Casino Capitalism

One Major Investment Flaw

One big psychological investment flaw to watch out for is: Fear or disgust of missing out on future gains.

This happens all the time. You buy a stock, it goes up to a reasonable valuation. Then you hold hoping for further gains and with time the stock collapses when earnings disappoint. Or you buy a stock, sell early, and the stock proceeds to triple. In both cases, the correct course of action is to move on and fight the Future Gain Fear.

Since the pricing of stocks is completely unpredictable and the future is highly uncertain, there is never any need to worry about missing out on any gains by selling early. If you've made money, by buying at a cheap valuation and selling at a reasonable valuation, that's a giant step in the right direction.

If the stock goes up tenfold after you sold, so be it. Another opportunity will always come along. It always does.

When gambling you need to always play the odds. In stocks, the odds are very high that in the long-term individual stocks will at some point go down tremendously. You will lose money if you are a so-called long-term investor.

Long-term investing may have worked a century ago before the market became a giant casino, but it is no longer is applicable or safe in the world of casino capitalism. Those who have made money holding onto securities long-term, such as the case of Berkshire Hathaway, are merely lucky and the exception to the rule. 99% of the time, individual stocks that have gone up substantially will decline enormously, and most stocks will drift toward negative returns with enough time. Don't believe me? Ask shareholders of once mighty and seemingly invicible Citigroup. Even Microsoft, one of the greatest businesses of all time, has treated its long-term investors to a negative ten-year return in the recent period.

There is no business that can grow forever, and so the the bottom-line is Sell when you can, Not when you have to and don't hold long-term.

Bottom for Stocks?

As the financial crisis mounts, the question of course is where is there a bottom for stocks. The fundamental rationale for any investing is that the price of the asset needs to be related to some underlying future economic variable (i.e. free cash-flow). Even though, it's impossible to truly estimate future cash-flow and the capitalization of that income stream is always up for debate, there will always still be some underlying cash-flow in the economy which will need to be capitalized. So from an optimistic standpoint, it's just a matter of getting a sense of the current cash-flow, and how much damage this recession will do to companies cash-flows before we can get a bottom in stocks. Once there is a rational way to estimate worst case scenario cash-flows, stocks should bottom. I suspect this can occur after the awful fourth quarter reports are out and companies provide an outlook based on the 1st quarter.  Based on recency bias, it's likely most companies will extrapolate the current recent horrible economic environment into the future, and forecasts may prove overly conservative providing some basis for a worst case base cash-flow. Of course, these estimates may still prove optimistic if the economy keeps collapsing, but it may prove profitable to gamble on the long side, once all the bad earnings are in.

The Three Reasons Why Stocks Go Up (and Down)

Given the tremendous uncertainties regarding future cash-flow, interest rates and other economic factors, there is obviously little justification for relying solely on financial figures to predict stock prices. Psychological factors play a much greater role in stock prices than economic variables.

Briefly there are three psychological factors which cause stock prices to go up (or down): Fallacy of Composition (a group of rational people acting together can cause an irrational result), Herd Mentality (the vast majority of people are imitators), and Recency Bias (we tend to place more weight on recent events and extrapolate from those into the future).

Understanding these three human foibles should be enough to formulate a profitable investment strategy.

A Solution to the Economic Crisis?

Looking for a solution to the current economic crisis? Read up on your Minsky. His definition of ponzi finance, aptly describes what has gone on in the US financial markets for the better part of decade. Ponzi finance is what leads to casino capitalism, and economic crises.

So how do you deal with the crisis? Like you would any ponzi scheme. You stop the scheme and everyone starts over with a focus on cash-flow, rather than refinancing.

Unfortunately, admitting that the US financial system has become one giant ponzi scheme and that our highest salaried citizens are merely gamblers, would wreak havoc on our existing social structure. So every effort will be made to keep ponzi finance alive and thriving. The only way to do that is thru massive inflation. That's the future, guaranteed. There's no other way for ponzi finance to survive.

Are Economic Facts Driving Stock Prices or Merely Rationalizations for Existing Price Moves?

