sounds like good cover to me.  How many other cockroaches will come out of the woodwork claiming their losses were due to Madoff? Hat tip to my wife for the idea.

This is funny. If he hadn’t already done this, I would have liked to have done a similar sarcastic “fix of the economy” on my show.

 Here’s a handy table (for your printing pleasure) that shows what percentage gain you need to get on your investments to get back to where you were before a certain percentage loss. So for example, the S&P 500 index is down about 40% year to date. Looking down the table, you’ll see that we’d need a gain of 66.7% to get back to where it was at the start of the year.

For Fannie Mae (FNM) you’d need a gain of 7839%. It closed at 39.98 on 31 Dec and now trades at about 0.51.

[An observant reader pointed out my mathmatical flaw in the article below. I have corrected it now. I had a feeling as I was adding percentages that I was doing something stupid. Doing the math properly makes a difference, but turns out it is not a major change to the result.]

The good folks at Index Funds Advisors have studied statistics about the stock market going back many years. One of my favorite statistics is the Monthly Rolling Period Analysis of, for example, IFA Index portfolio 100. (You can click on any of the other numbered portfolios from that page to get their Monthly Rolling Period Analysis.)  When you examine that table, you will see on the 4th row down is the 12-month rolling returns. Starting in January 1958 until December 2007 there were 589 such 12-month periods. Note we’re not just going from January to January but also February to February and March to March and so on. 

In columns six and seven you see that the worst 12-month period for the index portfolio 100 was from 10/73 until 9/74 when the portfolio experienced a loss at -35.73%. It now appears that the chart will have a new entry for lowest rolling period. According to information I have pieced together from the Benchmark Your Portfolio Tool and the Year To Date Returns of IFA Portfolios and Indexes as of Market Close 10/31/08, both available at IFA.com, the period from 11/07 thru 10/08 has just experienced a loss at -42.53% [corrected]. To arrive at this number, combine the -8% loss from 11/07 thru 12/07 with the -37.53% loss YTD in 2008. [This was the source of my math mistake: I added the percentages together.  Instead, I should take the percentage of the percentage. For example: $1000 with 8% loss is $920. $920 with 37.53% loss is $574.72. From the original $1000, that is a 42.53% loss.]

This will have a significant impact on the statistics and on the assumptions of risk going forward as the Monthly Rolling Period Analysis table gave an impression that the worst loss one might reasonably expect in a 12 month period was -35%. When the table is updated to show a maximum expected loss of 45%, it might cause investors to choose a portfolio with lower risk. Note that I have singled out 12-month rolling period. I suspect we have also set records in many other rolling periods as well. A quick check of the 2 year shows it was -23.86% and is now -29.57%. [The 2-year return is annualized, not total.] A more detailed check of the 2 year shows it was -23.86% but the most recent was only a -17.86% loss annualized.

Also using IFA data, I calculate that the S&P 500 12 month return just ended was (-4.81%) and  (-32.71%) resulting in -35.95%. If you examine the tables carefully, you will see that the S&P 500 has slightly more risk (measured by monthly standard deviation) than a portfolio 85, but with lower annualized returns. 

To create the Rolling 12-Month Analysis for any of the other 19 IFA Index Portfolios, use the Benchmark Your Portfolio Tool and select the portfolio of interest and choose the range from 1 November 2007 through 31 December 2007. Add Combine [properly] the total return (which is probably negative) to one of of the following 2008 Year-to-date returns through 31 October 2008:

But just to be fair, we should also examine the Highest Rolling Period Return and ask if we might someday overstretch its limits. It currently sits at 66.72% for the period 4/03 thru 3/04, a time after a recent recession. I wonder if after this recession we will bounce back higher? Note I’m not predicting that it will happen, just kinda wishing. Maybe after the 10% gain of the past few days, we’re on the right track?