How We Think...

The following publication was written August 7, 2003:

HOW TO THINK OUTSIDE THE BOX

"The bears don't live in Fifth Avenue mansions."
--Bernard Baruch

The famous French writer, Guy de Maupassant, said that if you don't have originality, you must acquire it. In Modern Times, Paul Johnson's seminal history of the 20th century, we learn that with the exception of Winston Churchill, virtually every world leader lacked vision and blundered time and time again in the wrong direction...like an ancient Greek tragedy.

Talleyrand's famous statement about the return to the French throne of the Bourbon Kings after the Revolution: "They have learned nothing and they have forgotten nothing."

The First World War set the tone for the entire 20th century. It's hard to believe that tens of millions of soldiers lived for nearly four years in bloody squalor in 35,000 miles of trenches, fighting for a few thousand feet of land.

As David Fromkin writes in A Peace To End All Peace:

"The opposing armies subjected one another to punishing and almost ceaseless artillery barrages, punctuated by suicidally futile charges against the other side's barbed wire and machine guns. Alternately, executioners and the executed, one side played the role of the firing squad whenever the other side launched one of its frequent attacks. No ground was gained. It was a deadlock."

With WWI and its aftermath came the peaking of Europe's power and the end of its great empires. As Robert Kagan points out in Of Paradise And Power: "After five centuries of imperial dominance, colonial empires in Asia, Africa and the Middle East were forced to be abandoned, probably the largest retrenchment of influence in human history."

The European suicide of WWI ushered in the Russian Revolution and Civil War, communism, Hitler, WWII, mass genocide, and well over one hundred million lives lost. And, it occurred simply because the leaders of Europe were incapable of thinking outside the box.

Only two of them, Lloyd George, the British Prime Minister, and Winston Churchill, then Lord of the Admiralty, thought creatively. They proposed an end run around the German forces through Turkey and Bulgaria to break the deadlock, which ultimately failed due to a lack of conviction on the part of the British military.

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Much of my thirty-plus years in the investment business has been spent developing tools that will help me think outside the box. In this report, I share some of them.

THE POWER OF CONTRARY THINKING

Of course, nearly everyone in the financial community pays lip service to contrary thinking, but few really practice it. It requires such independence of mind and disdain for popular opinion that by its very nature it can only be embraced by few persons.

Two stories on the subject are worth relating. Many years ago, I became an expert on using best-selling investment books as a contrary indicator, and in fact, they have a flawless record since the 1920s.

In the late 1970s, there were nearly half a dozen best-selling books predicting hyperinflation, the collapse of the U.S. dollar and depression. The books were selling so well that their publishers ran full-page ads in all the major newspapers, featuring bold-faced quotes from these doomsday forecasters, who were literally predicting the end of the world.

This was the impetus for me to take a contrary view, and in 1982, Gary Shilling and I wrote and published a book called, Is Inflation Ending? Are You Ready?

On December 14, 1983, I wrote an article for my clients entitled "The Power Of Contrary Thinking: Economic Boom And Major Disinflation Coming; Buy Basic Industry Stocks". This article, which referred to the contrary relationship of best-selling investment books, drew a tirade of abuse from the books' authors. The last paragraph in the article was particularly irksome to them, and we quote:

"The wide scale acceptance of a coming depression in 1979-1981 suggested we would eventually have a major economic boom. The popular belief in the late 1970s that inflation would last forever implied inflation was ending. Finally, the current widespread belief that the industrial age is over indicates that some of the best investment opportunities lie in the out-of-favor heavy industrial companies. If these contrary 'forecasts' work out, you won't need to make another prediction until a stock market book reaches the best-selling list, at which time it will be time to sell."

The second story involves the weekly breakfast I used to have with another contrarian, Bill Joseph. At these sessions, we tried to think of all the things that everyone knew was going to happen or knew for sure could never happen.

It was the summer of 1982, and interest rates were the highest in the history of capitalism. We were walking across Central Park and suddenly I turned to Bill and said: "Everyone thinks there is going to be a depression, so the best course of action is to leverage yourself to the hilt in stocks and bonds." We both burst out laughing, because it did seem so absurd and because it was so absurd, it was almost certainly the right thing to do.

