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The best investment advice you’ll never get

When I first saw this online, I grabbed a copy for my own use. Recently, I went back to reread part of it — and it was gone! Lucky I captured this before it disappeared. Enjoy.


The best investment advice you’ll never get
By Mark Dowie
San Francisco magazine, December 2006



For 35 years, Bay Area finance revolutionaries have been pushing a personal investing strategy that brokers despise and hope you ignore. The story of a rebellion that’s slowly but surely putting money into the pockets of millions of Americans, winning powerful converts, and making money managers from California Street to Wall Street squirm.



As Google’s historic August 2004 IPO approached, the company’s senior vice president, Jonathan Rosenberg, realized he was about to spawn hundreds of impetuous young multimillionaires. They would, he feared, become the prey of Wall Street brokers, financial advisers, and wealth managers, all offering their own get-even-richer investment schemes. Scores of them from firms like J.P. Morgan Chase, UBS, Morgan Stanley, and Presidio Financial Partners were already circling company headquarters in Mountain View with hopes of presenting their wares to some soon-to-be-very-wealthy new clients.

Rosenberg didn’t turn the suitors away; he simply placed them in a holding pattern. Then, to protect Google’s staff, he proposed a series of in-house investment teach-ins, to be held before the investment counselors were given a green light to land. Company founders Sergey Brin and Larry Page and CEO Eric Schmidt were excited by the idea and gave it the go-ahead.

One by one, some of the most revered names in investment theory were brought in to school a class of brilliant engineers, programmers, and cybergeeks on the fine art of personal investing, something few of them had thought  much about. First to arrive was Stanford University’s William (Bill) Sharpe, 1990 Nobel Laureate economist and professor emeritus of finance at the Graduate School of Business. Sharpe drew a large and enthusiastic audience, which he could have wowed with a PowerPoint presentation on his “gradient method for asset allocation optimization” or his “returns-based style analysis for evaluating the performance of investment funds.” But he spared the young geniuses all that complexity and offered a simple formula instead. “Don’t try to beat the market,” he said. Put your savings into some indexed mutual funds, which will make you just as much money (if not more) at much less cost by following the market’s natural ebb and flow, and get on with building Google.

The following week it was Burton Malkiel, formerly dean of the Yale School of Management and now a professor of economics at Princeton and author of the classic A Random Walk Down Wall Street. The book, which you’d be unlikely to find on any broker’s bookshelf, suggests that a “blindfolded monkey” will, in the long run, have as much  luck picking a winning investment portfolio as a professional money manager. Malkiel’s advice to the Google folks was in lockstep with Sharpe’s. Don’t try to beat the market, he said, and don’t believe anyone who tells you they can—not a stock broker, a friend with a hot stock tip, or a financial magazine article touting the latest mutual fund. Seasoned investment professionals have been hearing this anti-industry advice, and the praises of indexing, for years. But to a class of 20-something quants who’d grown up listening to stories of tech stocks going through the roof and were eager to test their own ability to outpace the averages, the discouraging message came as a surprise. Still, they listened and pondered as they waited for the following week’s lesson from John Bogle.

“Saint Jack” is the living scourge of Wall Street. Though a self-described archcapitalist and lifelong Republican, on the subject of brokers and financial advisers he sounds more like a seasoned Marxist. “The modern American financial system,” Bogle says in his book The Battle for the Soul of Capitalism, “is undermining our highest social ideals, damaging investors’ trust in the markets, and robbing them of trillions.” But most of his animus in Mountain View was reserved for mutual funds, his own field of business, which he described as an industry organized around “salesmanship rather than stewardship,” which “places the interests of managers ahead of the interests of shareholders,” and is “the consummate example of capitalism gone awry.”

Bogle’s closing advice was as simple and direct as that of his predecessors: those brokers and financial advisers hovering at the door are there for one reason and one reason only—to take your money through exorbitant fees and transaction costs, many of which will be hidden from your view. They are, as New York attorney general Eliot Spitzer described them, nothing more than “a giant fleecing machine.” Ignore them all and invest in an index fund. And it doesn’t have to be the Vanguard 500 Index, the indexed mutual fund that Bogle himself built into the largest in the world. Any passively managed index fund will do, because they’re all basically the same.

When the industry sharks were finally allowed to enter the inner sanctum of Google, they were barraged with questions about their commissions, fees, and hidden costs, and about indexing, the almost cost-free investment strategy the Google employees had been told delivers higher net returns than all other mutual fund strategies. The assembled Wall Streeters were surprised by their reception—and a bit discouraged. Brokers and financial planners don’t like indexed mutual funds for two basic reasons. For one thing, the funds are an affront to their ego because they discount their ability to assemble a winning portfolio, the very talent they’re trained and paid to offer. Also, index funds don’t make brokers and planners much money. If you have your money in an account that’s following the natural movements of the market—also called passive investing—you don’t need fancy managers to watch it for you and charge big bucks to do so.

Brin and Page were proud of the decision to prepare their staff for the Wall Street predation. And they were glad to have launched their company where and when they did. What took place in Mountain View that spring might have never happened had Google been born in Boston, Chicago, or New York, where much of the financial community remains at war with insurgency forces that first started gathering in San Francisco 35 years ago.

It all started in the early 1970s with a group of maverick investment professionals working at Wells Fargo bank. Using the vast new powers of quantitative analysis afforded by computer science, they gradually came to the conclusion that the traditional practices guiding institutional investing in America were, for the most part, not delivering on the promise of better-than-average returns. As a result, the fees that average Americans were paying brokers to engage in these practices were akin to highway robbery. Sure, some highly paid hotshot portfolio managers could occasionally put together a high-return fund. But generally speaking, trying to beat the market—also called active investing—was a fruitless venture.

The insurrection these mavericks would create eventually caught on and has spread beyond the Bay Area. But San Francisco remains ground zero of the democratizing challenge to America’s vast and lucrative investment industry. Under threat are the billions of dollars that mutual funds and brokers skim every year from often-unwary investors. And every person who has money to invest is affected, whether she’s patching together her own portfolio with a broker, saving for retirement or college, or just making small contributions each year to her 401K. If the movement succeeds, not only will more and more people have a lot more money in their pockets, but the personal investment industry will never look the same.

I was once a portfolio manager myself, and like the industry folks Google was protecting its employees from, I was certain I could outperform market averages and confident that I was worth the salary paid to do so. However, I left the investment business before this revolt began to brew. In the intervening years, I never stewarded my own investments as judiciously as I’d managed those of my former employers—Bank of America, Industrial Indemnity, and the Bechtel family. I was unhappy with the Wall Street firms I had been using, which had churned my account to make lots of money on the sales, and, despite instructions to the contrary, placed my money in their own funds and underwritings to make even more at my expense. So a couple of years ago, when it finally came time to get my own house in order, I knew I wanted help from an independent adviser, someone who was doing things differently from the big brokerage firms.

Eventually I found a small financial management firm in Sausalito called Aperio Group that, after only seven years in business, already had a stellar reputation. “Aperio” in Latin means “to make clear, to reveal the truth.” Indeed, truth-telling is key to Aperio’s mission, even if that means badmouthing its own industry in the process. One of the company’s founders, Patrick Geddes, aged 48, is a renegade from the top echelons of his field. For several years he served, first as director of quantitative research, then as CFO, at Morningstar, the nation’s leading company for researching and appraising mutual funds. But when he left, not only was he disenchanted with his own company’s corporate environment, he was also becoming uneasy with the moral underpinning of the entire industry. “Let’s be straight,” says Geddes in his soft-spoken but zealous way. “Being unethical is a good precondition for success in the financial business.”

His partner, a bright, high-energy Norwegian American named Paul Solli, 49, is another finance guy who didn’t have the gene for corporate culture. After graduating from Dartmouth’s business school, he tried investment banking but didn’t like it. He went out on his own, starting an investment advisory business, but says he flailed about, searching for a business model that would support his desire to “live deliberately” in the Thoreauvian manner.

Solli and Geddes consider themselves heirs to the Wells Fargo insurgency and, as such, part of a movement that includes academics, some institutional investors, a couple of large index fund companies, and a handful of small firms like their own that are dedicated to bringing the indexing philosophy to badly advised investors like myself. And unlike most mutual fund investment firms, which have $5 million and $10 million minimums, Aperio was willing to take on a messy six-figure portfolio.

Solli took one look at my unkempt collection of mut­ual funds and said, “You’re being robbed here.” He pointed to funds I had purchased from or through Putnam, Merrill Lynch, Dreyfus, and—yes—Charles Schwab (which referred me to Aperio) and asked, “Do you know that you’re paying these guys to do essentially nothing?” He carefully explained the many ingenious ways fund managers, brokers, and advisers had found to chip away at investors’ returns. Turns out that I, like more than 90 million other suckers who have put close to $9 trillion into mutual funds, was paying annual fees, commissions, and transaction costs well in excess of 2 percent a year on most of my mutual funds (see “What Are the Fees?” page 75). “Do you know what that adds up to?” Solli asked. “At the end of every 36 years, you will only have made half of what you could have, through no fault of your own. And these are fees you needn’t pay, and won’t, if you switch to index funds.”

All indexing calls for, Solli explains, is the selection of a particular stock market index—the Dow Jones Industrial Average, Standard and Poor’s (S&P) 500, the Russell 1000, or the broader Wilshire 5000—and the purchase of all its stocks and bonds in the exact proportions in which they exist in that index. In an actively managed fund, managers pick stocks they think will outperform a particular index. But the premise of indexing is that stock prices are generally an accurate reflection of a company’s worth at any given time, so there’s no point in trying to beat that price. The worth of a client’s investment goes up or down with the ebb and flow of the market, but the idea is that the market naturally tends to increase over time. Moreover, even if an index fund performed only as well as the expensively managed Merrill Lynch Large Cap mutual fund that was in my portfolio, I would earn more because of the lower fees. Stewarding this kind of investment does not require a staff of securities analysts working under a fund manager who makes $20 million a year. In fact, a desktop computer can do it while they sleep.

There are always exceptions, of course, Solli says, “a few funds that at any given moment outperform the indexes.” But over the years, he explains, their performances invariably decline, and their highly paid cover-boy managers slide into early obscurity, to be replaced by a new hotshot managing a different fund. If a mutual-fund investor is able to stay abreast of such changes, move their money around from fund to fund, and stay ahead of the averages (factoring in higher commissions and management fees) it will be by sheer luck, says Solli, who then offers me pretty much the same advice John Bogle and his colleagues offered Google. Sell the hyped but fee-laden funds in my portfolio and replace them with boring, low-cost funds like those offered by Bogle’s Vanguard.

It took Solli a couple more painful meetings and a few dozen trades to clean the parasites out of my account and reinvest the proceeds in index funds, the lifeblood of his business. Without exception, he moved me into funds that have outperformed the ones I was in, like the Vanguard REIT Index Fund, some Pimco bond and stock funds, and Artisan International. And he did it for an annual fee of .5 percent of money under management, saving me over a full percent in overall costs and a lot of taxes in the future. Then he did something I doubt any other financial manager would have done. He fired himself.

