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“Practical
men, who believe themselves to be quite exempt from any intellectual
influence,
are usually the slaves of some defunct economist.”
~
John Maynard Keynes
There
is an old joke about economists barreling down the road in a car with a
blacked out windshield, driving by way of rear view mirror. The analogy
has deep roots. These days we are always looking forward to the future,
but the ancient Greeks had a different perspective: they saw themselves
walking backwards through time. Keenly aware of where they had been,
past terrain offered the best guess as to what might be coming next.
As
investors and traders, we look forward as best we can; acting in the
present, informed by the past, taking calculated risks in hope of
getting it right. To some degree we walk backwards like the Greeks, yet
with a significant advantage: the awesome depth and breadth of our past.
As Mark Twain noted, history never repeats but often rhymes. Perhaps the
skilled investor has a bit of poetry in his soul.
But
what’s the point if Keynes was correct? Do our views really matter if
we are just slaves to some dead economist? Fortunately, Keynes was not
asserting some form of mind control beyond the grave. His point was to
highlight the astonishing power of ideas and beliefs, especially the
ones that act as building blocks for our assumptions, color our
perceptions on matters of great importance, and are typically ignored as
commonplace.
Many
of these key concepts are invisible, woven expertly into the fabric of
our assumptions. They hide in plain sight, like Poe’s purloined
letter. Most of us do not consciously tend to our core beliefs. Like the
foundation of a house, we place great weight on them sight unseen.
Yet
without a solid foundation to build on, the house –or in this case,
the investment portfolio- will not stand the test of time. A poor
foundation is no good for building wealth, and a shaky framework invites
collapse. The more volatile and dangerous things get, the more important
the foundation becomes. When the sky is blue and the sun is shining,
mistakes aren’t all that costly. But when the waters are churning and
the winds gathering, structural integrity becomes paramount.
There
is a tongue in cheek saying attributed to the Chinese (but potentially
of western origin): ‘May You Live in Interesting Times.’ That
certainly applies today, as opportunity and danger roar forth like a
pair of marauding lions. With two titans (China and the US) facing off,
neither at clear advantage and neither able to withdraw, the stakes have
never been higher for the global economy. Not to mention booming
commodities, inflation heading to the fore, crude oil on a long march to
triple digits, the world’s reserve currency in doubt, nuclear
confrontation, political turmoil on multiple continents, old strategic
alliances cracking up, new alliances taking shape, and unprecedented
financial leverage –from hedge funds to mortgage lenders to consumers
to central bankers- straining the system to near breaking point.
So:
do we seize the day, or run and hide? Is this a doomsday forecast? Not
at all. For some of us, the rapidly rising stakes are as much a call to
action as a call to caution. The commodity bull, already an impressive
beast, is still in very early days. The pace of development in Asia is
bringing forth a sea change of incredible proportions, with incredible
profit potential in tow. Skyrocketing energy prices are a driving force
in the development of fossil fuel alternatives and innovative 21st
century technologies, creating major investment opportunities. Precious
metals have awoken from their long slumber. And so on.
This
is where the value of core ideas and beliefs comes into play. Action and
caution must strike a balance. We don’t want to turtle up and let a
fortune pass us by… nor do we want to be reckless and rash.
So how do we go about maximizing our advantage in these
‘interesting times’, while successfully avoiding the tiger traps and
the crocodile pits? Three key observations will assist. Here they are:
Growth
and volatility go hand in hand.
Jack
be nimble.
Conviction
is key.
1)
Growth and volatility go hand in hand.
In
markets and in life, rarely do you see progress in a straight line
(except when massaged or artificially created). Corrections and setbacks
are natural, and even desirable. As experienced trend followers are apt
to say, the market has to breathe; a market that goes straight up
without taking a breath is likely to burst. As we rack up massive gains
in our energy and commodity positions, this principle is useful to keep
in mind. Better to keep a clear head and a longer term perspective than
to panic at the first sign of a healthy correction.
The
principle applies to countries and regions as well. If China’s growth
path over the 21st century compares to America’s in the
20th, the potential returns will be astounding. But keep in mind that
America still had its share of panics, crashes and setbacks over the
years- and China will too. Here too, this is healthy and not necessarily
a bad thing. Economic progress is largely based on creative destruction.
Without occasional periods of cleansing, old ideas and methods would not
be replaced by better ones. Without occasionally tearing down,
structures would not be rebuilt stronger than before. China has a lot of
work to do on its financial infrastructure, and some of that work will
be painful.
Recognizing
how markets work lends strength to our convictions. Anticipating
volatility –and knowing how we will handle corrections and setbacks
when they come- is a significant piece of the puzzle.
2)
Jack be nimble.
George
Soros, the man who broke the bank of England and made a billion dollars
in less than 24 hours doing it, has a useful observation for investors
and traders alike: “Volatility is greatest at turning points, and
diminishes as a new trend is established.”
Point
being, when you are on the right side of the trend, you want to relax
and let the market do its work, knowing that you are positioned for the
duration. But… when the market starts flashing warning signals in the
form of increased volatility and decreased directionality, thrashing
around without gaining ground, it’s time to be wary. And in the
current environment, it would signal a time to transition from a
commodity / energy overweighting to a precious metals overweighting.
Why? Because as John Mauldin notes, gold is seen by many as a neutral
currency rather than just another commodity. Gold is a safe haven in
periods of extreme financial instability, and there is enough leverage
in the system at moment that if things go south, they will not go south
quietly.
This
makes gold (and to a lesser degree silver) ideal as a sort of backstop
in the event of a China-driven commodity / energy correction. Precious
metals as an asset class will be advantaged if/when any of the following
events come to pass: a sharp (but temporary) drop-off in global economic
growth; a hostile unraveling of the financial standoff between China and
the United States; an act of terror or regional political crisis sending
crude to $100 overnight; inflation breaking loose and triggering a USD
freefall; or any combination of the above. It’s not necessarily time
to move yet, but it is time to think clearly and observe keenly.
3)
Conviction is key.
If
you are an active investor, you know the ride has been wild so far- and
wildly profitable as well. It’s going to get wilder still. But as
Jesse Livermore notes, the real money is made not in the trading, but in
the sitting: letting the major move develop and having the patience to
‘be right and sit tight.’
This
doesn’t mean blind buy and hold, and it certainly doesn’t mean
passive acceptance of whatever unfolds with no logical response. It does
mean having the foresight and conviction to see the dominating trend and
ride it to the fullest, not growing impatient or throwing in the towel.
If we see a correction in commodities or energy over the next few
months, it will be an invitation to book profits on marginal
positions… but it will also be an opportunity to add to core
positions, with an eye for the long term. Similarly, precious metals are
already back on form, and they will accelerate dramatically in the event
of an inflationary surge or a destabilizing political / financial
event… but in terms of long run opportunity, the move has only just
begun. We want to have tactical flexibility in the short to intermediate
term, but maintain the strength of our convictions as the dominant
cycles unfold.
© 2005 Justice Litle
The
Daily Reckoning Archives
 www.dailyreckoning.com
Editor's
Note: Justice Litle is an editor of Outstanding Investments. He has
worked with soybean farmers, cattle ranchers, energy consultants,
currency hedgers, scrap metal dealers and everything in between,
including multiple hedge funds. Mr. Litle also acted as head trader for
a private equity partnership, and made contributions to Trend Following:
How Great Traders Make Millions in Up or Down Markets, a popular trading
book by Mike Covel (FT/Prentice Hall, 2004). In addition, Justice Litle
has been quoted in the Wall Street Journal and by multiple financial
newswires, such as Dow Jones and Future Source
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