As mentioned in prior posts, stock prices for legitimate companies, and prices of other paper assets, are more a function of psychological factors, than economic realities. In fact, in many instances, economic facts are used to justify a price rise (or fall), after the fact. So in reality, the economic rationalization is a reaction to the price change, rather than a cause. It is used to “defend” the price change, or “market” the story.

Of course, an initial price movement off of a steady base may in fact, and is nearly always, due to specific economic considerations, but after that initial move the continued price rise is chiefly due to psychological factors (e.g. crowd psychology), with the economic facts merely providing support for the “bull” run.

What generally seems to happen, is as follows: Some stock, or asset, basically goes nowhere for quite some time. It displays little volatility and a tight range of prices, combined with a low valuation relative to underlying business fundamentals (this in fact the type of conditions you want to have before investing in any stock).

Some event subsequently changes the economic outlook for the company or asset, and a few investors recognizing the changed conditions begin buying the stock. This causes the price to rise. Thereafter, continued price rises are a function of other investors jumping on the bandwagon and fundamental results simply justifying the initial rise. However, in general the initial price rise will happen quickly, and will greatly eliminate any rational justification for the continued price rise. In other words, the game quickly changes from finance to psychology. 

The practical effect of the above, is that one needs to be very careful when analyzing any asset to understand the economic justification for a price rise, making sure that the economic reasons are not being used to rationalize the price rise. In fact, you need to be sure that you are buying in early into the story, before a major price rise, when the improved economic fundamentals are still unknown or underappreciated. Once the news it out and the game changes to psychology, it’s best to just sell and look for something else to invest in, no matter how much profit is left on the table.

As mentioned in the past, in any ponzi scheme, like the stock market, it’s important to Get In Early, and Get Out Early!

 

Is There Really a Financial Crisis?

As evidenced by recent government actions, there is absolutely no limit on the supply of money. Nor can there be any limit, since money in the modern financial system is not constrained by any physical reality.

While the world is somewhat limited in basic resources, such as oil/other commodities, and there is some limit on human capital, there is an unlimited supply of financial capital.

But, if the supply of money is unlimited, how can there be a financial crisis?

I surely don't have a good answer to this question, other than that the entire crisis is surely just psychological, at least on the macro level. Of course on an individual level of both people and businesses, there is crisis, since many people have far less paper money then they have had previously and asset values of many businesses have collapsed. But this too is merely a psychological issue, since if you have enough capital to pay for basic living necessities, and you remain in good health you surely are not really in crisis. And if as a business you are still producing products and/or services, you are not in a crisis, even if the abstract representation of your business, i.e. securities, has a lower value.

On a relative basis many of us have lost a lot of paper money, but on an absolute basis each of us and society as a whole is most probably not a bit poorer. If you want to see a real crisis, I recommend traveling to Africa or many other third-world countries, where basic necessities are sorely lacking for a wide part of the population.

So when will this crisis end? In time, individual will get used to living with less paper money, and businesses will adjust to lower capitalization values. A new benchmark will then emerge from which growth will resume. How long will it take to reach a new equilibrium? Since human emotions are entirely unpredictable, it's impossible to say. But, time surely heals all financial wounds.

What is the Source of Wealth?

When you analyze the great fortunes, whether on a macro or micro scale, it seems clear that wealth has three potential sources:

• Fraud and Theft of Capital and/or other Resources
  

Those with criminal mindsets simply steal resources and money thru exploitation and warfare. I'd hazard to guess that behind all great fortunes, whether of countries or individuals, lies some great robbery.

Throughout history warfare/exploitation played a primary role (especially for European countries in the not so distant past), since capital resources were scarce. In modern times, where paper money,which can be printed with abandon, is the primary source of capital, basic theft, without warfare, is more common. Theft by government and from the government (e.g. Healthcare in the US) is the primary means of capital robbery.

• Luck and Gambling in the Financial Casino
  

Since modern capitalism is basically a casino, with paper money being shifted around the globe into different asset classes and bets being made daily on basic economic outcomes, a vast amount of wealth accrues to those who gamble huge sums of money and by luck turn out to guess correctly on the flow of capital. Wealth also accrues to those who manage the house, i.e. banks, in the vast financial casino.