“You really don’t need me anymore,” he said, and closed my Aperio account that day, ending his fees, but not our relationship. I was curious. Who was this guy who was so open about the less-than-dignified ways of his own business? “You have to have lunch with my partner,” he said.

If Solli is an industry gadfly, Geddes, a modest, unassuming son of a United Church of Christ minister, is its chainsaw massacrer. “We work in the most overcompensated industry in the country,” Geddes admitted before the water was served, “and indexing threatens the revenue flow from managed funds to brokerage houses. That’s why you’ve been kept in the dark about it. This truly is the great secret shame of our business.

“The industry knows they are peddling bad products,” Geddes continued, “and a lot of people making the most money and getting the most prestige are doing so by gouging their customers.” And Geddes is quick to differentiate between “illegal theft”—the sort of industry scandals Spitzer has uncovered, such as illicit sales practices, undisclosed fees, kickbacks, and after-market trading—and “legal theft,” the stuff built into the cost of doing business that no attorney general can touch, but which in dollar amounts far exceeds investor losses to illegal activity.

Geddes wasn’t always full of such tough talk about the industry. Not that he had any qualms about speaking his mind; in fact, he was let go from Morningstar in 1996 for being openly critical of the company’s internal culture. “I still think of Morningstar as a potentially positive force in the industry,” he says. “But let’s just say they were weak at conflict management, especially at the senior levels.” It wasn’t until he took a freelance consulting job for Charles Schwab that he really saw the light about indexing.

“My job was to compile all the academic research on mutual funds, and that’s when it really became clear that active management doesn’t add any value,” he says. When he finished the project, Geddes started teaching a finance class through the University of California extension, where he started preaching his anti-industry gospel. “I had to be careful, because there were a lot of brokers in the class. I started noticing that some of them would get sort of irritated with me.”

Around this time is when he met Solli. Solli had a client, a doctor who was looking to learn about portfolio management and asked Solli what he thought of Geddes’s UC course. When Solli looked into it, he was bowled over. “Here was this guy who’d been CFO at Morningstar and had this incredible background, and I thought, what the hell is he doing at Berkeley teaching this course to guys like my client? This is too good to be true—I have to meet this guy.”

Slowly, inadvertently even, Aperio was born. But the fit was perfect. Geddes brought what he calls “the quant piece” to the table; Solli had the strategic vision. After a few months of brainstorming, they set out to see if a couple of guys who held themselves to high ethical standards could make it in the cutthroat financial industry.

And just how do these guys make money if they keep kicking out clients like me once they switch us into index funds, while alienating others with their irreverent critique of the entire mutual fund game? Geddes does take referrals from investment firms like Charles Schwab, which thrive on the sale of managed mutual funds. So why the rant? Isn’t he, too, in business to make a buck?

“Absolutely,” he admits. “I’m not Mother Teresa; I’m a capitalist who wants to succeed and make money. I just think the best way to do that is by building trust in a clientele by revealing to them honestly how this business works.”

Geddes also offers a customized version of indexing (on taxable returns) for wealthier clients, a service that requires an ongoing relationship and supplies Aperio a steadier source of income than my low-six-figure portfolio did. Aperio now has about $800 million under management. It’s a paltry sum compared with those of the big brokerage firms, which deal in the billions or even trillions, but Geddes is fine with that. “If I were making what I could be making in this business, I just wouldn’t like the person I’d have to be.”

“San Francisco was the only place in the country where this could have happened,” says Bill Fouse, a jazz clarinetist in Marin County who was present when the first shots were fired in the investment rebellion. It was 1970, and revolution was in the air.

While hippies, dopesters, and antiwar radicals were filling the streets of America’s most tolerant city with rage, sweet smoke, and resistance, a quieter protest was brewing in the lofty, paneled offices of Wells Fargo. There, a young engineer named John Andrew “Mac” McQuown, Fouse (who like many musicians also happens to be a brilliant mathematician), and their self-described “skeptical, suspicious, careful, cautious, and slow-to-change” boss, James Vertin, were taking a hard look at the conventional wisdom that for a century had driven American portfolio management.

Bank trust departments across the country were staffed by portfolio managers who, as I did at the time, believed that they alone possessed the investment formula that would enrich and protect the security of their customers. “No one argued with that premise,” Fouse recalls.

But McQuown suspected they were pretty much all wrong. He had met Wells Fargo chairman Ransom Cook at an investment forum in San Jose, and at a later meeting at company headquarters, persuaded him that traditional portfolio management was merely an investment variation of the Great Man theory. “A great man picks stocks that go up. You keep him until his picks don’t work anymore and you search for another great man,” he told Cook. “The whole thing is a chance-driven process. It’s not systematic, and there’s lots we still don’t know about it and that needs study.” Cook offered McQuown a job at Wells and a generous budget to conduct research into the Great Man Theory and other schemes to beat the averages. McQuown accepted, and a few years later Fouse came on as well.

They couldn’t have been more different: Fouse, a diminutive, mild-mannered musician, and McQuown, a burly, boisterous Scot. The two were like oil and water—McQuown even tried to have Fouse fired at one point—but their boss, Vertin, was the one who really was in the hot seat.

“You have to understand, Vertin’s career was on the line,” Fouse recalls. “He was, after all, running a department full of portfolio managers and securities analysts whose mission was to outperform the market. Our thesis was that it couldn’t be done.” Proof of McQuown’s theory could lead to the end of an empire, in fact many empires. “The poor guy was under siege,” says Fouse. “It was a nerve-racking time.”

Vertin’s memory of those times is no less vivid. “Mac the knife was going to own this thing,” he once told a reporter. “I could just see the fin of the shark cutting through the water.” Eventually, the research McQuown and Fouse produced became so strong that Vertin could not ignore it. “In effect it said that almost everything that every trust department in America was doing was wrong,” says Fouse. “But Jim eventually accepted it, even knowing the consequences.”

In July 1971, the first index fund was created by McQuown and Fouse with a $6 million contribution from the Samsonite Luggage pension fund, which had been referred to Fouse by Bill Sharpe, who was already teaching at Stanford. It was Sharpe’s academic work in the 1960s that formed the theoretical underpinning of indexing and would later earn him the Nobel Prize. The small initial fund performed well, and institutional managers and their trustees took note.

By the end of the decade, Wells had completely renounced active management, had relieved most of its portfolio managers, and was offering only passive products to its trust department clients. And it had signed up the College Retirement Equities Fund (CREF), the largest pool of equity money in the world, and Harvard University, the largest educational endowment. By 1980 $10 billion had been invested nationwide in index funds; by 1990 that figure had risen to $270 billion, a third of which was held at Wells Fargo bank.

Eventually the department at Wells that handled index­ing merged with Nikko Securities and was later bought by Barclays Bank, which created the San Francisco subsidiary Barclays Global Investors. Its CEO, Patricia Dunn, the scandal-tinged former chairman of Hewlett-Packard who had worked for 20 years at Wells Fargo, had been heavily influenced by indexing. Running Barclays, she became the world’s largest manager of index funds.

Fouse, now retired in San Rafael, explains why all this could have happened only in San Francisco. “When we started our research, almost all the trust clients out here were individuals with small accounts. Anywhere else, particularly on the East Coast, trust departments handled very large institutions—pension funds, university endowments, that sort of thing. If Mellon, Chase, or Citibank had done this research and come to the same conclusion, they would have in effect been saying to their large, sophisticated, and very lucrative clientele: ‘We’ve been doing things wrong for a century or more.’ And thousands of very comfortable investment managers would have been out of work.”

But even in San Francisco, as in the country’s other financial centers, Fouse and McQuown’s findings were not a welcome development for brokers, portfolio managers, or anyone else who thrived on the industry’s high salaries and fees. As a result, the counterattack against indexing began to unfold. Fund managers denied that they had been gouging investors or that there was any conflict of interest in their profession. Workout gear appeared with the slogan “Beat the S&P 500,” and a Minneapolis-based firm, the Leuthold Group, distributed a large poster nationwide depicting the classic Uncle Sam character saying, “Index Funds Are UnAmerican,” implying that anyone who was not trying to beat the averages was nothing more than an unpatriotic wimp. (That poster still hangs on the office walls of many financial planners and fund managers.)

Savvy investment consumers, however, were apparently catching on. As they began to suspect that the famous fund managers they were reading about in Business Week and Money magazine were taking them for a ride, index funds grew in size and number. And actively managed funds shrank proportionately. Even some highly placed industry insiders started beating the drums for indexing. From her perch at Barclays, CEO Dunn gave a speech at a 2000 annual industry meeting in Chicago. As reported in Business Week at the time, she started out with some tongue-in-cheek comments about fund managers’ “rare gifts and genius,” and then shocked the crowd by going on to denounce the industry’s high fees. According to the article, she even included this zinger: “[Investment managers sell] for the price of a Picasso [what] routinely turns out to be paint-by-numbers sofa art.”

It’s not as if Merrill Lynch, Putnam, Dreyfus, et al, were being put out of business by this new consciousness, but like any industry threatened with bad ink, the financial community continued to strike back at every opportunity. In May 2003, Matthew Fink, president of the Investment Company Institute, a mutual funds trade association, told convening members that his industry was squeaky clean and has “succeeded because the interests of those who manage funds are well-aligned with the interests of those who invest in mutual funds.” At the same convention, Fink’s remarks were echoed by ICI vice chairman Paul Haaga Jr., who, in his keynote address, pronounced that “our strong tradition of integrity continues to unite us.” Indeed, integrity had been the theme of every ICI membership meeting in recent memory.

Haaga then attacked his industry’s critics, including former SEC chairmen, members of Congress, academics, journalists, even “a saint with his own statue” (John Bogle). “[They] have all weighed in about our perceived failing,” lamented Haaga. “It makes me wonder what life would be like if we’d actually done something wrong.”

He didn’t have long to wonder. Four months later, the nation’s first big mutual fund scandal broke when Eliot Spitzer brought civil actions against four major fund managers for allowing preferred investors to buy and sell shares on news or events that occurred after markets had closed. Spitzer compared the practice to “allowing betting on a horse race after the horses have crossed the finish line.” Multimillion dollar fines were issued against the firms, which were also required to compensate customers damaged by what were called market-timing practices.

The market-timing scandals alone are estimated to have cost fund investors about $4 billion, and other industry violations were uncovered after that. But now more experts are convinced that the amount pales in comparison to  the tens of billions lost every year just to the fees and transaction costs by which mutual funds live and die. After the mutual fund scandals broke, Senator Peter Fitzgerald (R-Ill.) called a hearing before the Subcommittee on Financial Management, the Budget, and International Security, and said this in his opening statement: “The mutual fund industry is now the world’s largest skimming oper­ation—a $7 trillion trough from which fund managers, brokers, and other insiders are steadily siphoning off an excessive slice of the nation’s household, college, and retirement savings.”

