Friday, September 16, 2011

How Does The Machine Work?

People are always asking us, "What will happen next?"  This is part of their desperate search for safety in a non-linear, non-correlated financial world.  The reason we get this question has been covered at length.  People desire an unattainable certainty that they will be safe.  They will almost pay anything to believe this promise.  Unfortunately that is not how things work and certain losses await if this attitude persists.

In a fantastic Bloomberg interview Ray Dalio baffles A-Student, award winning, overpaid journalist Erik Schatzker as he literally gives away his secrets to success.  Ray says that everything is a machine and the key to his success is, "Understanding how the machine works."  He is a smart man and realizes that he can freely give this secret away because the audience is too inept to emulate his style.

Most people asking for direction are looking for a silver bullet.  The true path to profits is a journey and they are not willing to embark on such a quest.  At the risk of boring long-term readers we will again suggest the fundamental traits needed to make money in markets.

In 1993 Steven Landsburg wrote an amazing book titled The Armchair Economist: Economics & Everyday Life.  This text is available in used condition for as little as $2.50 a copy on  Landsburg breaks down how economics is only the study of people making choices based on conditions.  He posits, a sharp metal spike installed in the center of the car steering wheel would eliminate the need for seat belts.  Most readers think this is a stupid suggestion while Landsburg is trying to illustrate that the driver would be so focused on avoiding an accident that the roads would be safer.  Today we have such high safety standards that people are free to send text messages and focus on other distractions while the auto manufacturer provides safety. 

When the study of economics is taken seriously you begin to see it literally everywhere you turn.  It is driving behavior in all aspects of life.  Natural instincts and created incentives drive workers, managers, companies, governments and the direction of our entire society.  Dalio points out that people are baffled as each new detail of the European debt crisis unfolds.  Talking heads like Schatzker make their living by keeping people shocked at each detail while a simple, objective study of the situation would eliminate all surprise.  These countries are broke, there is no possible spin that can be applied.  They simply spent more money than they received in revenue and without the ability to print currency they are stuck.  So, there is a funding gap and who will fill it?  Someone has to purchase the debt required to continue funding these nations.  Go ahead and extrapolate this thought.  Once you take the derivative of this problem into consideration there should be no more confusion as to the nature of and outcome awaiting these debt issues.

This journey is yours and should be unique if you want to really learn how things work.  There are so many dislocated markets around us today that economic study can be practiced outside of universities.  Take for example the true money supply.  M1, M2 and M3 are metrics that today can not be accurately used in market study for several reasons.  The true money supply is a much more accurate measure of currency in the system as it includes:

  • The Currency Component of M1
  • Total Checkable Deposits
  • Savings Deposits
  • US Government Demand Deposits
  • Note Balances
  • Demand Deposits Due to Foreign Commercial Banks
  • Demand Deposits Due to Foreign Official Institutions
Here is a chart of the true money supply courtesy of The Mises Institute:
We know that the average US citizen is watching everything he owns decline in value while everything he buys is rising in price.  The true money supply metric shows us that recklessly created cash benefits only the first owner and has been creeping out into the system.  The average citizen has no ability to benefit from this windfall printing but is subject to its consequences.  Readers should be curious about what this means and how to allocate capital in light of it.  

During a time when the above mentioned challenges are faced and much of the world is bankrupt you should attempt to remove capital from situations that make it subject to the liabilities of others.  Precious metals held in physical form are one of the only choices that average people have if capital preservation is sought.  We concede to Warren Buffett that gold is an awful investment.  

Mr Buffett, we are not worried about investing we are only trying to survive the conditions that you and your friends have forced upon us.

Only you control the direction of your journey in markets.  The best course is to let go of all notions of how things "should" be and let objective thought lead you.  Ray Dalio developed a set of principals that guide him.  Most people are guided by what others think of them and then when they end up in a ditch covered in capital losses they look around for someone to blame.  Mr. Dalio is an independent thinker and a man of intellectual courage.  If we could conceive of two more respectful adjectives to describe him we would use them.  Do not be surprised by the continued success of a man who seeks to objectively trade what is.

1 comment:

DannyBly said...

Ray Dalio: 'There is no such thing as an intrinsic classic correlation...fixed notion of correlation doesn't exist.....there's only the logical behavior of each of those two markets that will then determine it's relationship' .....I think most of us, myself included, naturally seek out 'fixed correlations' instead of trying to better understand the underlying mechanisms...