Which brings us to the present.

In our WILTW of January 17, 2003, I prepared a list of all the things that everyone "knew" was going to happen or "knew" for sure could never happen. The list is set forth below.

Despite the passage of only a little more than six months, many of these certainties have been shown to be on very shaky ground.

The Japanese economy and stock market are both in a strong recovery phase without a weak yen. Germany is undergoing major regulatory reform. Pricing power is returning as evidenced by continually rising sales growth from major U.S. companies. Deflation fears have subsided. Technology stocks are leading the current bull market. The Internet is booming at rates that exceed even those of the optimists from the late 1990s.

The economies of emerging markets are outperforming those of developed countries and emerging markets' bonds and stocks are performing well. Housing prices continue to increase in value. So far in 2003, equity returns are already in double-digits for most developed countries, with the NASDAQ Composite up 27% year-to-date. The Brazilian, Mexican and Argentinean stock markets are rallying strongly.

To everyone's amazement, President Bush has pushed through two tax cuts, the repeal of the estate tax, a major cut in taxes on dividends and Medicare reform. Finally, some type of energy bill seems probable.

Another classic example of consensus thinking was the bearishness that prevailed early in 2003. During our three decades of market experience, we never saw more fear and uncertainty as that in February-March 2003. As we wrote in our March 21, 2003, WILTW:

"Although everyone wants the bear market over, no one wants the bull market to begin without them."

"Money on the sidelines is enormous. After all, there is so much uncertainty! What great buying opportunity ever occurred in a time of certainty? How many hundreds, if not thousands of times, in recent months, have we read the following words: 'What worries me is...What I'm afraid of is...I'm fearful of.'"

"Let them worry. A bull market climbs a wall of worry, and as long as so many worry about so much we are comfortable being bullish."

Earlier, in February, we had pointed out that money fund assets were at an all-time high of $2.3 trillion, earning the lowest fees in the history of the money fund industry. At the same time, money market funds, as a percent of all mutual fund assets, were a record 35.5% at yearend 2002. Also, money market funds, as a percent of U.S. household financial assets, were a record 3.8% as of September 30th, 2002, the most recently available data at the time.

It was clear to me that the great mass of investors were hiding in money market funds, earning a negative real rate of return. Clearly this was the wrong strategy.

As we wrote in our WILTW of February 7, 2003:

"It is highly unlikely the $2.3 trillion in money funds is in the right place. Why? And where should it be?...[One] possibility is that the widely expected low single-digit return for equities proves understated and that this money on the sidelines should be gradually put into the stock market."

MY THEORY OF CONTAGION

Many years ago, I developed a unique way of looking at the world and markets. It all began with the wave of hijacking that spread across the world in the 1970s. Almost like a spontaneous outbreak of forest fires, hijacking became an international problem overnight.

Ever since then, whenever I see a bull or bear market occurring in a country, or some unusual development, I watch closely for a contagion. Two or three confirmations is usually all I need.

My theory is this: The contagion will spread until proven otherwise.

Let me give you some examples of how I have used this successfully over the years. In 1979, Paul Volker was appointed head of the Federal Reserve and changed the nature of how the monetary authorities dealt with inflation. With the highest nominal and real interest rates in the U.S. in the history of capitalism, it was clear to me that disinflation was only a matter of time.

But disinflation was not just a U.S. event. It soon became a worldwide event.

We used the theory of contagion very successfully in Brazil in early 1994.

Brazil at the time was experiencing inflation of 5000% and it had had dozens of unsuccessful anti-inflation programs. There was huge skepticism that disinflation could ever occur in Brazil. But I noted the Brazilians were the best businessmen in Latin America and had coped well with this corrosive inflation.

It occurred to me that the economy and stock market in Brazil would boom, if the authorities were able to successfully control inflation, which seemed likely because then-Finance Minister, Cardoso had a plan with teeth. Also, anti-inflation programs were working in other parts of the world, including Latin America.

Accordingly, we took our profits from Hong Kong and reinvested them in Brazil. The market in Brazil went up nearly 300% in the next 3 years.