No one running a university endowment, independent foundation, or pension fund could match his numbers during his tenure: over the last 21 years, chief investment officer David Swensen has averaged a 16 percent annual return on Yale University’s investment portfolio, which he built with everything from venture capital funds to timber. He’s been called one of the most talented investors in the world. But lately he’s becoming perhaps even more famous for his advice to individual investors, which he first offered in his 2005 book Unconventional Success. “Invest in nonprofit index funds,” he says unequivocally. “Your odds of beating the market in an actively managed fund are less than 1 in 100.”

And there’s more. A recent entry on the Motley Fool, the popular investment advice website, made the following blanket statement: “Buy an index fund. This is the most actionable, most mathematically supported, short-form investment advice ever.” As long as 10 years ago, in his annual letter to his shareholders, Warren Buffett advised both institutional and individual investors “that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”

One would think, with that kind of advice floating about, that the whole country would by now be in index funds. But in the three decades since Wells Fargo kicked things off, only about 40 percent of institutional money and 15 percent of individuals’ money has been invested in index funds. So why is indexing catching on so slowly?

A big reason, according to Geddes, is that putting investors into index funds is simply not in the interest of the industry that sells securities. “They just won’t accept indexing’s minuscule fees,” he says. By now, most major brokerage firms offer index funds in addition to traditional mutual funds, but money managers typically don’t mention them at all. You usually have to ask about them yourself.

And it makes a certain kind of sense. If a naive investor calls a broker with $100,000 to invest, would the broker be likely to recommend the Vanguard 500 Index with its .19 percent annual fee, of which he receives nothing and collects but a small portion of his firm’s approximately $100 transaction fee? Or might he suggest the client buy Putnam’s Small Cap Growth Fund B Shares, which carry a 2.3 percent annual fee, 1 percent ($1,000) of which goes to him? And will he tell his client about the hidden transaction charges that further reduce the return on investment? It’s simply not to his advantage to do so.

It’s hard to find active fund managers who are willing to talk about these issues. I spoke to several, but no one was comfortable discussing the high cost of their practice, and few were willing to talk on the record. Ron Peyton, president and CEO of Callan Associates, a San Francisco–based institutional investment consulting firm, offered a list of advantages of active management, which essentially boiled down to the fact that it’s more fun. “They can raise and lower cash positions [read: buy and sell whatever stocks excite them at any given moment] and go into fixed-income or foreign securities [read: look for investments wherever they want].” I know from experience that he’s right, but it’s kind of beside the point.

The most forthright comments came from Baie Netzer, a research analyst in the Orinda office of Litman/Gregory Companies, a San Francisco–based investment management firm specializing in mutual funds. Netzer told me outright, “Eighty percent of active managers underperform the market. But we do believe that some managers add value, and those are the ones we look for.” Still, if you factor in fees and transaction costs, you have to wonder how much that remaining 20 percent would slip.

But even if the number of active managers who consistently beat the market is small, Stanford’s Bill Sharpe still sees a real need for their services. While he is a strong partisan of index funds, he is neither as surprised nor as concerned as Geddes that they don’t represent a higher proportion of overall investment. “If you’d told me 35 years ago that indexing would one day represent 40 and 15 percent of investments, I would have asked you what you were smoking,” says the personable Sharpe with his characteristic chuckle. If everyone invested in index funds, he points out, the market itself would die a natural death. “We need active managers,” he says. “It’s buyers and sellers who keep prices moving, which is what drives the market. Index funds simply reflect what the market is doing.” He believes we’d even start to see a decline in market efficiency if index funds rose to 50 percent of total investments.

Does this mean that, when we look at mutual funds, half our options would still be burdened with unconscionable fees and hidden costs? Hopefully not. With the call getting louder from financial experts and industry watchers to reform and regulate mutual funds, it’s hard to believe that the fee system can last much longer, particularly with strong Republican voices like Peter Fitzgerald’s in Congress.

But while Wall Street has considerable soul-searching to do, full blame for the gouging of naive investors does not lie with the investment management industry alone. There is an innate cultural imperative in this country to beat the odds, to do better than the Joneses. In some ways the Leuthold Group was right when it said that index funds are un-American. It’s simply difficult for most of us to accept average returns on our money, or on anything for that matter. The ultimate example of the nation’s attraction to the big score is, of course, right now under our noses. If on August 18, 2004, you had invested $100,000 in Google, that stock would now be worth $550,000. So while evidence mounts that it’s almost impossible to hit the jackpot with cost-burdened mutual funds—and that for every Google, there’s an Enron—we simply refuse to stop trying.

Perhaps Solli and Geddes had it right when they selected the name for their company. The real purpose of this whole revolution is “to make things clear, to reveal the truth.” As Solli puts it, “As long as people know what they’re dealing with, they can invest their money with full awareness. Whether it’s playing it safe with indexing or taking a flier on a hedge fund—at least they’re the ones in control.”

What about hedge funds?
So, the bulk of your savings is safely tucked away in a sensible index fund or two. Why not set aside 5 or 10 percent and take a chance on the post-dot-com insider’s investment craze?

It’s certainly tempting. The most high-profile manager, Edward “Eddie” Lampert, has reportedly earned investors in his ESL Investments hedge fund an average return of 29 percent a year since 1988. After successfully buying Kmart with his investors’ money, Lampert turned the merged retailer around and in 2004 personally took home $1 billion.

Another of the world’s most successful funds is San Francisco’s Farallon Capital Management, which has amassed assets of $12.5 billion over two decades by delivering post-fee returns of 17 percent a year on its flagship fund, according to a 2005 article in Institutional Investor magazine. Forty-eight-year-old Tom Steyer’s investors include universities, pension funds, and individuals; at any one time, the magazine said, the managers there might be nursing 300 to 500 investments in everything from real estate—Farallon recently bought into the Mission Bay development—to international finance.

But the road from Wall Street is scattered with the bones of bitter hedge fund investors. Since 1995, more than 1,800 known hedge funds have folded completely. In the last few months alone, two large funds—MotherRock and Amaranth Advisors—have gone south.

The high failure rate should come as no surprise, given how hedge funds operate. There’s no working model, so they vary widely, but the basic idea is that they rely on risky, untraditional investment strategies—ranging from arbitrage to taking over floundering companies, as Lampert did—to make big money fast. The industry is largely unregulated, and most funds involve private partnerships that operate in strict confidence.

They’re also extremely expensive, which limits their user profile. Though fees average just 2 percent of the investment, the same as in a typical Silicon Valley venture fund, managers also withhold a sizable chunk (averaging 20 percent, but sometimes going as high as 50 percent) of whatever profit the funds produce. The typical minimum required to get into a fund is between $1 million and $5 million.

The SEC periodically considers applying minimal rules to hedge funds, such as prohibiting pension funds from investing in them. Last October, the call for reform came from Congress when Senator Charles Grassley, chairman of the Senate Finance Committee, asked administration officials and Congress members for their views on how to improve hedge fund transparency. But so far, the hedge fund lobby has managed to keep all regulators at bay. —Mark Dowie

What are the fees?
Every fee that a mutual fund charges should be outlined somewhere in its prospectus. But many people don’t even think to look for it, and you can’t necessarily trust your broker to bring it up. “The first step is simply getting people to pay attention to fees,” says Patrick Geddes, chief investment officer of Aperio Group, in Sausalito. Hang tough in asking your broker for the full breakdown of what those fees will cost you each year. If you need help, the National Association of Securities Dealers has a useful tool for computing fees, called the Mutual Fund Expense Analyzer, on its website. You put in the name of the fund, the amount invested, the rate of return, and the length of time you’ve had the fund, and it tells you exactly how much you’ve been charged.

You can also compare past fees for different funds before you invest. For example, if you had put $100,000 into Putnam’s Small Cap Growth Fund Class B Shares and held it for the past five years, you would find that Putnam would have charged you $13,809 in fees during that time. Vanguard’s Total Stock Market Index Fund, on the other hand, would have charged only $1,165 for the exact same investment. —Byron Perry

Which index fund?
In some ways indexing is a no-brainer: invest your money and let it do its thing. Still, there are varieties. Aperio Group’s Patrick Geddes pushes two rules in choosing a fund: “The broader the better, and the cheaper the better.” When you invest in a broad domestic fund, you’re investing in the entire U.S. economy, or “owning capitalism,” as it were, Geddes says. The Vanguard Total Stock Market Index Fund, which represents about 99.5 percent of U.S. common stocks, is a great one to start with. If you choose a narrower fund, like a tech or energy index, you’re basically just speculating (though you’ll most likely still fare better than if you tried to pick the next Google). Narrow index funds also typically command higher fees. With indexing gaining in popularity, everyone’s trying to get into the game and sneak in unnecessarily high fees. Geddes says there’s no good reason to pay more than .19 percent. —Byron Perry


Mark Dowie, who managed the municipal bond portfolio at Bank of America and all nonequity investments for Industrial Indemnity, and advised the Bechtel family on economic and investment strategy, now watches his modest portfolio of index funds grow from his home near Point Reyes Station.

Market Interlude

David R. Kotok
Cumberland Advisors, October 22, 2013



We have entered an interlude between the last incarnation of the budget, debt, debt-limit, and sequester confrontation and the next incarnation of the budget, debt, debt-limit, and sequester confrontation. Let’s think of this commentary as potpourri following “Done Deal.”

Item 1. Katie Darden, editor of SNL Financial, corrected an error that we made. The event we had discussed surrounding Congressman Dan Rostenkowski took place in 1989, not 1979. Here is the link to a Chicago Tribune report of that event: Thank you, Katie, for the correction and for the link so that we may read precisely what citizens can do if they get sufficiently enraged to act.

Item 2. A handful of readers corrected my statement that the Senate had not passed a budget in five years. It has actually been four years. Technically, a budget is passed every time there is a continuing resolution to authorize some spending. I do not know about other readers, but I do not consider that a budget process. I consider that to be an emergency, stop-gap adjustment that is put together because the politicians that we elect have no choice but to do so in order to fund the continuation of government. In fact, you could argue this last budget was not really a fully developed budget.

Item 3. We can witness the disgrace in this process by examining the inclusion of an additional $2.1 billion for the Olmsted Lock and Dam Authority. The developer is URS Corp. This Ohio River project is approaching a cost overrun of four times the original cost estimate. Defenders of the project say it is necessary. Detractors wonder how such earmarking of spending will ever stop. Readers may note that Senator Mitch McConnell says the White House requested the money and argues it was not a “Kentucky kickback” as the conservatives have labeled it. Note that 81 Senators and 285 House Members voted “aye” on the deal. Most of them say they didn’t know the dam-funding extension was in the legislation.

Item 4. Let’s get to the Fed. The debate has swung back to tapering. When, how much, what criteria? We shall know something soon, since the next Fed meeting is at the end of this month. Today’s release of the September employment report is abysmal. It further extends the Fed’s tapering time horizon. The report shows how weak things were before the shutdown. Private sector job growth is declining by many measures; we assume that the shutdown only worsened this trend.

