Walking the streets of Geneva it would never occur to you how much money courses through its banking system. A close look at the manner of people conjures up the description "discreetly sophisticated". I was therefore not surprised to find my old friend Mr. Practical still residing there.
We talked about a lot of things over breakfast before one of my meetings, a range of topics including politics and of course financial markets. I relay to you some of his thoughts.
On politics he told me that one of America's biggest problems (a common problem around the world, but particularly troubling for the shining light of democracies) was term limits, or lack thereof, for politicians. I readily agreed that campaign contributions and lobbying by corporations and other large organizations had compromised the political process; the result being a larger and larger government fostering a kind of cronyism and deterring true entrepreneurism. I had never thought of attacking the problem from this angle, but the more he talked, the more he made sense.
"The real problem is life long bureaucrats. Their motivation is not 'what is the right solution', but 'what is going to get me re-elected'. Furthermore, what makes a professional politician, most likely trained as a lawyer, more qualified to make policy than a businessman who has lived the real world and can "see" the real problems. If the U.S. allowed people to hold any specific office only once, drawn from the general populace, special interest money would immediately become ineffective and elected officials would be better attuned and motivated to solve the problems they see in the real world, mostly because they had just come from and were about to return to it. It seems to me that Congress (et al) by dealing with this problem by introducing campaign finance reform is merely assuaging the public and avoiding the solution. But then why should they truly want to fix it: it is like asking them to cut their own throats."
I thought about the value of experience: doesn't it count for something that our elected leaders understand the system and learn how to maneuver around in the "system". I didn't even ask the question out loud because I immediately realized that was part of the problem: a politicized system built by and maintained for those most benefited. It was a short conversation as I just nodded my head.
When we inevitably started talking about financial markets, I am sure he must have noticed a far away look in my eyes. I related to him the regret of some of our readers on missing such a large rally in the stock market. He nodded and smiled understandingly as he began to respond.
"First of all, I have little remorse for "traders" who complain in hindsight at missing a nominal short term rally in stocks. Market timers are like gamblers, especially the more short term oriented they are. Whining in this situation is analogous to a gambler in a large casino bemoaning the fortunes of a particular black jack player hitting it big. The problem with this is that for every player they see hitting it big, and they only see them because they are hitting it big, there are hundreds of others losing. They certainly do not begrudge the losers. Envy is only self destructive.
If you are not a gambler, but a long term investor, your strategy is much different. You are most likely steadily committing small amounts of capital to riskier assets like equities based on a longer time horizon (at least a few years and probably more like ten) than for non-risky assets: as the amount of your capital increases (through income) that you will not touch for long periods, you apportion that to the stock market; as it decreases (by nearing retirement) you draw it out into safer investments. Unfortunately, this strategy has not worked either, a testament to just how destructive to wealth the U.S. stock market has been over the last five years.
Although the nominal gains in stocks for U.S. investors over the last year have been substantial, their gains in terms of actual wealth are much less impressive. And if we look at longer time periods, these same investors have actually lost vast amounts of wealth. This is simply because as the U.S. stock indexes have fluctuated on a nominal basis, the value of the dollar, especially against the Euro (which I consider important because the Euro as a currency represents the part of the world closest to the U.S. in standard of living and the most likely place for Americans to relocate to), has declined. Over the last year, the SP 500 has risen approximately 36% on a nominal basis, but because the dollar has declined 19% over the same time period, actual net wealth has increased by around 17%. But over the last two years, net wealth as calculated in the same way has fallen a dramatic 41%. For the last five years, net wealth has fallen 19.5%.
Most importantly, those that have stayed away from stocks over the last year or more, most likely did so because of risk. Risk is not invisible, but it is hard to find. One must search it out and understand it. Most people actually choose to turn a blind eye to it, that is, until it stabs them in the back. The machinations of the mutual fund industry further masks true risk.
Sure the nominal markets have rallied over the last year, but they were, and in my opinion still are, fraught with risk. Stock price fluctuations are driven by perhaps more than anything else the "risk premium" investors attach to equities: as the "perceived" risk premium decreases over other asset classes, stock prices will rise.
I want you to tell your readers a story to see if they understand risk. There once was an amusement park that just completed the world's greatest roller coaster. People came from several states away on opening day to ride "The Beast" as it was named. Three fun loving sisters named Sharon, Shelly, and Sheryl drove many hours to ride the Beast. They waited in line for hours and watched curiously as many who got to the front of the line simply walked away.
When they finally got to the front of the line, the engineer stopped them, just like everyone else, and told them very carefully, "This ride is undoubtedly the best ride in the world and you will remember it for the rest of your life. But in order to make it so fun and wild, we had to take some chances. We estimate that there is around a three percent chance that the roller coaster will jump the tracks and kill all aboard on any one ride. If that is clear and you still want to ride, please sign this release."
Sharon, the craziest of the three quickly signed the release before her sisters could say anything and jumped on board. Shelly and Sheryl stepped to the side to talk it over as they watched Sharon take off. After watching Sharon ride the Beast three times and having the time of her life, Shelly couldn't take it anymore. Despite Sheryl's protests, Shelly told her, "Don't worry; I will just ride it once. Sharon has already ridden it three times and nothing has happened. I can't miss all the fun. I promise to get her to stop after this one time!"
Sheryl was the only sister to leave the park that day.
There were two fellows several years ago that claimed that the Dow Industrials will go to 100,000 soon. Their case was built on the fact that stocks actually had lower risk than bonds. But to make that assumption, one would have to have an extremely long time horizon, perhaps 100 years. The problem with this point of view is that the longer the time horizon, the less certain things are. A great percentage of people would have to believe that several generations of their heirs would keep money in equities in order to apportion enough assets to stocks to drive indexes to the kind of levels these fellows are talking about. Most people just don't think this way. Besides, during this long time period there will certainly be risky events that would probably force one of the heirs to sell. Certain families have held large blocks of stock for several generations and become very rich. But this usually occurs for owners that found particular companies. And there have been many more families that have lost it all with this strategy than those that have become rich. You just don't hear about any of them.
By the way, I do believe the massive and coordinated physical and psychological intervention by various central governments has gone a long way to reduce this "perceived" risk premium. The Federal Reserve understands all too well that the consumer has had little incentive on an income basis to be positive. It becomes paramount then that the consumer feels little risk in committing the vast liquidity that the Fed has produced to stocks. This in turn affects their feeling of "wealth" as stocks rise in price.
The fact that the massive increase in liquidity produced by the Fed has also produced vast amounts of debt that has not yet caused interest rates to rise in the U.S. is only courtesy of our friends in Japan. I view that situation as untenable.
The fact that U.S. consumers and investors have so far ignored the negative affect on their real wealth from the decline in the dollar is only a temporary phenomenon perpetuated by a low headline CPI number. It is somewhat amazing that people ignore the fact that the headline CPI is calculated using hedonics and that the variables employed are misleading, such as the fact that it is calculated not with housing prices that have doubled and tripled, but with rental statistics that have remained subdued (guess why). Washington and Wall Street have also persuaded the public to focus on CPI ex food and energy when these two components are essential to our everyday lives.
For my part, I believe the risk premium remains high."
Thanks Mr. Practical. I think?
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