Sunday, June 19, 2011

Dangers of Linear Thought

We exist in a society that seeks out and rewards linear thought.  Our education system rewards linear thought from an early age.  Tests are designed to reward memorization of data.  Properly regurgitating the data in a way that pleases the linear minded professor yields high marks.  Inquiring as to why U does not follow Q in the alphabet after a strictly linear grammar lesson yields detention.


We must define the terms linear and nonlinear before highlighting their powerful and essential role in profitable investing:

  • Linear- Progressing from one stage to another in a single series of steps; sequential
  • Nonlinear- Involving measurement in more than one dimension
Studying economic history shows that all markets move through cycles.  These cycles are unnoticed as they begin.  Raw economics drive the early stages.  Human beings take over at some point and eventually push the cycle to an extreme not supported by economic fundamentals creating dislocated conditions.  When viewed without any biases these markets are merely moving closer to or further from their mean.  What most people are not capable of predicting is the cause, frequency and timing of these movements.  

Humans crave certainty.  A chance at success is often exchanged for guaranteed mediocrity.  This explains the existence of annuities, the entire concept of a corporate ladder and even socialism.  Once certainty has been established in a satisfactory manner however, a new desire takes over.  Now a larger slice of the certain outcome is desired.  Back-testing of the recent past begins and linear assumptions are made about the future.  Intense focus on the certainty of the linear outcome takes over and all nonlinear economic forces are ignored.  This is the behavior that eventually creates dislocated prices and is always followed by a misunderstood collapse.

Real Estate Market 

Over the course of a decade several economic choices were made which eventually dislocated the entire housing related real estate market.  Regulatory barriers were removed and congress actually mandated that a percentage of loans be made to disadvantaged borrowers (these borrowers later proved why they were disadvantaged in the first place).   Federal guarantees were applied more liberally to loans in an effort to boost lending.  The value of the US dollar began to decline a few years into this cycle and real assets experienced natural appreciation.  Financial corporations made linear assumptions based on falling interest rates and continued easy access to credit.  All economic sign posts were ignored as the mass clambered for a larger share of the certain outcome.  Now most adults understand what eventually happened. 

In the first quarter of 2009 your editor began to experience some curiosity surrounding the housing portion of the real estate market.  After years of excessive increases in home ownership due to unnatural market conditions this sector had experienced capitulation.  Here were the facts at the time:
  • Nearly every adult in the country had bought a property
  • Many people were not paying their mortgages
  • Most mortgage payments were much higher than comparable rental rates
  • Credit must become marginally less available
  • Who would buy all of these houses?
  • The number of renters should increase on the margin   
When something begins to increase at the margin it means that there is one additional unit of demand being added.  You want to invest in sectors that are about to experience marginal growth.  Floating downstream is easier but many insist on the opposite and begin cursing the river for not cooperating.

A pricing model was created based on the premise that rental housing should be valued using net cash flows exclusively.  The model failed to yield any success for months.  The market was still littered with investors from the previous cycle holding out for things to "come back."  These type of investors have a secret desire to lose and their behavior is driven by other psychological motives often not understood by them.  If you listen carefully you will hear them describe the unfair treatment that they have received during market busts in a myriad of asset classes.  

As the lenders and the court system began to separate former owners from their bad deals the model started working.  Now the houses are entering their second year of operation and not only has over 20% of capital been returned, rents are beginning to firm.  Yesterday the Tampa Tribune ran this story on the front page and we can objectively observe that this is a signpost on our journey.  
Housing Article

What Happens Next?

While the housing related real estate market still offers room for more investment, the tide has certainly turned.  When this happens we find a market much less exciting.  Preferring the role of pioneer or hunter we move on leaving room for the gatherers to follow safely in our footsteps.

The primary goal of this website is to help people learn to think for themselves.  Our efforts are always directed towards that end and we may never fully know if we have been successful?

With capital as your army you must decide where to send your troops.  Never set out looking for war with a predetermined enemy.  Instead, look for the weakest enemy with the most attractive array of assets and focus your power there.  Not all soldiers will return home from war so those that do must be very successful.

Properly observing market conditions in order to find the most vulnerable target is the first step:
  • The world is bankrupt, technically insolvent
  • The unplayable liabilities are denominated in paper currency terms
  • There is no solution for this condition other than a crisis
  • Faith in a political solution is far too high and impossible
  • Belief that more debt will fix the problem is overwhelming
  • Politicians scramble to gain power for personal benefit only
  • The currency system has been abused and shows signs of extreme stress
  • Nominal interest rates are at levels so low that any further decline would make them negative
  • Rates remain low even while the underlying credits have exceeded junk status
Gold and silver, monetary metals, are still a very misunderstood asset class.  Gold is money.  It has always been money and while a change is possible we do not see the catalyst for it.  At some point a major bond auction will fail or a commodity merchant will refuse settlement of a trade in paper currency.  This will set into motion capital searching for something real.  Confidence in this trend will build creating certainty as it builds momentum.  Some will wait for paper to "come back."  These holdouts will be the last to realize that the currency has been created in unlimited quantity and the longer they hold it the less it buys.

As gold reaches our 2011 target of $2,000/oz in late October or early November and closes the year between $1,750/oz and $1,800/oz, consider the value of owning equity in mining firms.  As the price of the material they produce increases gross profit experiences a terrific rise.  During this type of move costs tend to increase at about 25% of the rate of the profit acceleration.

When we read a local newspaper headline on the benefits of gold mining we will begin to rethink this thesis.