• Creativity to Develop or Satisfy Existing or New Demands
  

Bursts of creativity by certain individuals, leads to new development of previously non-economic resources and/or the creation of new products/services that satisfy a human need, whether real or perceived.

If you think about it, creativity, plays a very small part in the creation of wealth since it requires other capital to both pay for the new product/service, and more importantly grow. Growth is key since most of the creative energy is targeted at developing new needs that nobody really demands. So it requires a huge amont of capital to actually market new products/services to convince people to pay for these, largely wasteful, products and services.

Furthermore, many of the successful business creations are later morphed into paper money, and the great wealth is then created by the financial casino. This is why most great entrepreneurs in modern times, have no desire to create profitable businesses. The game is marketing the potential of the business with investors and selling shares to the big gamblers, who proceed to flip the shares to other gamblers ad infinitum.

In sum, if you want to get rich, you need to either steal, gamble, or create. If you take the higher path of creation, just remember that you'll be dependent on those who steal or gamble, to actually supply the capital.

Defining Earnings Capacity

Previous posts mentioned the term: Earnings Capacity, without a proper definition. In this post, I'll cover what I mean by “earnings capacity”.

One important initial point: The stock of a company without sufficient “earnings capacity” is in reality worthless. Trading in it is probably worse than gambling at a casino (and a lot less fun, I might add). Simply deciding whether a company has real “earnings capacity” or not is usually sufficient to eliminate most bad investments and focus on the good opportunities.

What I mean by Earnings Capacity is actually the free cash-flow that a business can generate over a significantly long period of time (again “significantly" requires definition, but maybe 10 years is a fair enough period? ).

Free cash-flow is defined as EBITDA - recurring working capital adjustments – debt repayments/interest - capex - taxes. So in essence Earnings Capacity = Long-term and Sustainable Free Cash-Flow.  Notice how Earnings Capacity has absolutely zero to do with the Accounting Earnings that most companies report and that are used by Wall Street to move stock prices.

Using the above definitions will generally help you avoid most terrible investments and locate some extraordinary investment opportunities. This is because very often most publicly-traded businesses that seemingly generate accounting earnings do not really generate any sustainable free cash-flow (or generate minimal free cash-flow) and hence are practically worthless for an outside passive investor. This is because these businesses either have extensive cap-ex needs, and/or they rely on continued financings to stay in business, implying that the business cannot support the debt and is at  best a ponzi scheme.

At the same time, many publicly traded companies that seemingly report huge losses are actually generating sustainable free cash and hence have some value as businesses and offer potentially great investment opportunities.

Looking at cash-flow and balance sheet statements over long periods of time can mostly help you separate the ponzi schemes from the legitimate concerns and the potentially profitable investment opportunities.

One last practical points:
Never Focus on Last Year or Next Year in the Stock Market: Focus on Sustainability and the Long-Term

If you want to make money with stocks you need to completely disregard the earnings for the past year and the earnings from the next year. What matters is the long-term free cash-flow generating capacity of the company and the sustainable cash-flow.

What happened last year or what will happen next year is only important if it reflects on the long-term and sustainable cash-flow and in most times it is misleading.

In fact, companies with good earnings in the past year will inevitably be overvalued while those with bad earnings and even major losses, could potentially be undervalued.

 

Investing with the US Government: Is it a Good Idea?

What's interesting about the current government bailout and stimulus mania in the US and in other parts of the world, is that for a long time, businesses with meaningful revenues from the government tended to sell for lower valuations,due to the fact that for obvious reasons, government-focused businesses are simply unreliable. In fact, there are generally risk clauses in many companies SEC filings that focus on the degree of government reliance and the uncertainty this creates.

Now with the government meddling in every business and essentially taking over the entire financial system, as well as proposing an almost ludicrous stimulus package (implying that the government will try to create a viable business by pumping money into the economy?), we are all now directly investing in the US government.

Shouldn’t this then be the strongest argument yet as to why valuations need to be significantly lower in the stock market? Who in their right mind, unless one is considering fraud (and government businesses are rife with fraud and a goldmine for those with a criminal mindset), would want to invest in a business with major government control? Is there anything more unreliable, fickle, and inefficient, than the government? What kind of discount is needed before one ventures to invest in a business which is by definition filled with corruption and inefficiency?