We are as suspicious of public markets as we are of public toilets. But the average investor believes he can buy a stock in the public markets at the market price and get a fair deal. It isn't so.
Traditionally, most people were smart enough to know that the stock market was no place for an honest working man. The proles and plebes put their money in banks, earned a fixed, reliable rate of return, and left the speculation in equities to the pros. Even today, in much of the rest of the world, people know better. Ordinary people are not fool enough to think they can beat the insiders at their own game.
"Here in Argentina," an economist explained to us, "most people put their money in the bank or buy property with it, because it is something they understand."
Argentina has been through inflation rates as high as 1,000%, a major depression, debt default, a currency crisis, bank closings and a stock market crash — all in the past 10 years. What the Argentines don't know about financial risks, in other words, isn't worth knowing.
But in the United States, the lumpeninvestoriat has not faced such challenges in more than 70 years. It sees almost no risks at all. It thinks it can invest — and invest like the pros.
Some things, we all recognize immediately, are simply too amazing for words: Shakespeare. Mozart. Sex. Air transportation. And the attitude of amateur investors in the United States, circa 2007. They leave us in shock and awe.
Ordinary people turn over billions of dollars' worth of their hard-earned money — immediate, tangible, personal money — believing that strangers will give them back even more. A plumber is supposed to have about as much chance of winning at stock speculation as a corporate insider, they believe.
Of course, it is a monumental fraud — almost equal to "every vote counts" or the "divine right of kings." The market is supposed to be a level playing field, with all the players having an equal chance to kick the ball. The little guy is supposed to be as likely to make money as the big guy.
In theory, it works perfectly; in practice, the little guys lose consistently. They lose in two ways: First, they pay out too much to the financial industry in fees, commissions and spreads. And second, they lose money because they become patsies of the public spectacle.
They read the newspapers. They watch TV. They listen to the experts, the commentators, the pundits. As a consequence, they are buyers to whom the elite sells. They are the sellers from whom the elite buys. Without the amateurs, investing wouldn't be nearly as rewarding for the pros ... or nearly as amusing to the spectator.
What's more, this con is aided and abetted by the Supreme Court itself, which held in Basic Inc. v. Levinson, in 1988, that manipulating a share price constituted a "fraud on the market" that could be measured by movements in the share price itself. In other words, the market really does know best. The market's judgment is "perfect," declared the Supremes.
They were convinced by the academic theory we mentioned earlier, the Efficient Market Hypothesis, according to which prices set by the market are so perfect you're wasting your time trying to outsmart them.
But prices are not perfect at all. They are constantly in motion — subject to influence, sometimes too expensive, sometimes too cheap — always correcting and overcorrecting. Still, if you believe the Supreme Court, the Securities and Exchange Commission and the academics, you'd think that unless there is some illegal manipulation, the little guy can pay whatever price the market dictates and still get a fair deal.
Yet, at the same time, the market is also famously fickle and indecisive. A stock can be perfectly priced at $50 one day and then at $10 the next. Which price is correct? Both, says the theory. The market can do no wrong!
The whole idea is preposterous. But every public spectacle needs its myths. And the myth of an efficient market keeps the chumps at the investing tables. They think they have as much chance of making money as Goldman traders. They believe because — no matter how much they pay — it can't be too much.
Then in 2006, along came a hot new trend suggesting not only that markets are far from perfect, but that the little mom-and-pop investors haven't a chance. Private equity it's called, and it works on the opposite principle of the EMH. It supposes that markets are not efficient and not fair and that a few rich, smart, well-connected people can outsmart the many ignorant middle-class investors. In fact, it counts on it.
For example, private-equity firms bought the Hertz rental car business from Ford, a public company, in December 2005. Eleven months later, they sold it back to the public in an initial public offering. Michael Lewis assesses the damage to the public:
In buying the company they put up $2.3 billion in equity capital. By the time they sold it, they had gotten $1.3 billion of their money back, and held shares — which they no doubt plan to get rid of as soon as they can — valued at another $3.5 billion or so. In less than a year they had netted a fairly clean $2.5 billion profit.
Where did the profit come from? Not from other private-equity firms, nor from shrewd private investors such as Warren Buffett. It came from the investors in the public market.
The lesson: Don't be a public market investor. Invest like a private investor.
And what do private investors buy? They buy private businesses. They buy the business next door. They buy the businesses they know better than anyone else.
DON'T BE A PATSY
There are investment markets, and there are markets of investments.
In the markets of investments, buyers and sellers apply their individual judgments to the value of an investment, and the market price is established.
In the investment markets, on the other hand, both buyers and sellers read the papers in order to try to figure out what "the market" is doing. That is to say, an investor leaves behind the things he knows and understands for things he knows very little about and will never understand.