Another example was our work on global deflation in 1996. We began by publishing a survey of the inflation rate for 45 countries. We found that year-over-year inflation was declining in 42 countries, indicating a powerful, secular global force. We followed those statistics carefully over the ensuing months, arguing that lower global inflation rates meant lower global interest rates.

We began to publish a survey of the 17 major global bond markets and whether they had broken their 1993-1994 lows in yield. When we began the survey, only 3 bond markets out of the 17 we studied had broken the low.

By January 1997, seven bond markets had broken the low. By February 1997, the list had jumped to 11 bond markets. The rest, of course, is history.

We quote from our November 18, 1998, memo, entitled "GLOBAL DEFLATION; MORE COUNTRIES FALL INTO CONSUMER PRICE DEFLATION":

"As recently as our April 1997 survey, there was only one major country with year-over-year consumer price deflation. Now, there are five: Japan, China, Singapore, Sweden and Brazil.

"If Germany and France join Japan in deflation, as seems increasingly likely, some 31% of global GDP will be experiencing outright consumer price deflation. If you add China, Singapore, Brazil and Sweden, the figure jumps to 38% of global GDP.

"It may be useful to recall our long-term experience with isolated events that turned into major secular trends.

"If the number of countries experiencing deflation continues to expand, global interest rates may keep falling...and falling...and falling."

One of the most interesting contagions was the Asian boom/bust. We had opened an office in Hong Kong not long after the Tiananmen Square disaster, which had caused Hong Kong stocks to crash. The Hong Kong stock market was then selling at about 6 to 7 times earnings, had a 4.5% dividend yield, and the best 30-year earnings record in the world.

Yet, the Hong Kong stock market was also selling at a China "discount". We thought it should sell at a China "premium". And, as a result, after organizing many trips to Hong Kong, our clients put many billions of dollars into the Hang Seng Index under 2,500.

However, what was a contrarian opinion in 1991-1992 became consensus by early 1994 and we closed our office and sold all our Hong Kong stocks. There were a large number of magazine cover stories on the coming Asian century and the enormous investment opportunities in the region. Meanwhile, real estate speculation was rampant and emerging Asia was the recipient of much more foreign investment than it could handle.

We watched the region's stock markets go sideways for nearly 3 years. Then, we learned that Malaysia had built the world's highest building and planned to construct the world's longest building, certainly a kiss of death if there ever was one.

At the same time, several stock markets, such as Thailand and Korea, were breaking down from major tops.

On November 8, 1996, we published "IS THE PACIFIC RIM SLIDING FROM BOOM TO BUST?" This series eventually grew to over 100 memos.

Our thesis was that the contagion would spread from Thailand and Korea to the entire region, and the stock market gains of the 1990s would erode and provide investors with a full roundtrip to the downside. We also argued that the contagion would spread to all developing countries and finally to the developed world.

Realizing that over-investment was the culprit in Asia, we concluded the same was likely to occur elsewhere. On November 13, 1997, we wrote a memo entitled, "OVERINVESTMENT BOOM IMPERILS THE GLOBAL ECONOMY". We said as follows:

"Now, the great question of the age is whether we can stop this investment-led expansion from turning into a boom-bust. Has global downsizing, privatization, financial deregulation and liberalization, and the opening up of emerging markets released a tidal wave of excess capacity that will take years to work off?

"Have we lost the ability to control overexpansion? Do we still know how to stimulate demand? Can the world's policy makers shift from fighting inflation to deflation? Can previously profligate governments, now so proud of their fiscal rectitude, reverse course and open up the spending floodgates? What tools are available to governments to stimulate demand after the boom-bust of an investment-led expansion?"

Perhaps the most prophetic example of our theory of contagion is terrorism. In the fall of 2000, we noticed a striking increase in hostilities between Palestinians and Israelis, in fact, reaching a level of intensity that had not been seen for at least 30 years.