Item 5. Uli Kortsch put together some interviews and is developing a full book sequence from a conference held at the Federal Reserve Bank of Philadelphia. The speakers included Bill Poole, former President of the St. Louis Fed; Lord Adair Turner, former Chair of the British equivalent of the Securities & Exchange Commission; Michael Kumhof of the IMF; Larry Kotlikoff, top economist on intergenerational issues; and economist Jeff Sachs, Director of the Earth Institute at Columbia. I was fortunate to be one of the presenters at that conference. Here is a link to Uli’s video: . The video has excerpts from six presentations, slides, and commentaries. If you have the time to look at it in detail, you might find it worthwhile. For those who would rather have an abbreviated version, here is a link to a conference summary video from the organization that Uli is involved in developing:

Item 6. As we anticipate the next iteration of the debt-limit fight, we can draw some clear conclusions from the last crisis. The US is not going to default. Politicians of both parties have come together and agreed on that. The structure and duration of the government shutdown hurt both political parties. It hurt the Republicans more, but it hurt both of them. The question facing them now is whether the citizens have memories long enough to reach to the next election. That will come in a year. Then we’ll find out who is re-electable.

During this interlude, the ball is back in the Federal Reserve’s court. Congress is going to spend the next couple of months dealing with the crazy crisis-resolution process they worked out. It is timed with precision and is set up to lead to another fierce division of viewpoints. In the meantime, the Fed has to meet. It has to deal once more with the question of tapering or no tapering, in the midst of a change of leadership. It has to evolve some policy that is articulated with clarity. Right now, markets are confused about the Fed. They do not know the direction, depth, or timing of policy. The Fed officials know this and have to fix it.

One thing seems clear. The zero-interest-rate limitation in the short-term end of the yield curve is going to persist for at least another couple of years. It may continue a lot longer. The shock of the US government shutdown and the antics of our politicians have only exacerbated the slowing of the US economy.

What does it mean when the short-term interest rate is zero for a long period of time? It means that asset classes have a long and volatile, but favorable, upward bias. On this subject, here is a three-minute interview by Rhonda Shaffler of Reuters. In it, Rhonda asked me a question about the US stock market and why I think it is going to go higher. Here is the link: .

At this juncture, Cumberland equity accounts are fully and strategically invested around the globe using exchange-traded funds. We think that very-low-interest-rate policies will remain in effect worldwide for some extended period of years. We want to take advantage of them.

Our bond accounts are configured to reflect the duration changes from all of these policy shifts. We are sensitive to credit risk. If we think there is trouble, we want to run fast. The idea is that pressured governments cannot rely on other governments to bail them out. The bailout era, with tons of money thrown precipitously at problems, seems to be drawing to a close. The difference between “bailout” and “bail-in” is a shift of responsibility. Lehman-AIG triggered a bailout. In the next round of trouble, bail-in will mean that risks have risen for the investor. The investor has to perform the risk management now, because the government will not save him or her from the errors that our system is prone to repeat.

We want to thank readers for emails received in response to our commentary entitled “Done Deal!” About 300 responded. To put that into perspective, our primary email list includes approximately 10,000 clients, consultants, referring professionals, and others who request to be on the list. There is no charge to be on the primary list, and people can get on the list by going to our website: . Secondary distribution of our commentaries has been estimated at about 2 million.

A final note is about something which we find disturbing. Fox Business’ Neil Cavuto interviewed John McAfee about data security, hackers and the Obamacare website rollout. McAfee’s expertise is in internet-related security issues and software security. His suggestions are eye-opening and he doesn’t mince words. Here is the YouTube link:


David R. Kotok, Chairman and Chief Investment Officer

‘When Did You Bring Them to Trial?”

Manal Mehta of Sunesis Capital points out this must read transcript from Elizabeth Warren as she makes her debut on Senate Committee on Banking and these notable quotables from Sen. Tim Johnson’s Hearing on Wall Street Reform

‘when did you bring them to trial?” MUST READ – ELIZABETH WARREN MAKES HER DEBUT ON SENATE COMMITTEE ON BANKING – Notable Quotables from Sen. Tim Johnson’s Hearing on Wall Street Reform

WARREN: I want to ask a question about supervising big banks when they break the law, including the mortgage foreclosures, but others as well. You know, we all understand why settlements are important, that trials are expensive and we can’t dedicate huge resources to them. But we also understand that if a party is unwilling to go to trial, either because they’re too timid, or because they lack resources, that the consequence is they have a lot less leverage in all of the settlements that occur.

Now, I know there have been some landmark settlements, but we face some very special issues with big financial institutions. If they can break the law and drag in billions in profits, and then turn around and settle, paying out of those profits, they don’t have much incentive to follow the law.

It’s also the case that every time there is a settlement and not a trial, it means that we didn’t have those days and days and days of testimony about what those financial institutions had been up to.

So the question I really want to ask is about how tough you are about how much leverage you really have in these settlements? And what I’d like to know is, tell me a little bit about the last few times you’ve taken the biggest financial institutions on Wall Street all the way to a trial?



Chairman Curry?

CURRY: To offer my perspective…


CURRY: … of a bank supervisor? We primarily view the tools that we have as mechanisms for correcting deficiencies. So the primary motive for our enforcement actions is really to identify the problem, and then demand a solution to it on an ongoing basis.

WARREN: That’s right. And then you set a price for that. I’m sorry to interrupt, but I just want to move this along.

It’s effectively a settlement. And what I’m asking is, when did you last take — and I know you haven’t been there forever, so I’m really asking about the OCC — a large financial institution, a Wall Street bank, to trial?

CURRY: Well, the institutions I supervise, national banks and federal thrifts, we’ve actually had a fairly fair number of consent orders. We do not have to bring people to trial or …

WARREN: Well, I appreciate that you say you don’t have to bring them to trial. My question is, when did you bring them to trial?

CURRY: We have not had to do it as a practical matter to achieve our supervisory goals.

WARREN: Ms. Walter?

WALTER: Thank you, Senator.

As you know, among our remedies are penalties, but the penalties we can get are limited. And we actually have asked for additional authority — my predecessor did — to raise penalties. But when we look at these issues — and we truly believe that we have a very vigorous enforcement program — we look at the distinction between what we could get if we go to trial, and what we could get if we don’t.

WARREN: I appreciate that. That’s what everybody does. And so, the really asking is, can you identify when you last took the Wall Street banks to trial?

WALTER: I will have to get back to you with the specific information, but we do litigate and we do have settlements that are either rejected by the commission, or not put forward for approval.

WARREN: OK. We’ve got multiple people here. Anyone else want to tell me about the last time you took a Wall Street bank to trial?

You know, I just want to note on this, there are district attorneys and U.S. attorneys who are out there every day squeezing ordinary citizens on sometimes very thin grounds, and taking them to trial in order to make an example, as they put it. I’m really concerned that Too Big Too Fail has become Too Big For Trial. That just seems wrong to me.


If — if I can, I’ll go quickly, Mr. — Chairman

Johnson, I have one more question I’d like to ask and that’s a question about why the large banks are trading at below book value?

We all understand that book value is just what the assets are listed for, what the liabilities are and that most

big corporations trade well above book value. But many of the Wall Street banks right now are trading below book value and I can only think of two reasons why that would be so.

One would be because nobody believes that the banks books are honest or the second would be that nobody believes that the banks are really manageable. That is that they are too complex either for the — their own institution to manage them or for the regulators to manage them.

And so the question I have is what reassurance can you give that these large Wall Street banks that are trading for

below book value. In fact, are adequately transparent and adequately transparent and adequately managed.

Governor Tarullo or (inaudible).

TARULLO: So there — there’s — there’s certainly another reason we might add to your list, Senator Warren, which is investor skepticism as to whether a firm is going to make a return on equity that is in excess of what the investor regards as the — the value of the individual parts.

And so I think what — what you would hear analysts say is that in the wake of the crisis, there have been issues on

just that point surrounding first, what the regulatory environment’s going to be, how much capital’s going to be required, what activities are going to be restricted? What aren’t going to be restricted.

Two, for some time there have been questions about the — the franchise value of some of these institutions. You know the — the crisis showed that some of the so-called synergies were not very synergistic at all and in fact, there really wasn’t the potential at least on a sustainable basis to — to make a lot of money.

I — I think what, though — and — and part of it, I think, it probably just the economic — the – the environment of economic uncertainty.

I think that in some cases, we’ve — we’ve seen some effort to get rid of large amounts of assets at some of the large institutions. It is indirectly in response to just this point, that some of them I think have concluded that they are not in a position to have a viable, manageable, profitable franchise if they’ve got all of the entities that they had before.

And so, a couple of them, as I say, have actually reduced or in the process of reducing their balance sheets.

The other thing I — I would note, is you’re absolutely right about — about the — about the difference there. The difference actually is the economy has been improving and some of the — some of the firms have built up their capital. You’ve seen that difference actually narrowing in — in a number of cases as they seem to have a better position in the view of the market from which to proceed in a — in a more feasible fashion.

WARREN: Good. Well I — I appreciate it and I apologize for going over, Mr. Chairman. Thank you.

Sen. Tim Johnson Holds A Hearing On Wall Street Re.., sked FINAL

2013-02-14 19:29:44.991 GMT


February 14, 2013







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FEBRUARY 14, 2013













































JOHNSON: This committee is called to order.

Before we begin, I would like to extend a warm welcome

to Senator Crapo as ranking member, and to Senator Manchin,

Senator Warren, Senator Heitkamp, Senator Coburn, and Senator

Heller, who are joining this congress. And I would also like

to welcome back my friend, Senator Kirk.

Earlier this week, I released my agenda for this

congress, and I look forward to this committee’s continued

productivity. I’m optimistic that we can work together on a

bipartisan basis. To that end, Ranking Member Crapo and I

sent a letter yesterday to the banking regulators on the

importance of (inaudible) implementing Basel III, and I look

forward to hearing from each of you and working with the

ranking member on this issue.

Today, this committee continues a top priority,

oversight of Wall Street reform implementation. Wall Street

reform was enacted to make the financial system more

resilient, minimize risk of another financial crisis, better

protect consumers from abusive financial practices, and

ensure American taxpayers will never again be called upon to

bail out a failing financial firm.

This morning, we will hear from regulators on how their

agencies are carrying out these mandates of Wall Street

reform. Many of the law’s remaining rulemakings, like QRM and

the Volcker Rule, require careful consideration of complex

issues, as well as interagency and international


I appreciate your efforts to finalize these rules. To date, the regulators have proposed or finalized over three-quarters of the rules required by Wall Street reform. These include rules that have recently gone live in the market, such as the data reporting and registration rules for derivatives that impart new oversight of a previously unregulated market. But there is still more work to do.

JOHNSON: That is why I have asked each of our witnesses to provide a progress report to the committee, both on rulemakings, that your agency has completed, and those that your agency has yet to finalize. I ask that you craft these rules in a manner that is effective for smaller firms like community banks, so that they can continue to make — meet the needs of their customers and communities. The work does not end when the final rules go out the door. Regulators must enforce the rules, and ask that each agency inform us of how they intend to better supervise the financial system. While concerns have been raised about whether a few firms remain too-big-to- fail, Wall Street reform provides regulators with new tools to address the issue head on.

