The stock market is probably the best thing in the world, but the true risks of the stock market are vastly greater than the representations. And this leads to extremely strange situations in which, say, someone has a bakery, is extremely paranoid about suppliers, very careful about risks, and protects his business with appropriate insurance. Then, at some point, he puts his $122,000 in savings in a fund that he knows nothing about, based on risk measures he knows nothing about, in companies very few people know much about.

He obviously doesn’t work for a retail investment manager…

We have this culture of financialization. People think they need to make money with their savings rather with their own business. So you end up with dentists who are more traders than dentists. A dentist should drill teeth and use whatever he does in the stock market for entertainment.

People should have three sources of variation in their income. The first one is their own business that they understand rather well. Focus on that. The second one is their savings. Make sure you preserve them. The third portion is the speculative portion: Whatever you are willing to lose, you can invest in whatever you want.

I’m sure the 20 year bull market had nothing to do with this attitude towards risk. As Jim Rogers often puts it, there was a day when you sent your ‘idiot son’  to go work on wall street.

Read the full interview and learn why Nassim Taleb thinks government debt is a giant ponzi scheme.

Abstract In this paper I discuss the possibility that the U.S. economy may become enmeshed in a Japanese-style, de‡ationary outcome within the next several years. To frame the discussion, I rely on an analysis that emphasizes two possible long-run outcomes (steady states) for the economy, one which is consistent with monetary policy as it has typically been implemented in the U.S. in recent years, and one which is consistent with the low nominal interest rate, de‡ationary regime observed in Japan during the same period. The data I consider seem to be quite consistent with the two steady state possibilities. I describe and critique seven stories that are told in monetary policy circles re- garding this analysis. I emphasize two main conclusions: (1) The FOMC’s extended period language may be increasing the probabil- ity of a Japanese-style outcome for the U.S., and (2) on balance, the U.S. quantitative easing program o¤ers the best tool to avoid such an outcome.JEL codes: E4, E5.

Seven Faces of Peril Final Jul 28 Bullard 2010

Part 2: Hugh Hendry on inflation vs deflation

The market is now fully ST overbought. The last couple of times this has happened it led to abrupt downdraft either immediately or within about 1 week. I’m thinking it will happen again given the gap and run nature of this market advance since the lows in early July. As usual, be prepared for head fakes in either direction as Mr. Market doesn’t like too much company when going where he wants to go.

There was an excellent piece this past weekend by John Hussman over at www.hussman.net. Even though there have been times where I have disagreed with him and pointed out biases in his thinking, I make it a routine to read his commentary every week. Not only does he provide unique and in depth perspectives and has made some great calls (yup, he has some bad ones too like everyone else), he is amazingly knowledgeable about the intricacies of economics, financial markets, the fed and pretty much anything related to finance which makes me feel quite humble. He has my respect and you can learn a lot from him even if you don’t agree with his market outlook.

I find that the weakness of guys like Hussman who know all this stuff about market is that they get a false sense of their abilities. They think that because of their abundant knowledge, they have the market figured out and they typically will reassure themselves by back testing models/theories they come up with. …as if the market is some sort of equation that can be solved. As a result they become quite dogmatic with their views failing to adjust them quickly when they are flat out wrong or get their timing wrong (same difference in my book).

Here’s the problem with knowing too much and models that use back testing…..the market is not an equation that can be solved. It’s never the same from cycle to cycle and there’s not enough data points to back test models. 100+ years may seem like a lot of data points but it’s not in the context of human existence. In addition to that, although fear and greed never go away, as the decades go by government authorities learn from prior mistakes made (maybe not all the time). Liquidity, market transparency and global integration of markets have improved exponentially compared to the early days. Human knowledge and technological advancement has exploded exponentially as well as centuries have passed. The progesss we have made in the past 200 years dwarfs the progress made for 1000 years prior to that. The spread of democracy and capitalism across the world througout the decades is another huge paradigm shift.

All of these positive structural factors undermine dogmatic notions such as “true market lows only happen with the p/e of the market is ___” or “market peaks always happen when the p/e is ___” simply because this was the average in previous market cycles. When you take into account the above mentioned ongoing structural positives you can make the case that the average P/E multiple at cyclical tops and bottoms will be higher going forward as the human race progresses and as we learn from the mistakes of the past becoming more experienced with capitalism.

Now yes, there are also some negative structural problems as well. The moral decay of North American culture (Europe as well I guess), unfavorable demographic trends in developed nations and a substantial rise in debt levels. However, my point is that the stock market is a dynamic beast that is very new to human beings when you consider that they’ve been on this earth for about 200,000 years give or take a few millenniums. It also cannot be approached from a mathematical/scientific approach because it’s underpinnings are in a constant state of flux. Conclusion: You need to approach the market as an artist more so than a scientist. You probably know a lot less about where the stock market is headed in the long run than you think because you don’t know what types of major paradigm shifts lie ahead and just how well/poor the human race will advance. This is why you must always keep an open mind and reject dogmatic views.

Rogers also astutely points out that big media is basically a farce and a quasi-PR agency for big corporations. I tend to agree. Anyone that dependent on advertising dollars is going to worry about how they portray their sponsors.

Hussman writes:

The financial markets are in a bit of a fight here between technicals and fundamentals. On a technical basis, a variety of widely-followed trendlines, moving average crossings, and resistance areas converge on the 1100 area for the S&P 500. Market internals have also firmed somewhat during the rally in recent weeks, suggesting that investors are eager to re-establish a speculative tone to the market. At the same time, fundamentals are bearing down hard on the market. We continue to observe a clear deterioration in leading indicators of economic activity.

Over the short-term, my impression is that the technicals may hold sway for a bit. The economic data points simply do not come out every day, and to the extent that economic news is not perfectly uniform in its implications, the eagerness of investors to speculate can easily dominate briefly. We established enough contingent call options at lower levels that we’ve now got about 1% of assets in roughly at-the-money index calls – a modest “anti-hedge” that removes any concern we might have about a frantic short-squeeze if the S&P 500 moves materially above 1100. At the same time, the historical evidence suggests that fundamentals have ultimately trumped technicals when we’ve observed similar warnings from economic indicators in the past. My impression is that the economic cold water could hit investors very abruptly, so that gains achieved over several weeks may be suddenly erased in a matter of a few days.

Read the full commentary

Read the full explanation

Letting bubbles inflate and then fighting them when they burst actually worked for a while. That’s what makes it dangerous. It worked in the ’90s. But you shouldn’t read too much into this: This period was assisted by unusually favorable conditions. From 1981 until early last decade, commodities were in a bear market after a bubble in the ’70s and early ’80s. And interest rates were falling throughout the ’80s and ’90s, too. They almost never stopped falling. That made Fed policy look like it was working.

Bubbles can still happen without expansionary monetary policy. In the 19th century, you had bubbles in railroads, for example. But today, the Fed has created a bubble in everything — in every single asset class. This is an achievement even for a central bank. Stocks. Commodities. Bonds. Real estate. Gold. Everything goes up when the Fed prints. The only asset that goes down is the U.S. dollar.

Read the complete article