We decided to research the subject, and we noticed that terrorism was on the increase, not only against the U.S. (U.S.S. Cole, October 2000; the simultaneous bombing attacks on U.S. embassies in Kenya and Tanzania, August 1998; the bombing of the U.S. military base Khobar Towers in Saudi Arabia, June 1996; and the February 1993 WTC bombing), but around the world. For example, some 60,000 Indians had been killed by terrorists in the previous two decades, and the rate of violence appeared to be accelerating.

Accordingly, we began to study terrorism, which in turn led us to Islamic Fundamentalism, a subject we studied in depth before finally writing, THE WORLD'S GREATEST THREAT: TERRORISM on August 29, 2001.

MY THEORY ON ANOMOLIES

An anomaly is an inconsistency. It might be something that should be happening and isn't or it might be something that is happening and shouldn't. The best known and most common examples are stocks (or a stock market) that go down on good news or refuse to fall further on bad news.

I've found anomalies to be highly useful in getting at the truth. Consider the following examples. Stock market breadth (the relationship of advancing to declining issues) peaked in late 1998, while the major averages deceptively went on to new highs. The same occurred in the late 1920s. Also, while the major averages soared in 1999 and early 2000, commodity prices remained weak, foretelling the coming recession.

I have been a student of commodities my entire career in the financial markets. They have been invaluable as leading indicators of economic activity and inflation/deflation.

Commodities and real estate were the great anomalies of the past recession. Commodities, as measured by the CRB, bottomed in early 1999. After 9/11, the CRB had a successful test of that low, and in early 2003, the index rose to its first "higher high" since the bear market in commodities began in 1980. In other words, the CRB rose to a high of 251 in February 2003, versus its prior cyclical high of 233 in late 2000.

So the anomaly was this: if the economy was so strong in 1999, why were commodities weak? If the economy was so weak in 2002 and early 2003, why were commodities so strong?

At the same time, residential real estate was rising in a very unusual fashion. In fact, in every boom/bust of the 20th century, residential real estate had collapsed along with the stock market.

Much now has been written about how the rise in real estate offset the losses in stock prices, but I was one of the first ones to point out this anomaly of rising real estate and its importance to the economy. To me, this indicated the economy was perhaps much stronger than the consensus believed.

We quote from WILTW of March 18, 2002:

"The most important economic question of 2002? The direction of residential real estate. According to the Fed's Survey of Consumer Finances, about 49% of U.S. households have capital in the stock market with an average value of $25,000. By contrast, over 66% of households own a house with an average value of $100,000. Thus, the direction of house prices is more important to consumer confidence than the direction of the stock market."

When we first started focusing on the importance of residential real estate to the economy in early 2002, it was unknown when the housing bubble would burst, if there was one. Many reasonable and intelligent people thought there was one.

However, at the time, there was too much publicity about the "housing bubble" for us to believe it would happen soon. Several magazines ran cover stories warning of the bubble in house prices, including Fortune Magazine, which showed a house about to fall over a cliff.

Perhaps since commentators missed the last bubble, they wanted to be sure to catch the next one.

When an anomaly first appears, it is only a subject for further study. Perhaps the anomaly will disappear. But if it persists, then you must ask the question why? It is the answer that leads you to the truth.

In the spring of 2003, we had an amazing anomaly: bond yields collapsed, the stock market rose, the dollar dropped significantly and commodity prices strengthened. Obviously, one of the markets was wrong. It was unlikely that two or three of the markets were wrong. If one market were to be wrong, it clearly was the bond market--because rising commodity prices and a weak dollar were not consistent with a healthy bond market.

As is well known, commodities kept rising for years.

MY THEORY OF INVESTOR PSYCHOLOGY

A long time ago, I came to the conclusion that investors base their attitudes on their last traumatic experience. That says a lot about the past, but virtually nothing about the future. The more traumatic the losses, inevitably, the bigger the bull market in the aftermath.

After the 1929 crash, investors shunned the stock market for a generation. Yet, the values at the bottom in 1932 were the greatest in the history of the U.S. stock market. Obviously, the returns from such lows were hard to ever equal again.

