“No persons are more frequently wrong than those who will not admit that they are wrong”
Francois De La Rochefoucauld
Dear Clients and Friends,
Earlier this spring, I mentioned in one of my writings that 2014 was a difficult year for me as an investor. I got two major investment themes wrong. Number 1: I was quite sure that interest rates were headed higher throughout the year. Rates not only didn’t go higher, they declined by a surprising 40 basis points which produced a whopping +20% total return on an investment in the 30 yr. Treasury bond. Number 2: The shale oil boom was in full swing last year and we were discovering with regularity, vast new reserves of oil in the United States. I was quite sure that energy independence was now a reality and OPEC no longer held the control over oil prices that they once had. On the day after Thanksgiving last year, OPEC announced that they had no intention of restricting production. They were willing to let the price of oil be dictated by real supply and demand. That announcement caused the price of oil and oil related investments to fall in a rapid and near catastrophic fashion. When the dust had finally settled, the price of oil and energy related stocks had fallen by nearly 60% (in just 3 months)! On both counts, I could not have been more wrong with my thinking. Since the beginning of 2015, I have promised myself that I would do what I could to prevent this kind of thinking from repeating itself again. I circled back and began to look for advice of some the most successful investors I have known. In this process I ran across an interview with Ray Dalio in Business Insider. Ray is the founder and co-CIO of Bridgewater Associates, the worlds’ largest and one of the most successful hedge fund firms. Ironically, he speaks to exactly what I had been thinking and searching for. His advice is not only pertinent for investing but also has applications for effective every day communication. Here it is:
To make money in the markets, you have to think independently and be humble. You have to be an independent thinker because you can’t make money agreeing with the consensus view, which is already embedded in the price. Yet whenever you’re betting against the consensus, there’s a significant probability you’re going to be wrong, so you have to be humble.
Early in my career I learned this lesson the hard way — through some very painful bad bets. The biggest of these mistakes occurred in 1981–’82, when I became convinced that the U.S. economy was about to fall into a depression. My research had led me to believe that, with the Federal Reserve’s tight money policy and lots of debt outstanding, there would be a global wave of debt defaults, and if the Fed tried to handle it by printing money, inflation would accelerate. I was so certain that a depression was coming that I proclaimed it in newspaper columns, on TV, even in testimony to Congress. When Mexico defaulted on its debt in August 1982, I was sure I was right. Boy, was I wrong. What I’d considered improbable was exactly what happened: Fed chairman Paul Volcker’s move to lower interest rates and make money and credit available helped jump-start a bull market in stocks and the U.S. economy’s greatest ever noninflationary growth period.
This episode taught me the importance of always fearing being wrong, no matter how confident I am that I’m right. As a result, I began seeking out the smartest people I could find who disagreed with me so that I could understand their reasoning. Only after I fully grasped their points of view could I decide to reject or accept them. By doing this again and again over the years, not only have I increased my chances of being right, but I have also learned a huge amount.
There’s an art to this process of seeking out thoughtful disagreement. People who are successful at it realize that there is always some probability they might be wrong and that it’s worth the effort to consider what others are saying — not simply the others’ conclusions, but the reasoning behind them — to be assured that they aren’t making a mistake themselves. They approach disagreement with curiosity, not antagonism, and are what I call “open-minded and assertive at the same time.” This means that they possess the ability to calmly take in what other people are thinking rather than block it out, and to clearly lay out the reasons why they haven’t reached the same conclusion. They are able to listen carefully and objectively to the reasoning behind differing opinions.
When most people hear me describe this approach, they typically say, “No problem, I’m open-minded!” But what they really mean is that they’re open to being wrong. True open-mindedness is an entirely different mind-set. It is a process of being intensely worried about being wrong and asking questions instead of defending a position. It demands that you get over your ego-driven desire to have whatever answer you happen to have in your head be right. Instead, you need to actively question all of your opinions and seek out the reasoning behind alternative points of view.
This approach comes to life at Bridgewater in our weekly research meetings, in which our experts on various areas openly disagree with one another and explore the pros and cons of alternative views. This is the fastest way to get a good education and enhance decision-making. When everyone agrees and their reasoning makes sense to me, I’m usually in good shape to make a decision. When people continue to disagree and I can’t make sense of their reasoning, I know I need to ask more probing questions or get more triangulation from other experts before deciding.
I want to emphasize that following this process doesn’t mean blindly accepting the conclusions of others or adopting rule by referendum. Our CIOs are ultimately responsible for our investment decision-making. But we all make better decisions by maintaining an independent view and the conflicting possibilities in our minds simultaneously, and then trying to resolve the differences. We’re always in the place of holding an opinion and simultaneously stress-testing the hell out of it.
Operating this way just seems like common sense to me. After all, when two people disagree, logic demands that one of them must be wrong. Why wouldn’t you want to make sure that that person isn’t you?