This is one of the many reasons why — why fully implementing the law remains important. Not just for our constituents, but for future generations. As we approach the five year anniversary of the failure of Bear Sterns, we must not lose sight of why we passed Wall Street reform. Congress enacted the law in the wake of the most severe financial crisis in the lifetime of most Americans.

How costly was it? I asked the GAO to study this question to better understand the impact the crisis had on our nation. In a report released just today, which I am entering in the record, the GAO concluded that while the cost — precise cost of this crisis is difficult to calculate, the total damage to the economy may be as high as $13 trillion. I say again, $13 trillion, with a T, dollars. That should urge you to consider the benefits of avoiding another costly, devastating crisis as you continue implementing Wall Street reform. I would like to make one final comment on Director Cordray and the CFPB, since he was appointed as head of the CFPB last year, Director Cordray and the CFPB have worked tirelessly to finalize many rules and policies to protect consumers in areas such as mortgages, student lending, service member rights and credit cards.

They have done good work, and I urge my colleagues to confirm Director Cordray to a full term without delay and allow the CFPB to continue this important work protecting consumers. I now turn to Ranking Member Crapo?


The Good, the Bad, and the Greek (Risks)

The Good, the Bad, and the Greek (Risks)
By John Mauldin
February 6, 2013


Save the Dates: May 1-3
Prisoner of the Bureaucracy
A Deep Sense of Injustice
The Good, the Bad, and the Greek (Risks)
Chris Kyle, R.I.P.



“The euro will not survive the first major European recession.” – Milton Friedman, 1999

“It seems to me that Europe, especially with the addition of more countries, is becoming ever-more susceptible to any asymmetric shock. Sooner or later, when the global economy hits a real bump, Europe’s internal contradictions will tear it apart.” – Milton Friedman, 1999

“… there will be asymmetric shocks hitting the different countries. That will mean that the only adjustment mechanism they have to meet that with is fiscal and unemployment: pressure on wages, pressure on prices.” – Milton Friedman, 1998




“Barry Eichengreen (1990b), in a detailed analysis of the potential lessons for EMU from the U.S. experience, concluded that monetary integration would limit fiscal independence. He argued that the extent of fiscal transfers in the European Union would have to significantly exceed the extent of fiscal transfers in the United States to be successful, as regional shocks were likely to be significantly greater in EMU countries than in the states of the United States.” – From a lengthy (and exhausting) paper at the Econ Journal Watch, analyzing the writing of scores of US economists about the euro from 1989-2002. The paper was humorously titled “It Can’t Happen, It’s a Bad Idea, It Won’t Last: U.S. Economists on the EMU and the Euro, 1989-2002.”

Greece was (and is) the first real test of the euro. Until the Greek crisis, there was no real need for any eurozone country to actually write a check for any other member. Ireland obligingly shouldered the responsibility for its own bad bank debts, paying off mostly German, French, and British bankers. But Greece required someone else to take the losses and write the checks to bail the country out. The European Central Bank had to agree to allow the Bank of Greece to create euros to bail out its banks (with the fig leaf that somehow Greece will pay them back). As the Greek economy collapsed in the aftermath of the recent crisis, it became evident even to European bankers and regulators that Greece could not pay its debt. Money began to flee Greek banks.

Greece is a small country with large implications. Last week we began to explore what I learned from my recent trip to Greece. In this week’s letter we will finish those observations and in particular look at some of the comments from my meetings with over 40 people: owners of small businesses and large ones, billionaires, taxi drivers, politicians, central bankers, investors, ex-patriots, wives, and mothers. I believe we can arrive at some small understanding of the problems Greece faces. Then we will consider the broader consequences for Europe.

Save the Dates: May 1-3

But first, I take great pleasure in announcing the speaker line-up for my 10th annual Strategic Investment Conference, May 1-3. Here they are, in alphabetical order: Kyle Bass, Mohamed El-Erian, Niall Ferguson and his wife, Ayaan Hirsi Ali, Lacy Hunt, Charles and Louis Gave, Jeff Gundlach, Anatole Kaletsky, David Rosenberg, Nouriel Roubini, and Gary Shilling. We are finalizing a few other well-known names as well. Seriously, where else can you see a roster like that? Those who come regularly know that the real value is in meeting the other attendees. The conference is cosponsored by my longtime partner Altegris Investments.

Invitations have been sent out to past attendees and those who are members of the Mauldin Circle. We are now going to open up registration. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business.

If you think you should have had an invitation or missed it, call or write your Altegris representative. Otherwise, you can start the process by going to http://meetings.StrategicInvestmentConference10. There is a significant early-bird registration discount. The conference always sells out in a few weeks, so I suggest you register at your earliest convenience.

Prisoner of the Bureaucracy

As I noted last week, I visited Athens with my friend Christian Menegatti, who is head of research for Roubini Global Economics. Between the two of us, we stayed very busy with meetings. Below is some of what I learned. (I will put generalized quotes in italics, and the commentary after them will be mine.) Let’s start by recalling the story we finished with last week:

The next night offered quite a contrast. In the evening we walked to the base of the Acropolis, found what looked like a promising venue, and entered. It was early by Greek standards, but a performer was playing a guitar and singing Greek tunes to a table of six (ahem) older gentleman, clearly old friends eating and drinking together. (Later we found out they had been gathering once a month like this for 20 years.) As the evening went on and the wine kept flowing, they began to sing. A second guitar appeared. The aromatic cigars came out and were smoked directly beneath the no-smoking sign, with no sense of irony. One patrician gentleman stood a few times to have his picture taken with locals who dropped by that evening.

The singer sang on for three hours without a break, clearly into the moment. Evidently, you cannot sing certain songs without using your arms. At first it was just one participant providing the counter-melody, but then others joined in a multi-part chorus of practiced harmony.

The young owner of that tavern came by, and we started out as we had the night before, asking questions. When he found out what we were looking for, he went to the table and pulled one of the elderly gentlemen away and introduced us. It turned out that he was an economic journalist and chairman (emeritus) of a Greek journalism society. I quickly borrowed a pen and began to take notes on a paper placemat.

He was an odd mixture of pessimism and hope, a perfect living metaphor for what I found from top to bottom in Greece. This was the best government he had seen in his life: “I trust this government.” But when asked if he was optimistic, he shook his head wearily and said no. When we pressed him as to why – and we had heard variations on this throughout the trip – he said, “The government is the prisoner of the bureaucracy. We have 4,021 associations and 6,200 codes. You simply cannot change things. There are 600,000 tax elements. No one really knows who pays what.”

Another of the gents added, “The problem is a problem of laws: you get new laws and yet the old laws don’t go away; who knows what to do? If you don’t know what laws to follow, that becomes the biggest problem. Actually there are two problems: the number-one biggest problem in Greece is the legal system – there is no rule of law. Number two, the legal system is slow; you can’t get a ruling.” A lot of heads nodded in agreement with this statement.

The first guy continued, “Remember the spectacle a few years ago, when a new government came in and found massive debts and accounting irregularities? They blamed all the problems on the old government as they negotiated for new loans from the EU. Of course, the people they were blaming were bureaucrats they themselves had appointed, the last time they were in power.

“The government still to this day does not know how money is spent. They will try to change. But even if they pass new laws, under the rules a minister does not have to enforce them.”


Seven Varieties of Deflation

A Little Chronic Deflation
John Mauldin
October 13, 2012



One of the questions I (and other analysts) get asked most frequently is whether I think there is deflation or inflation in store for the US. My quick answer is “Yes.” A brief answer is that we are in a deflationary period and have been for over 30 years, but like all cycles it will come to an end. A great deal of the “when” depends on how the US deals with its deficit following the election. If we put the US on a realistic glide path to a balanced budget (over time) then that deflationary impulse will last longer than most observers think, even given QE3+++. If we do not deal with the issue, and try once again to kick the can to the next election, inflation could be a very real problem.

But one of the definitive experts on the question, and someone who has taught me a great deal over the years, is Dr. Gary Shilling, who has literally written the book (several, actually) on deflation. This week he summarizes a recent client letter for our Outside the Box, and I think you’ll will find stimulating. His is not the consensus view, but it’s one we need to understand.

You can subscribe to Gary Shilling’s Insight for the special introductory rate of $275 for Outside the Box readers (email delivery) and get a copy of the full Insight report excerpted here plus a copy of Gary’s latest book, Letting Off Steam, a collection of his commentaries on matters great and small, complex and mundane, serious and frivolous.

Gary will be writing about the details of who will be winners and losers in the Fed’s QE3 program, how overseas economies are faring, and what it all means for US stocks and the American economy. To subscribe to Insight call them at 888-346-7444 or 973-467-0070 and be sure to mention you read about the offer here.

This has been an interesting week. I was supposed to speak at a client meeting for Common Sense Investments at noon on Wednesday in Portland. Kyle Bass of Hayman Advisors was also speaking, so he graciously offered to let me fly with him in his plane rather than catching a redeye the night before. I got up early and made it to the hangar, but the plane had a mechanical problem. A quick call to American Airlines and a mad dash to the airport got me on a scheduled flight that would have gotten me in on time. Except that flight too had issues and the other flights were booked solid. An extremely helpful staff member at American somehow sorted it out and got me onto a full flight (with wifi!) and into Portland in time to let me give a speech as the “closer” for the day. Meanwhile, Kyle was in Chicago and found another way to get to Portland. The other speaker had a personal tragedy to deal with and couldn’t make it; so I called my old friend Ed Easterling, who lives not far from Portland, and he kicked the meeting off with his usual dynamic presentation while the rest of us figured out how to get there.

The next day, the founder of Common Sense Investments, Jim Bisenius, took us to his 36,000 acre ranch (and wildlife preserve) in Eastern Oregon to do a little hunting and fishing. It is a rather amazing place. He is such a gracious host and has a gift for getting people to tell their stories. Kyle brought along a young man who had been Special Operations in Iraq and who now carries around about four pounds of metal from a IED that can’t be gotten out of him. He’s in quite a lot of chronic pain but is rather cheerful and can tell some pretty amazing stories. It makes me humble to realize what sacrifices people make for our freedoms. The courage he and his brethren display on a regular basis is inspiring. I simply stand in awe and gratitude.

I was able to hitch a ride back to Dallas, got in late, got up the next morning, taped videos and read some emails, and then hopped another plane to Houston, where I am getting ready to go to my 40th Rice University class reunion. I am sure it will be another night of old friends and great stories, so I think I will hit the send button and go on to the party. Have a great week!

Your rather amazed at how much fun I get to have analyst,

(Even more amazing is that I get paid for this!)

John Mauldin, Editor
Outside the Box

Seven Varieties of Deflation

By Dr. A. Gary Shilling

Inflation in the U.S. has historically been a wartime phenomenon, including not only shooting wars but also the Cold War and the War on Poverty. That’s when the federal government vastly overspends its income on top of a robust private economy—obviously not the case today when government stimulus isn’t even offsetting private sector weakness. Deflation reigns in peacetime, and I think it is again, with the end of the Iraq engagement and as the unwinding of Afghanistan expenditures further reduce military spending.