The neighborhood bank stock is dumped like an old girlfriend; the man is ready for big-time action on Wall Street. He listens to Jim Cramer and forgets to smirk. He looks for the consensus view on next year's earnings and the likely direction of the market in the months ahead. He is no longer an intelligent, independent investor, but a mass-market speculator.
Actually, calling him a speculator is pure flattery. A real speculator has a realistic view of the odds and almost always operates on a simple premise — that the crowd usually underestimates the odds of discontinuity.
Take the case of the market that goes up every year for 10 straight years. What are the odds that it will go up again? There is no way to know. But mankind is a credulous beast. If he smites his first-born and it rains the next day, he will be smiting his first-born every time there is a drought for centuries to come.
And if the market has gone up for 10 years straight, a kind of sentimental momentum tells him it will keep going up. He is loath to accept pure chance as an explanation. He knows there's a reason for it. Low inflation, record profits, favorable Fed policies: He reads the papers; he knows what's up.
The real speculator may know no more about tomorrow than the common man. But he has an advantage — he knows the common man. And he knows you don't win by predicting the future; you win by getting the odds right. You can be right about the future and still not make any money. At the racetrack, for example, the favorite horse may be the one most likely to win, but since everyone wants to bet on the favorite, how likely is it that betting on the favorite will make you money? The horse to bet on is the one more likely to win than most people expect. That's the one that gives you the best odds. That's the bet that pays off over time.
Unlike the lump, the speculator knows he is guessing. So, if he has his wits about him, he will insist that the odds be wildly in his favor. He will buy a stock trading at half its usual price, for example, on the hunch that it will soon revert to its mean. Or he will take a position in a risky gold exploration company or an improbable new technology — betting that if it doesn't blow up in his face, it will produce a 10-for-1 bonanza. He might even take a flier on the supposed next Microsoft, hoping that if it doesn't bankrupt him, it will make him rich.
When you make an investment, the last thing you want is a level playing field. If, as the SEC assumes, everyone actually has the same information to go on, investors' results would be completely random.
They'd win sometimes and lose sometimes, just as they would at a slot machine at Las Vegas where everyone faces the same odds. And since it costs money to play — the house has to make money somehow — over time they'd lose money. Of course, that is exactly what happens to most investors. But not to everyone.
The mark of the real speculator is that he looks for bets that are not fair; he looks for opportunities to play where the field is tilted in his favor. In this sense, the public-market investor who believes the market will go up next year because it went up last year and because Abby Joseph Cohen [a senior investment strategist for Goldman Sachs & Co. of New York] said so is not even a real speculator. He is merely a patsy. He is the person you want to keep in your sights, the way a hunter targets a deer.
If you want to speculate, you need to know what he is doing — and do the opposite.
Better yet, be a real investor.
How can you be a real investor? Buy a real investment, the kind of investment chumps don't buy. What kind of investment is that? A low price is generally an outward sign of inward grace. And one sector that looks cheap now is commodities — especially soft commodities, such as grains and foodstuffs.
"Here's the only trade you have to make in the next 25 years," says our friend, [rsearch analyst] Steve Sjuggerud. "Buy commodities now. Sell them in 2016." He points out that when stocks zig, commodities zag. Bull markets in commodities last about 16 years. This one began about six years ago and has about 10 left to run. By contrast, the bull market in stocks began in 1982 and must be near its end.
Buy into a bull market after it has gotten under way, says Mr. Sjuggerud, but before it has gotten very far. Stick with it until it reaches an end. And then, sell the thing that is most popular at its peak and buy what is least popular.
While more and more farmland is taken out of production by encroaching suburbs and highways, the demand for food is soaring. Forty percent of the world's population — mostly in Asia — is generating the financial means to buy food on the world market.
The Chinese, for example, consume about 2,500 calories per day — the same as the Taiwanese.
But on the island of Taiwan, more of the calories tend to be of the animal variety; the average Taiwanese person consumes nine times as much meat as his cousin on the mainland.
The Chinese are trying to catch up — with meat consumption rising at a 20% annual rate. What this means to the grain market is obvious, too.
It takes about nine units of grain to produce one unit of meat. This is why China and India, both of whom used to be self-sufficient in grains, now need to import the stuff. But from where?
Everywhere you look, the entire agricultural sector is short of water. Just as the planet seems ready to reach peak oil production — the point at which future production is likely to be lower than past production — so, too, does it appear to be reaching a kind of peak water limit. India and China both have their well-known problems with water, but so does the United States. The great lake under the American prairie — the Ogallala Aquifer — is the world's fastest-disappearing water supply.
The water under the Klamath Basin in Northern California is also dropping fast — down 20 feet in the past three years.
Energy companies, hustlers, and hallucinators are trying to replace oil with grain. But it takes huge amounts of land, water, and energy to produce enough grain to make a significant impact. Switching from oil to ethanol will merely suck the earth dry of water faster — and send food prices soaring.
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