The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (12 page)

Some people would say Warren has lost his touch. We don’t think so. We think he just lost his bubbles. Warren is still an excellent investor, but he tends to do very well during stock market bubbles and not so very well when there is no bubble.

So, is it any wonder that Warren doesn’t want to believe we are in a bubble economy? Is it any wonder that he so fervently pushes stocks as a good investment? Remember
Figure 3.1
at the beginning of this chapter that showed how well stocks had performed relative to gold and T-bills? He needs to push stocks because he desperately needs a bubble economy and a bubble stock market in order to show good growth. Now, of course, he doesn’t say that, but clearly that is true.

And if the stock bubble were to continue to rise, you couldn’t make a better choice than putting your money with Warren Buffett. But if the stock bubble does not continue to rise or if it pops, then you could be in real trouble betting on Warren. You could even end up like those who invested in another master of conventional wisdom investing, Bill Miller (see the sidebar that follows).

Buffett’s reliance on CW is already showing problems because the stock market bubble is no longer rising. As
Figure 3.5
shows, stocks don’t look nearly as good now, while gold looks fantastic. Mr. Buffett would say this is simply a diversion from the longer-term pattern. We say the pattern is changing for all the reasons we discussed earlier in this chapter and in our previous books.

Figure 3.5
Stocks versus Six Month T-Bills and Gold, 2000 to 2011

What $100 invested in 2000 would be worth today.

Source
: Bloomberg

The people managing hedge funds are some of the best investors in the business. That’s the Conventional Wisdom, and this time we agree with conventional wisdom. So, if CW is working, they would be some of the best practitioners of CW and would have some of the best returns to show for their CW investing.

So, let’s look at hedge fund returns. Fortunately, another John Wiley & Sons author, Simon Lack, recently published a book about hedge funds called
The Hedge Fund Mirage
(2012) that reviewed the actual performance of hedge funds. Before we go on, we should clarify that not all hedge funds use conventional wisdom. Many are truly hedge funds and use a variety of non-CW strategies to get high returns.

However, most hedge funds are surprisingly unhedged and very conventional. They are essentially leveraged stock funds. You can see this clearly by looking at the correlation between stock market returns and hedge funds in
Figure 3.6
. As the chart shows, they really do make a good case study of the best in CW investing.

Figure 3.6
Increasing Correlation of Hedge Fund Returns and the Stock Market

Since 2004, hedge fund returns are becoming increasingly correlated with the stock market.

Source
: Bloomberg.

So, what did Simon Lack find in his research on hedge funds? Basically, what he found is that hedge funds did very well when they were first created in the early 1990s. They were smaller, which made it easier to find a good niche from which to extract higher profits. As they got bigger—much bigger—it became harder to find more or larger niches to properly invest their funds. And there was more opportunity when the stock bubble was just starting. Also, like any industry, they may have been a bit more creative when they were first starting—they had to be to attract capital to a type of investing that was not well accepted.

So returns fell over time. However, fees did not.

That wasn’t a big issue until the stock market collapsed in 2008. At that point, hedge funds lost an enormous amount of money. They weren’t really hedged at all. Or at least a large number of them weren’t. Let’s keep in mind we’re looking at an entire industry. There always have been outstanding performers and likely will be in the future. But, as an industry, it wasn’t looking very good in 2008.

Mr. Lack found that, after deducting fees, hedge funds had lost almost
all
of the profits that the industry had
ever
made for investors in the stock market crash of 2008–2009. That’s right, over 15 years of profits lost in less than 6 months, as shown in
Table 3.7
. Please note that this table does not take into account “survival bias” (when companies go under) and other reasons why these numbers are actually more conservative than reality. In other words, it was even worse than this.

Table 3.1
Hedge Fund Returns after Fees

So much for the best of CW investing. They had bet heavily on a rising stock market and had lost everything they had
ever
made in the few short months when the market took a big fall. And these people are the best in the business. The bottom line is that it’s increasingly tough to make money with CW investing.

This short summary of Mr. Lack’s groundbreaking work does it little justice. It’s a great book, whether you have any interest in hedge funds or not. It’s an honest and fascinating look at how the best American investors operate. Pick up a copy today—and hats off to another great John Wiley & Sons author.

The key to correct investing in the future is to recognize that the future will be significantly different from the past. Conventional Wisdom says that nothing is fundamentally different about the economy; we are just going through a rough spot. If we can just be patient and don’t do anything rash with our investments, we can count on “natural growth” to eventually return and all will be okay. Whereas, Aftershock wisdom says that there is no “natural growth,” only real growth created by real productivity improvements. We have not had any significant real productivity improvements for many years. Instead, we had the rise and now the decline of multiple bubbles, and therefore the future is not the past, we are in a very different economy than before. In fact, the entire world is in a very different economy than before because we are in a worldwide bubble economy that is popping.

This is different from the past. We have seen bubbles before, such as the Internet bubble, and its demise really wasn’t such a big deal, especially on a global level.
But it is different this time
. This time we have not one smallish bubble, but six, huge, interdependent bubbles, and when they fall fully, it is not going to be anything we have seen before—involving rising inflation, rising interest rates, and falling assets across the board.

We have also had inflation before, such as in the late 1970s and early 1980s,
but it is different this time
. This time, because we have so many colinked bubbles, high inflation and high interest rates are going to be the final blow to our multibubble economy and to the world’s bubble economy, as well.

Our earlier books,
America’s Bubble Economy
(2006) and
Aftershock
(2009 and 2011), described in detail what created the multibubble economy, and how the final two bubbles—the dollar and government debt bubbles—will be the next to pop, bringing on the Aftershock. Here is a quick summary:

Since the early 1980s, we have been borrowing more and more money (pumping up the government debt bubble). One of the key factors that made so much borrowing possible, especially in the past few years, has been the ability of the Federal Reserve to do massive money printing (pumping up the dollar bubble). This massive money printing worked to keep interest rates low and has allowed the government to borrow astronomical amounts to fund its deficit spending. In the years since the financial crisis of 2008, both the dollar and government debt bubbles have grown bigger than ever, in an effort to keep the rest of the multibubble economy afloat. All that was, and still is, okay—as long as the massive money printing can continue.

But here is the problem: massive money printing cannot continue forever. Why? Because massive money printing eventually causes rising inflation. Rising inflation eventually causes rising interest rates, and rising interest rates are not going to be good for maintaining this fake, stimulus-created “recovery.” Instead, rising inflation and rising interest rates are going to be the final blows that pop the bubbles.

The dollar bubble will pop as a result of inflation spiking up, reducing the buying power of the dollar. There is no permanent way around this coming inflation, only short-term delaying tactics. If somehow massive money printing would never, ever cause rising future inflation, that would be great—in that case, we could forget about paying taxes or even earning money because we could all just print money instead. Clearly, that won’t work.

High inflation and high interest rates will make dollar-denominated assets not so appealing, especially to foreign investors, who currently own more than $20 trillion in U.S. assets. When inflation comes, foreign investment will fall, and the dollar bubble will fall. Anyone who deludes himself into thinking foreign investors will stay in the United States because they “have nowhere else to go” is just being silly. Of course they will have other places to go. They will go back to their own countries’ assets, such as their own short-term debt, which will be falling as well, but will not be falling as much as our dollar-denominated assets. Even today most money stays in other countries. It doesn’t all come to the United States.