Chronic Deflation

Few agree with my forecast of chronic deflation. They’ve never seen anything but inflation in their business careers or lifetimes, so they think that’s the way God made the world. Few can remember much about the 1930s, the last time deflation reigned. Furthermore, we all tend to have inflation biases. When we pay higher prices, it’s because of the inflation devil himself, but lower prices are a result of our smart shopping and bargaining skills. Furthermore, we don’t calculate the quality-adjusted price declines that result from technological improvements in many big-ticket purchases. This is especially true since many of those items, like TVs, are bought so infrequently that we have no idea what we paid for the last one. But we sure remember the cost of gasoline on the last fill-up a week ago.


Furthermore, many believe widespread deflation is impossible and that rampant inflation is assured in future years because of continuing high federal deficits, regardless of any long-run budget reform. And annual deficits of over $1 trillion are likely to persist in the remaining five to seven years of deleveraging, as I explain in my recent book, The Age of Deleveraging. The 2% annual real GDP growth I see persisting is well below the 3.3% needed to keep the unemployment rate stable. So to prevent high and chronically rising unemployment, any Administration and Congress—left, right or center—will be forced to spend a lot of money to create a lot of jobs.

But big federal deficits are inflationary only when they come on top of fully-employed economies and create excess demand. That’s obviously not true at present when large deficits are reactions to private sector weakness that has slashed tax revenues and encouraged deficit spending. Indeed, the slack in the economy in the face of persistent trillion dollar-plus deficits measures the huge size and scope of the offsetting deleveraging in the private sector, as noted earlier.

The deleveraging, especially in the global financial sector and among U.S. consumers, will be completed in another five to seven years at the rate it is progressing. At that point, the federal deficit should fade quickly, assuming a war or other cause of oversized government spending doesn’t intervene. The resumption of meaningful economic growth will reduce the pressure for economic stimuli and rising incomes and corporate profits will spur revenues. Serious work on the postwar baby-related bulge in Social Security and Medicare costs will also depress the deficit.

Good Deflation

A decade ago in my two Deflation books, I distinguished between two types of deflation—the Good Deflation of excess supply and the Bad Deflation of deficient demand. Good Deflation is the result of important new technologies that spike productivity and output even as the economy grows rapidly. Bad Deflation results from financial crises and deep recession, which hype unemployment and depress demand.

I’ve been forecasting chronic good deflation of excess supply because of today’s convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output. Ditto for the globalization of production and the other deflationary forces I’ve been discussing since I wrote the two Deflation books and The Age of Deleveraging. As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. The rapid productivity growth so far this decade is likely to persist (Chart 1).

While I’ve consistently predicted the good deflation of excess supply, I said clearly that the bad deflation of deficient demand could occur—due to severe and widespread financial crises or due to global protectionism. Both are now clear threats.

My forecast is that the unfolding global slump will initiate worldwide chronic deflation. A number of indicators point in that direction. Sure, much of the recent weakness in the PPI and CPI has been due to falling energy and food prices. Excluding these volatile items, prices are still rising but at slowing rates (Charts 2 and 3). Consumer price inflation is also falling abroad in the U.K. and the eurozone.


5 Theories Why Romney Won’t Release His Tax Records

Invictus here.

Mitt Romney didn’t have a very good week. When the Romney Campaign releases his 2011 taxes as a subject-changer, it’s a safe bet that things haven’t been going swimmingly.

Let’s oblige them by wading into this tax story.

Here is what we know: GOP candidate Mitt Romney has released his two most recent tax returns. According to Politifact, that’s far fewer than most presidential candidates disclose. As an example, Romney’s father, George, had released 12 years of tax returns. He has steadfastly refused to release the rest, despite being goaded by many players — not just Democrats and media pundits, but by members of the GOP establishment as well. Regardless, he has not been very forthcoming.

Why has he refused? There are no good answers, only speculations. Given that not releasing additional tax docs has cost Romney politically only increases the arm chair hypothesizing. All summer, the incumbent has battered the challenger on this (and related issues). Romney’s approval ratings have been hurt. His refusal is helping to coalesce a detrimental media narrative: There are different rules for people of privilege than for the rest of the country, and Romney has taken advantage of them. These week’s 47% gaffe only plays into that same narrative.

While the Obama ads have been politically effective, it’s been even more surprising that there has not been a successful counter from the GOP candidate. Romney was even vetted as a Veep candidate in 2008 by the McCain camp, where they ostensibly saw his tax records. McCain himself said Romney provided 20 years of records, and has paid his taxes . . . but then again, he passed over Romney for Sarah Palin as Veep.

The Obama campaign has offered to drop the issue if Romney releases just 5 years of tax docs. Still, the Romney camp has refused.

All of these minor sleights and unanswered accusations have led to a cottage industry of imagining what secrets might be hidden in these tax records. We do not know, but we can use some deductive reasoning to come up with some reasonable theories as to why Romney won’t share with voters what he showed the McCain camp (or perhaps, what took place post-McCain).

Here are our 5 top contenders:

1) 0% Tax Rates: The released tax documents show a very low tax rate, and Romney has said he never paid less than a 13% rate over the past 10 years. However, its not inconceivable that through a combination of aggressive tax planning, use of Trusts, earned income carry forwards and use of tax havens like Switzerland, Lichtenstein, Cayman Islands and Bermuda, Romney may have paid no taxes whatsoever in 2009 and years prior. His advisors may have correctly surmised this would be fatal to his Presidential aspirations.

Since I began composing this post, the Romney campaign has released a letter from his accountants to the effect that, over the period reviewed, the Romneys’ lowest tax rate was 13.66 percent (though there was a bit of numerical gymnastics to make that true in 2011). Note that Romney’s letter from PricewaterhouseCoopers discusses “adjusted gross income” — not total income; this subtle difference has already been debunked.

Not surprisingly in the post-Enron, post-WorldCom world, the word of an accountant ain’t worth the pixels used to write it. And, if it’s true, why not just get them out there and be done with with?

Well, maybe it’s:

2) Voter FraudThe Guardian and others came up with an even simpler theory: That Romney has voted in a state in which he was not technically a resident (i.e. voting in Massachusetts when he was actually a resident of California).

I first saw this in Forbes, which mentioned that “Romney appears to have escaped relatively unsinged from the apparently unrelated revelation that he may have committed voter fraud in January 2010, when – despite not owning a house in Massachusetts and having given every appearance of having moved to California…”

3) Broken Tax Laws: Personally, I assign this a very low to moderate probability. However, without releasing his returns, Romney leaves himself open to speculation that he may perhaps have crossed a line and submitted returns that are somehow numerically fraudulent and/or otherwise illegal (separate and apart from the aforementioned address issue).

BR has raised the issue of Romney’s IRA. William Cohan at Bloomberg has also wondered how he was able to legally amass $102 million in his individual retirement account — tax free! — during the 15 years he was at Bain Capital, despite contribution limits that would seem to make that all but impossible. What sort of rate of return is that, anyway?

Regarding the IRA contributions, Victor Fleischer, Professor of Law at University of Colorado is rather blunt: “Bottom line: Mitt Romney has not paid all the taxes required under law.”

Beyond that, it’s possible he is:


Mankiw’s Ode to the Governmental Competition that Made Romney Wealthy

Mankiw’s Ode to the Governmental Competition that Made Romney Wealthy
By William K. Black




This is the second part of my discussion of N. Gregory Mankiw’s column asserting that governmental competition is desirable for the same reason that private competition is.  Mankiw was Chairman of President Bush’s Council of Economic Advisors from 2003-2005.  He was one of the principal architects of the perverse incentive structures that proved so criminogenic and drove the ongoing financial crisis.  He gave no useful warnings of the necessity for containing the developing crisis – even after the FBI’s September 2004 warning that mortgage fraud was become “epidemic” and would cause a financial “crisis” if it were not contained.  He is now Mitt Romney’s principal economic advisor.  His column favors the “competition” argument that led him to support crippling financial regulation even as private sector competition led to endemic fraud.  Mankiw is a moral failure as well as a failed economist.  His infamous response to Akerlof and Romer’s 1993 paper (“Looting: the Economic Underworld of Bankruptcy for Profit”) was that it would be “irrational” for CEOs not to loot “their” corporations.  He ignored all of the prescient warnings we made about how accounting control fraud drove our crises and he continues to ignore those warnings and the reality of our recurrent, intensifying financial crises.  He wants the U.S. to move even more rapidly downward in the “competition in regulatory laxity” that is driving those crises.


Mankiw is serving as Romney’s propagandist in chief.  He is writing columns trying to defend Romney’s vulnerabilities, e.g., claiming that Romney should pay a marginal income tax rate that is lower than the marginal rate his secretary pays.  In the column I am responding to, Mankiw chose this frame for his analysis:  “SHOULD governments — of nations, states and towns — compete like business rivals?” (The capitalization is in the original.)  He answered his question in this self-referential manner.

“[K]nowing that I have to keep up with the Paul Krugmans and the Glenn Hubbards of the world keeps me on my toes. It makes me work harder, benefiting the customers — in this case, students. The upshot is that competition among economics textbooks makes learning the dismal science a bit less dismal.

For much the same reason, competition among governments leads to better governance.”

The title of Mankiw’s article reflects his claim:  “Competition Is Healthy for Governments, Too.”

It is inevitable that Mankiw thinks that competition makes his textbook superior.  I leave analysis of that claim to future columns to be written with the aid of readers.  I am announcing a competition among readers of our New Economic Perspectives blog at UMKC.  I will provide “Mankiw Mendacity and Morality” t-shirts to the providers of the three top suggestions from readers of our blog (and Mankiw’s textbook) for the worst predictive and policy follies contained in that textbook.  See details on our website.

Suffice it to say here that Mankiw’s belief that his ability to sell a textbook famous for its failed predictions and theories demonstrates the success of private markets in helping students learn actually constitutes proof of the market’s folly.

This column represents the second part of my discussion of his claim that the public and private sectors are sufficiently similar that competition in both sectors benefits the public.  All three premises are overstated and frequently false.  It is not true that competition in the private sector is unambiguously socially desirable.  It is not true that completion in the public sector is typically desirable.  (That will be the subject of the third part of my discussion of Mankiw’s ode to governmental competition.)  It is not true that the public and private sectors are typically sufficiently comparable that they should be run under the same governance principles.  Mankiw also ignores the destructive interaction effects of encouraging unrestrained public and private sector competition.  (Those claims will be the subject of the fourth and fifth parts of my discussion.)  I argue that competition in the public sector is generally a grave error and that competition in the private sector has become increasingly harmful because regulation and law enforcement has been crippled by Mankiw’s policy of encouraging “competition in laxity.”

Mankiw conflates “choices” with “competition” when he discusses government.  We may benefit from the ability of a federal system to have what Justice Brandeis referred to as laboratories for experimentation.  The competitive dynamic, however, is frequently harmful in government.