Ever since the FED embarked on their quantitative easing programs during the financial crisis of 2008, there has been a prevailing fear that we would return to a period of hyperinflation not unlike what we had experienced the late 1970’s. I must say that even I was to some degree worried about that as well. After all, between the period of late 2008 and the fall of 2014, the FED had pumped nearly $4 trillion into the economy. The simple definition of inflation is, “too much money chasing too few goods” and based on that definition, it seemed likely that inflation had to be just around the corner. Now here we are 7 years later and inflation as measured by the CPI, remains firmly entrenched in the 1% to 1.5% range. I have my own thoughts as to why conventional wisdom has been wrong about inflation (the “long tail” of the Great Recession has continued to dampen the appetite for risk and demand for money at all levels and sluggish employment growth has kept wage costs down). But as usual, our friend and Chief Economist at First Trust, Brian Westbury does another masterful job of taking what I have been thinking and puts it into terms that we can all understand so, with his permission I have included his article from last Monday.
Monday Morning Outlook
Where’s the Hyper-Inflation?
Brian S. Wesbury – Chief Economist
Bob Stein, CFA – Deputy Chief Economist
If we had a dollar for every time we’ve heard about the threat of hyperinflation, we’d probably have enough money to never worry about it.
The Federal Reserve’s balance sheet has ballooned to an unprecedented size. In August 2008, the balance sheet was $870 billion. Today, after Quantitative Easing I, II, and III, it stands at $4.4 trillion. Between 1995 and 2008, the balance sheet expanded at a 6% rate. If it had simply continued to grow at this pace, it would be about $1.3 trillion right now.
This expansion in the Fed’s balance sheet led to a proliferation of forecasts for hyperinflation. We don’t have to tell you who they are; you’ve probably seen their videos on the internet multiple times already. And yet, here we are, with the consumer price index down 0.1% from a year ago. Excluding energy, the CPI is up just 1.8% in the past year.
Of course, certain items have gone up faster. Beef and veal prices are up 13% from a year ago, but make up only 0.6% of the typical consumer budget. And we’re sure government statisticians sometimes miss minor changes to packaging that can hide inflation. But the statisticians also have a tough time measuring the true value of improvements to cell phones and other high-tech devices as well. Streaming radio, free maps, and GPS everywhere are nearly impossible to value.
In other words, the inflation data from the government aren’t perfect, but we think offsetting errors leave them very close to the truth. In other words, hyperinflation fears were totally overblown and are likely to remain that way.
The huge expansion in the Fed’s balance sheet has been due to the Fed’s purchase of trillions in bonds. This pumped cash into the banking system, which the banks have chosen to hold as excess reserves. Banks are sitting on these excess reserves, not because rates are low, but because the economy has not demanded all this cash. In other words, the money multiplier has fallen sharply.
Another way to think about the situation is to imagine that you’re heating your house and have the furnace cranked up to the max; it’s pumping out as much heat as it can. But you also have the windows wide open and it’s only ten degrees outside. Normally, if the furnace is working that hard, you’re going to heat and then overheat your house. But, with the windows open, the temperature doesn’t rise much.
Higher capital standards for banks, Dodd-Frank, stress tests, and the threat of “macro-prudential” regulation are like open windows. No wonder GE wants out of the banking business. At the same time, a large increase in government redistribution, which can weaken the incentive to work and invest, just like higher tax rates is also holding the economy back. Note: none of these policies look likely to change much anytime soon. However, banks now have excess capital to go along with their excess reserves. In recent months, both the M2 measure of money and bank loans have started to accelerate. And don’t forget that companies have lots of cash, too.
All this is to say that “liquidity” is plentiful, while at the same time, these open windows are keeping inflation subdued.
We understand the temptation to believe in doom and gloom. The Panic was painful. But, the comparisons of the US economy today, to 1937, to Japan, or to the Weimar Republic, are entirely too simplistic.
The bottom line is that the Fed is accommodative; the heater is cranked up. But the economy is flexible and resilient. Hyper-inflation and deflation are not in the cards. Carry on.
This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics.
I hope that you have found these articles informative and useful.
— 66.6% of all companies who have reported earnings for the 1st quarter have either matched earnings estimates or have beat those estimates. Profits have continued to grow but the top line (revenues) have been impacted by a strong dollar.
— The top 5 metropolitan cities with the largest annual influx of 25 to 34 year-olds from 2010-2014: Houston – 12.5 million; Denver – 12 million; San Francisco – 11.9 million; Austin – 10.9 million and Washington D.C. – 9.2 million.
— The Millennial is impacting the economy in ways we have not seen before. They prefer not to own life’s major acquisitions like cars and homes, preferring Uber and the flexibility of renting after witnessing the devastation from the Great Recession and facing enormous student debt burdens.
— The number of people actually working in the private sector is only 116 million, while 159 million people in the U.S. are receiving one or more kinds of government benefits such as Social Security, Medicare and food stamps. The math says that for every person working in the private sector, 1.4 are receiving some sort of aid.
— The last two points are contributing to sub-par economic growth.
Sources: First Trust, Bridgewater Associates, 361 Capital and Real Money.
Ken Beach, President of Cascade Investment Group, member FINRA & SIPC. Cascade Investment Group is not a tax or legal advisor. You should always consult with your tax advisor or attorney before taking any actions that may have tax consequences.