I Am The Caveman, I Am The Caveman, I Am The Walrus

With apologies to the greatest band ever (The Beatles, of course), I punned the above title to remind all of us how we share the commonality of our ancestors and how this all comes back to that source of “frozen desire” as coined by James Buchan, ie MONEY.
 
Now, when I talk about commonality of our ancestors, I am not referring to the 18th century, the 15th century, even the first century. No, I am referring to 50 or 60,000 years ago, when grandma and grandpa just started to walk on two legs. The primary consideration of mankind at that time was survival. They were concerned with the next meal; they were concerned that Ty Rex or some other beast wouldn’t eat THEM for dinner. In other words, their time horizon was now. Long term for them was probably two or three hours. So, you might ask, what does this have to do with money (or anything else for that matter?)
 
Well, a lot. My point is that mankind is hot-wired not to think about the “long-term”. It is not in our DNA. Although much lip service is paid to the benefits of “long term investing, that is only so much b.s. And so we see this today. Who remembers the collapse in Dubai? How quickly the market has discounted (and forgotten )Greece. The pundits will say the market is a discounting mechanism. I reply the market can only discount what it has seen before. You can’t discount the unknowable.
 
So, my point is simply, these things, just because they no longer make front page headlines, don’t go away. The smart investor will recognize his DNA shortcomings and remember that, even though mankind does not want to think about the long term, the market will punish him for not doing so. 
 
Or, as the Walrus sang in “The Magical Mystery Tour”, boo boop de doop.
 
THERE ARE MANY REASONS to believe the coming collapse of China (as I do) and I shall chat about them in the coming weeks. But I would today like to present one reason which falls into my broad view that history repeats itself in one way or another, and if something can’t go on forever, it won’t.
 
There is ONE reason, and ONE REASON ALONE, why China has reached the stage in which it finds itself today. That reason is the availability of massive amounts of a reserve currency in this case dollars, AND, what most forget , the willingness of the United States to run massive balance of payments deficits.
 
The breath-taking rise in the Chinese trade surplus, and the mercantilistic desire to prevent currency appreciation drove the Asians and the sheiks to buy Treasuries, essentially printing their own currencies. The presence of fractional reserve banking allowed huge amounts of leverage to goose up higher commodity prices. This was their version of QE, masquerading as a cheap currency regime It succeeded, as opposed to Japan and the current situation in the US, because it raised the velocity of monetary circulation.
 
If you go back 10 years to the introduction of the Euro, you will remember the new currency IMMEDIATELY lost 31% of its value. At that time, it was unthinkable the dollar would become so fragile. Then came China. In order to finance the emergence of a new superpower, an abundance of dollars was necessary. To be precise, had the dollar NOT been a reserve currency, there would be no Chinese “miracle” today.
 
Again: lots of dollars were needed, and delivered to China. And by America’s willingness to sustain huge trade deficits. And huge trade deficits mean loss of jobs. No other country would be willing to sacrifice loss of domestic employment for the betterment of world trade
 
But now, with China rebuilt and the trade deficit in full retreat (note the -47% contribution from net exports to China’s GDP growth in the first 9 months of last year), there are LESS DOLLARS being exported overseas. So, China is diversifying. So much so, in fact that a country with less than 8% of global GDP, they account for more than half of the world’s steel production, more than half of global seaborne iron ore freight. And remember, investments in fixed capital formation make up 95% of China’s GDP growth. In other words, China IS Commodities, Inc.
 
In other words, China shares the same risk as the world’s largest pension plans. As Wlliam White , former chief economist at the BIS has argued:

 
Many countries that relied heavily on exports as a growth strategy
are now geared up to produce goods and services to heavily indebted
countries that no longer have the will or means to buy them”

 
As a consequence, the Chinese surplus is set to fall further and, with fewer dollars needed to be recycled to maintain the currency peg, demand for Treasuries will sink. The currency peg will have to be lifted Commodity prices will collapse as deflationary forces take hold and the Chinese will have lost their primary engine of growth, a seemingly unending supply of dollars, with no domestic demand to pick up the slack.
 
More next time. But let us shift gears for a bit and face the question of:: how much do you really understand financial numbers? Clearly, anyone bright enough to read this publication is successful in his or her on way, but that is not to say that “what you see is what you”. As an example, see if you can solve the following puzzle:
 
Three men are attending a convention at a hotel. They rent aa booth for $30, and after they go to the booth, the manager realizes the cost of the booth is only $25, thereby overcharging them by $5. He gives $5 to the hotel porter and directs him to find the three men and return $5. Not knowing how to divide the $5 evenly between three men, the porter decides to give$1 to each of the three men and pocket the remaining $2 for himself. Later that night, the porter realizes that the men each paid $9($10 minus the$1 they received from the porter). Thus, since the $27 the men paid (3x $9=$27) plus the $2 that he took for himself comes to $29, the porter wonders what happened to the missing dollar. 
 
What did happen to it?.. If anyone cares, just let me know and I shall explain it (although I am also absolutely sure all of you figured it out.
 
HEDGE FUNDS AND INVESTING-To those of you have been following me for the past few years, you might remember that I have always been more than a bit skeptical of the rise of these so-called hedge funds”. So-called because very few of them actually hedge; they are mostly momentum driven, closet. indexing trend followers. But they are rich, at least the survivors.
 
So I am taking it upon myself here to once again try to disabuse anyone thinking of following the crowd in this type of investment,
 
Notice if you will my choice of words. I could have said, as most do, “asset class” instead of investment. But I am here to tell you hedge funds are NOT a new or separate asset class. I would refer you to the character Alfred Borden, a magician played by Christian Bale in the movie “The Prestige”. In it Borden counsels a small boy on the art of illusion.

“Never show anyone anything. No one is impressed by a secret.
It is what you use it for that impresses.”

The “secret” of hedge fund investing is that they have some sort of “patented” strategy, or they have some “proprietary” trading strategy (do I hear Long-Term Capital?) The strategy is secretive because they need to justify the outrageous fees they charge for mimicing the indexes.
 
Hedge funds do NOT create new asset classes or new investments, and investing in them does not make you more diversified. YOU CANNOT BE MORE DIVERSIFIED THAN THE MARKET PORTFOLIO, and hedgies trade in the global markets. If you go long and short market assets, the mix does NOT become more diversified.
 
The stock market offers a simple way to look at this.
 
Together, active and passive investors own 100% of the global stock market. The average return of all passive and active investors together is exactly equal to the average return of the global market. The average return of passive investors, the indexers, is also equal to the average return of the global stock market.
 
This means that active investing is a ZERO-SUM game. Given that passive investors’ return is the average, active investors must also have the same average return as the global market, before fees, before expenses, before taxes. If some hedgies wildly outperform the market, as some claim to do, other hedge funds must also spectacularly UNDERPERFORM
 
Taken as a whole, active managers will underperform the market average by an amount equal to cost of trading. In case you forgot, that’s YOUR money we’re so casually chatting about.
 
Until next time
 
Chuck Karasick