Government is not just like business and governmental competition is often harmful


Determining whether competition among governments is desirable as Mankiw argues requires us to examine the areas and manners in which governments compete.  I start with a fundamental duty of government (as many governmental leaders have conceived the task) – national security and conquest.  Some governments seek to conquer other nations or regions and seize wealth, people, and power.  Each of the nations that is currently a major power, and was previously a major power over the last 300 years has engaged in conquest as a major function.  Nations (and, in civil wars, rival governments) engaged in armed struggle are engaged in the ultimate form of competition.  Even when wars are fought with restraints they are vicious.  The explicit goal in less restrained wars is to ensure that the competition ends.  The rival nation and people are destroyed.  Carthago delenda est (Carthage must be destroyed) is the famous cry.  (Mankiw’s version of Cato the Elder’s murderous demand would be “financial regulation must be destroyed.”)  The “competitor’s” people are annihilated in a genocidal fury or their cities razed and their populations sold into slavery.  Terror is a common tactic of governments, failed states such as Afghanistan under the Taliban, and would be-state actors such as the IRA “competing” with nation states.   Woman and children are often targets.  Rape is common and sometimes a deliberate tactic.  Torture and atrocities are common.  Mass deaths and maiming are expected.

Competition in the run-up to war, or the effort to deter war, is also typically destructive from an overall societal standpoint.  We engage in arms races and battleship races that lead to a waste of resources whether or not the war occurs.  The opportunity costs of taking many of our brightest thinkers and skilled engineers out of inventing, developing, and manufacturing useful goods and services and diverting them to figuring out clever means to maim and kill is severe.

Some nations and proto-national movements engage in warfare by non-traditional means.  They launch cyber attacks, counterfeit other nation’s currencies, and kidnap foreign nationals to trade them for cash and weapons.  They sell illegal drugs or counterfeit goods to fund their efforts.

Governmental military competition is a leading cause of death and misery.  This competition can be seen as essential from the standpoint of individual nations, but it is, net, a social catastrophe.  It threatens our survival as a species given weapons of mass destruction.  It is not “healthy.”

Economic “War”

Some nations compete economically by theft.  One form is the theft of intellectual property by conventional means, but nations also use their intelligence services to steal trade secrets and learn about other nations’ secret international trade bargaining positions.  They suborn foreign nationals as secret assets who will betray their nation’s interests.   Another form of economic warfare is factory fishing.  This can produce over-fishing and habitat destruction that can permanently destroy other nations’ traditional fishing industries.  Nations and their businesses compete with other nations and their businesses (an example of the interaction of public and private competition) for exports by bribing foreign nationals (particularly government officials).


Charles Munger: A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business

I’m going to play a minor trick on you today because the subject of my talk is the art of stock picking as a subdivision of the art of worldly wisdom. That enables me to start talking about worldly wisdom—a much broader topic that interests me because I think all too little of it is delivered by modern educational systems, at least in an effective way.

And therefore, the talk is sort of along the lines that some behaviorist psychologists call Grandma’s rule after the wisdom of Grandma when she said that you have to eat the carrots before you get the dessert.

The carrot part of this talk is about the general subject of worldly wisdom which is a pretty good way to start. After all, the theory of modern education is that you need a general education before you specialize. And I think to some extent, before you’re going to be a great stock picker, you need some general education.

So, emphasizing what I sometimes waggishly call remedial worldly wisdom, I’m going to start by waltzing you through a few basic notions.

What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form.

You’ve got to have models in your head. And you’ve got to array your experience—both vicarious and direct—on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head.

What are the models? Well, the first rule is that you’ve got to have multiple models—because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models, or at least you’ll think it does. You become the equivalent of a chiropractor who, of course, is the great boob in medicine.

It’s like the old saying, “To the man with only a hammer, every problem looks like a nail.” And of course, that’s the way the chiropractor goes about practicing medicine. But that’s a perfectly disastrous way to think and a perfectly disastrous way to operate in the world. So you’ve got to have multiple models.

And the models have to come from multiple disciplines—because all the wisdom of the world is not to be found in one little academic department. That’s why poetry professors, by and large, are so unwise in a worldly sense. They don’t have enough models in their heads. So you’ve got to have models across a fair array of disciplines.

You may say, “My God, this is already getting way too tough.” But, fortunately, it isn’t that tough—because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And, of those, only a mere handful really carry very heavy freight.

So let’s briefly review what kind of models and techniques constitute this basic knowledgethat everybody has to have before they proceed to being really good at a narrow art like stock picking.

First there’s mathematics. Obviously, you’ve got to be able to handle numbers and quantities—basic arithmetic. And the great useful model, after compound interest, is the elementary math of permutations and combinations. And that was taught in my day in the sophomore year in high school. I suppose by now in great private schools, it’s probably down to the eighth grade or so.

It’s very simple algebra. It was all worked out in the course of about one year between Pascal and Fermat. They worked it out casually in a series of letters.

It’s not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it’s fundamental truth. So you simply have to have the technique.

Many educational institutions—although not nearly enough—have realized this. At Harvard Business School, the great quantitative thing that bonds the first-year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They’re amazed to find that high school algebra works in life….

By and large, as it works out, people can’t naturally and automatically do this. If you understand elementary psychology, the reason they can’t is really quite simple: The basic neural network of the brain is there through broad genetic and cultural evolution. And it’s not Fermat/Pascal. It uses a very crude, shortcut-type of approximation. It’s got elements of Fermat/Pascal in it. However, it’s not good.

So you have to learn in a very usable way this very elementary math and use it routinely in life—just the way if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn—to have a certain grip and swing in a different way to realize your full potential as a golfer.

If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an asskicking contest. You’re giving a huge advantage to everybody else.

One of the advantages of a fellow like Buffett, whom I’ve worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations….

Obviously, you have to know accounting. It’s the language of practical business life. It was a very useful thing to deliver to civilization. I’ve heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention.

And it’s not that hard to understand.

But you have to know enough about it to understand its limitations—because although accounting is the starting place, it’s only a crude approximation. And it’s not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn’t make it anything you really know.

In terms of the limitations of accounting, one of my favorite stories involves a very great businessman named Carl Braun who created the CF Braun Engineering Company. It designed and built oil refineries—which is very hard to do. And Braun would get them to come in on time and not blow up and have efficiencies and so forth. This is a major art. And Braun, being the thorough Teutonic type that he was, had a number of quirks.

And one of them was that he took a look at standard accounting and the way it was applied to building oil refineries and he said, “This is asinine.”

So he threw all of his accountants out and he took his engineers and said, “Now, we’ll devise
our own system of accounting to handle this process.” And in due time, accounting adopted a lot of Carl Braun’s notions.
So he was a formidably willful and talented man who demonstrated both the importance of accounting and the importance of knowing its limitations.

He had another rule, from psychology, which, if you’re interested in wisdom, ought to be part of your epertoire—like the elementary mathematics of permutations and combinations.

His rule for all the Braun Company’s communications was called the five W’s—you had to tell who was going to do what, where, when and why. And if you wrote a letter or directive in the Braun Company telling somebody to do something, and you didn’t tell him why, you could get fired. In fact, you would get fired if you did it twice.

You might ask why that is so important? Well, again that’s a rule of psychology. Just as you think better if you array knowledge on a bunch of models that are basically answers to the question, why, why, why, if you always tell people why, they’ll understand it better, they’ll consider it more important, and they’ll be more likely to comply. Even if they don’t understand your reason, they’ll be more likely to comply.

So there’s an iron rule that just as you want to start getting worldly wisdom by asking why, why, why, in communicating with other people about everything, you want to include why, why, why. Even if it’s obvious, it’s wise to stick in the why.

Which models are the most reliable? Well, obviously, the models that come from hard science and engineering are the most reliable models on this Earth. And engineering quality control—at least the guts of it that matters to you and me and people who are not professional engineers—is very much based on the elementary mathematics of Fermat and Pascal:

It costs so much and you get so much less likelihood of it breaking if you spend this much. It’s all elementary high school mathematics. And an elaboration of that is what Deming brought to Japan for all of that quality control stuff.

I don’t think it’s necessary for most people to be terribly facile in statistics. For example, I’m not sure that I can even pronounce the Poisson distribution. But I know what a Gaussian or normal distribution looks like and I know that events and huge aspects of reality end up distributed that way. So I can do a rough calculation.

But if you ask me to work out something involving a Gaussian distribution to ten decimal points, I can’t sit down and do the math. I’m like a poker player who’s learned to play pretty well without mastering Pascal.

And by the way, that works well enough. But you have to understand that bellshaped curve at least roughly as well as I do.

And, of course, the engineering idea of a backup system is a very powerful idea. The engineering idea of breakpoints—that’s a very powerful model, too. The notion of a critical mass—that comes out of physics—is a very powerful model.

All of these things have great utility in looking at ordinary reality. And all of this cost-benefit
analysis—hell, that’s all elementary high school algebra, too. It’s just been dolled up a little bit with fancy lingo.

I suppose the next most reliable models are from biology/ physiology because, after all, all of us are programmed by our genetic makeup to be much the same.

And then when you get into psychology, of course, it gets very much more complicated. But it’s an ungodly important subject if you’re going to have any worldly wisdom.

And you can demonstrate that point quite simply: There’s not a person in this room viewing the work of a very ordinary professional magician who doesn’t see a lot of things happening that aren’t happening and not see a lot of things happening that are happening.

And the reason why is that the perceptual apparatus of man has shortcuts in it. The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren’t there.

Now you get into the cognitive function as distinguished from the perceptual function. And there, you are equally—more than equally in fact—likely to be misled. Again, your brain has a shortage of circuitry and so forth—and it’s taking all kinds of little automatic shortcuts.

So when circumstances combine in certain ways—or more commonly, your fellow man starts acting like the magician and manipulates you on purpose by causing your cognitive dysfunction—you’re a patsy.

And so just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations. And this knowledge, by the way, can be used to control and motivate other people….

So the most useful and practical part of psychology—which I personally think can be taught to any intelligent person in a week—is ungodly important. And nobody taught it to me by the way. I had to learn it later in life, one piece at a time. And it was fairly laborious. It’s so elementary though that, when it was all over, I felt like a fool.

And yeah, I’d been educated at Cal Tech and the Harvard Law School and so forth. So very eminent places miseducated people like you and me.

The elementary part of psychology—the psychology of misjudgment, as I call it—is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.

Terribly smart people make totally bonkers mistakes by failing to pay heed to it. In fact, I’ve done it several times during the last two or three years in a very important way. You never get totally over making silly mistakes.

There’s another saying that comes from Pascal which I’ve always considered one of the really accurate observations in the history of thought. Pascal said in essence, “The mind of man at one and the same time is both the glory and the shame of the universe.”

And that’s exactly right. It has this enormous power. However, it also has these standard misfunctions that often cause it to reach wrong conclusions. It also makes man extraordinarily subject to manipulation by others. For example, roughly half of the army of Adolf Hitler was composed of believing Catholics. Given enough clever psychological manipulation, what human beings will do is quite interesting.


Is Decoupling Possible in a Global Economy?

Factors and their impact on Monetary Policy
the Economy, and Financial Markets
Investment letter – January 13, 201


Is Decoupling Possible in a Global Economy?

An improvement in U.S. economic data in the fourth quarter has convinced many investment strategists that the U.S. will continue to grow 2% to 3% in 2012, absent a Lehman Brothers type of crisis in Europe. After all, U.S. GDP growth likely exceeded 3% in the fourth quarter, while Europe was slipping into recession, and China’s growth throttled down 8% to 9%. Further evidence can be found in how equity markets performed around the world in 2011. In the U.S., the DJIA was up 5.5%. In Europe: Germany -14.6%, France -16.9%, Italy -25.2%, Spain -13.1%, Portugal -27.6%, Greece -51.8%. In Asia: South Korea -10.9%, Australia -14.5%, Singapore -17.0%, Japan -17.3%, Hong Kong -19.9%, China -21.6%, India -24.6%. In South America: Brazil -18.1%.

Hardly a day passes that a strategist or expert on a financial news broadcast doesn’t remind viewers that the stock market is always looking out six to twelve months, which is why it is a discounting mechanism. We’re told the market anticipates events like recessions, recoveries, and decoupling far better than we mere mortals. If the market does indeed peer into the fog of the future, the U.S.’s outperformance in 2011 should provide investors comfort about the next six to twelve months, right? As we have discussed on a number of occasions, we do not believe the stock market is a discounting mechanism, which anticipates economic events, i.e. recessions and recoveries. For instance, in March 2000, was the Nasdaq Composite telling us that the New Paradigm in technology would continue, so there was no need to worry, just be happy? At the top in October 2007, were the market’s tea leaves suggesting that the credit crisis would be contained, so there would be no recession, as most strategists and advisors believed? And, in March 2009, when the market indicated that the sky was indeed falling, were most strategists and advisors justified in being negative, because the market was plumbing new lows?

The majority of strategists and advisors who believe the ‘market is a discounting mechanism’ axiom can be compared to car drivers who navigate their way by looking in the rear view mirror. If the markets are consistent in at least one facet, it is they always take the long and winding road. When a majority of drivers peer into their rearview mirror and reflect on how lovely the drive has been, they won’t notice their car has left the road until it is airborne and in free fall. Of course, the opposite occurs at market bottoms. Drivers only see potholes and ditches in the rearview mirror, and feel as if they’ve been driving in the Baja 500 without shock absorbers forever. At every market top and bottom, the market is wrong. Not convinced? Just ask all those folks who bought condos in Florida, Nevada, and Arizona in 2006! For all our intelligence, we humans are too often induced to become herded by the newest craze, or an investment that seems to offer a sure fire path to riches. Whenever a herd mentality takes over, i.e. technology stocks in 2000 or housing in 2006, separating from the crowd is really difficult. But that’s what makes contrary opinion, one of the more powerful investment tools, and far more valuable than believing the market is a discounting mechanism.


Germany is the largest economy in the European Union and derives more than 35% of its GDP from exports. In the last five years, more than half of its growth in GDP has come from a surge in exports. This growth was largely the result of productivity gains relative to other countries in the EU. In effect, as the low cost producer, Germany became the China of the European Union.

This productivity edge has lowered Germany’s unemployment rate from 9.6% at the end of 2006, to 6.8% in December, the lowest since 1991. In contrast, since the end of 2006, the rate of unemployment in France has risen to 9.8% from 8.9. The combined unemployment rate for the 10 periphery countries has soared from 7.4% at the end of 2006 to 15.2% in October. Italy’s unemployment rate reached 8.6% in November, but for those under age 24 it was over 30%. Greece’s overall unemployment rate is over 18%, and in Spain it is almost 23%.

The differential in unemployment rates between members of the European Union underscores one of the major structural problems that will be painful to correct, and potentially socially unacceptable. Labor comprises 60% to 70% of the cost of goods. In order for the countries with high unemployment rates to be able to compete with Germany and globally, they must lower their production costs by 10%, 20% or even 30%. If the Italian Lira was still Italy’s currency, Italy could devalue the Lira by 20% and immediately lower its cost of production and increase its competitiveness within the E.U. and worldwide. This option is not available since Italy’s currency is the Euro. For Italy, and every other EU member country that has a cost of goods problem, the Euro is an albatross. In order to increase their competiveness, the workers in each country must accept a significant decline in wages in order to lower their country’s cost of production. This ‘internal devaluation solution’ not only creates a burden for the workers involved, but it also creates social and budgetary problems for Italy, Greece, and any other country in the E.U. that is uncompetitive. If a worker has less income, they have less income to spend and will pay less in taxes. In order for Greece and Italy to reduce their excessively high debt to GDP ratios, they need strong economic growth, and more workers paying taxes on rising wages. Obviously, this austerity ‘solution’ will not work, as workers unite, and launch labor strikes that will result in more social disorder in coming years.

The flags represent the US, Japan, Germany, France, Britain, Portugal, Italy, Ireland, Greece, and Spain.

The diminishing level of productivity in Greece and Italy over the last five years is a bit like rust. And, as we all know, rust never sleeps. Like many other developed nations, Italy was also affected by China’s emergence, and a lack of energy independence that became more costly as oil prices rose. Rather than adopting policies to address their weaknesses, both countries borrowed money on the back of low borrowing costs afforded members of the European Union, made even cheaper by a strengthening Euro. Greece is small enough to force private holders of its debt to accept a ‘voluntary’ haircut of 50% on their Greek bond holdings. This could lower Greece’s total indebtedness of $450 billion by about 30%. This will help. But, given Greece’s cost of borrowing and its shrinking economy, a default seems a foregone conclusion. There is also the possibility that some of the private holders of Greek bonds will not go along with the 50% haircut, since the ECB is scheduled to receive the full face value of their Greek bonds. Should private holders not go along with the current ‘voluntary’ haircut plan, a default by Greece could be triggered by March 20.


Changing the Rules in the Middle of the Game

Changing the Rules in the Middle of the Game
By John Mauldin
November 25, 2011


Changing the Rules
When Even Germany Fails
European Inverted Yield Curves
Time to Review the Bang!Moment
The Risk of Contagion in the US
Time to Start Watching China
New York, China, and Some Links

Angela Merkel is leading the call for a rule change, a rewiring of the basic treaty that binds the EU. But is it both too much and too late? The market action suggests that time is indeed running out, and so we’ll look at the likely consequences. Then I glance over the other way and take notice of news out of China that may be of import. Plus a few links for your weekend listening “pleasure.” There is lots to cover, so let’s get started.

Changing the Rules

I have been writing for a very long time about the changes needed to the EU treaty if Europe is to survive. Specifically, last week I noted that Angela Merkel has made it clear that the independence of the ECB must not be compromised. This week Sarkozy and the new prime minister of Italy, Mario Monti, agreed to stop their public calls for such changes (at least until their own crises get even worse, would be my guess). And Merkel has called for a new, stronger union with strict control of budgets as the price for further German aid for those countries in crisis. In seeming response:

“The European Commission on November 23 proposed a new package including budget previews at EU level, the establishment of independent fiscal councils and growth forecasts, closer surveillance of bailout recipients and a consultation paper on Eurobonds. There is also a growing consensus among EU policy makers on the need for the adoption of fiscal rules in national legislation. However, it is far from clear whether EU countries would accept the implicit loss of sovereignty this would involve and agree to treaty changes enshrining legally enforceable fiscal oversight at EU level. The German Chancellor, Angela Merkel, is willing to support a change in Germany’s own constitution if the EU Treaty change to that effect is agreed first.” (

But this means a major treaty change that must be approved by all member countries. Note that Merkel wants the treaty change first, or at least the language, before she takes it to German voters, which will certainly be required, since what she is suggesting is not allowed by the present German constitution. Without the changes stated clearly and explicitly in advance, it is unlikely, as I read the polls, that German voters will go along. Merkel has made it clear that any proposed changes will be limited to fiscal issues and central control and not touch on the ECB’s independence. She is adamant against eurozone bonds and putting the German balance sheet at risk (see more below).

But will the rest of Europe go along with what would be a major alterations of their own individual sovereignty and their ability to adjust their own budgets, no matter what? And agree to all this in time to deal with the current crisis? Such changes will be controversial, to say the least. And they would require, if I understand, the yes votes of all 27 European Union members, or at a minimum the 17 eurozone members.

That is problematical. Will even German voters give up their independence and listen to an EU commission tell them what they can and cannot do with their own budget? A budget that is in theory controlled by the rest of Europe? The answer depends on whom you listen to last, as the answers range all over the board.

When Even Germany Fails

Let’s get back to the German balance sheet. This week the markets were greeted with a failed German bond offering. The German central bank had to step in and buy German bunds, at a recent-series-high rate. And while the “trade” has been to buy German bunds as a hedge, Germany is not precisely a model of balance and austerity, with high (above 4%) deficits and a rising debt-to-GDP ratio. And the market senses the contradictions here. When even German bond auctions fail, whither the rest of Europe?

As a quick aside, notice that German yields are not higher than those of UK debt at some points. The market is clearly signaling that the lack of a national central bank with a printing press is an issue. Go figure. But that is a story for another letter at another time.

Let’s look at some recent headlines. Greek 2-year bonds are now at 116%. You read that right. “Bond yields on short-term Italian debt rose above 8 per cent on Friday as Rome was forced to pay euro-era-high interest rates in what analysts called an ‘awful’ auction. A peak of 8.13 per cent was reached on three-year bonds, according to Reuters data, as Italian debt traded deeper into territory associated with bail-outs of Greece, Portugal and Ireland in the past 18 months.

“Italy raised its targeted €10bn in an auction of two-year bonds and six-month bills but at sharply higher yields. ‘Rates have skyrocketed. It’s simply not sustainable in the long run,’ said Marc Ostwald, strategist at Monument Securities in London.

“Investors demanded a yield of 7.81 per cent for the two-year bond, up from 4.63 per cent last month. The six-month bills saw yields of 6.50 per cent, up from 3.54 per cent. That was significantly higher than Greece paid for six-month money earlier this month when it issued bills at 4.89 per cent.” (Reuters)

Spanish bond yields are slightly lower but not by much, with both countries paying more for short-term debt than Greece.

And no one is really talking about Belgium, which I have been pointing to for some time. Belgium debt yield on its ten-year bonds went to 5.85%. Notice the recent trend, in the chart below. It looks like Greece in the not-very-distant past. (Chart courtesy of and Reuters data)

European Inverted Yield Curves

Let’s rewind the tape a little bit. Both the Spanish and Italian bond markets are close to or already in an “inverted” state. That is when lower-term bonds yield higher than longer-term bonds, which is not a natural occurrence. Typically, when that happens, the markets are sending a signal of something. (Charts below courtesy of my long-suffering Endgame co-author, Jonathan Tepper of Variant Perception, who lets me call him up late for data like this.)

Note that Greece (especially) and Portugal inverted when they began to enter a crisis. And shortly thereafter they went into freefall. Why did it happen so suddenly?