After WWII, investors and businessmen widely expected another depression as the military was discharged. They were looking backward to the aftermath of WWI and the bust of 1920-1921 after the inflationary boom of the war. But what they failed to understand was the huge pent-up demand stemming from the depression years of the 1930s, as well as the optimism that fueled the enormous postwar boom.

By 1980, after 30 years of gradually rising inflation, culminating in a painful double-digit inflation, investors became convinced inflation would last forever. It took nearly 13 years--until 1993--for investors to believe in disinflation...just the moment when the first serious trend reversal began.

In the early 1990s, our theme for the decade was the loss of pricing power. It took 10 years for this to sink in, but in 2002, everyone was obsessed with lack of pricing power and deflation, just when we saw the first signs of the return of pricing power.

In the 1990s, there developed a widespread sentiment about buying the dip. Those who've studied market history knew this would lead to tears. And, in fact, once the market peaked, there were some 11 failed rallies in the NASDAQ. As a result, the new mantra became: sell the rallies.

After an 82% plus decline in the NASDAQ, everyone was disgusted with technology stocks and the consensus was they would never come back. Yet, the NASDAQ is outperforming all other market indexes year-to-date.

Understanding investor psychology is the most critical determinant of investment success. It is the irrational under-pricing of assets that creates the best investment opportunities. Investors who consistently can judge that psychology--by buying assets that are under-priced and avoiding or shorting those that are overpriced--will be successful in the long-term.

HOW I PROCESS INFORMATION

My uncle, the late James Hunt, graduated from Harvard Business School in 1931, joined a prominent investment banking firm, then became a major player in the OSS during WWII and finally became one of the top people in the CIA after the war.

He told me that the investment business was very similar to the intelligence business--there is a lot of disinformation and bad information. Who do you trust? And what information can you believe?

I've watched the rise and fall of so many stock market gurus that I could write a book about it. The common theme among all of them was that their biases ended up destroying them. Often, I see very gifted money managers and/or market practitioners basing an investment strategy on certain assumptions. But, as often as not, those assumptions prove false, and then, the whole basis of their strategy crashes to earth.

One of the reasons for George Soros' immense success is his recognition of his own fallibility, and his willingness to change his opinions in a nanosecond. If you read Soros' books and published articles, you'll often see that his written conclusions are wrong, but he still manages to make money. So, obviously, he changed his mind.

In the fall of 1998, Soros published a book entitled, The Crisis of Global Capitalism: Open Society Endangered. He made some excellent points that are still valid, namely that markets go to extremes and there needs to be international regulation to prevent this tendency to overshoot on the up and the down side. But, because the authorities of the world believed in free markets, no one wanted to interfere. He thought it was very dangerous and threatened the very basis of capitalism.

In any event, as soon as the book was published, the U.S. stock market entered a recovery phase, and Soros quickly changed his mind and became bullish--at least temporarily--on the equity markets. Ultimately, of course, Soros was proven right.

The French philosopher Descartes said: "The only thing that I know for certain is that I know that I know nothing". It's a good place to start processing information. But many people do the opposite--they start with an assumption and then look for the data and the statistics to support their view.

Back in the late 1970s and early 1980s, I kept voluminous files on newspaper headlines and magazine cover stories. Invariably, whatever the media focused on was not of great significance, and most certainly was not useful investment information. But many people are swept up in the noise and hype of the media and lose track of what's really important.

I learned a lot about how this works in the prelude to the invasion of Iraq. I must have read literally thousands of articles espousing people's fears of all that could go wrong. It was a virtual feeding frenzy of worry and fear.

A simple analysis of recent history might have proven more useful than all this hype over what could go wrong. First, the American military had been hugely successful in Afghanistan, a place where virtually everyone, including me, expected us to be caught in a quagmire for years.

Secondly, we knew the Iraqi economy was in terrible shape. Roger Cass believes that under Saddam, Iraq's GDP had fallen a cumulative 60% since 1980 and per capita incomes were less than one-third their peak levels. Inflation averaged 50% annually over the past decade and the dinar plunged from 0.3 to over 3,000 to the dollar.

Prior to the war, manufacturing production in Iraq had virtually ceased, with the Arab Labor Organization reporting that two-thirds of Iraq's 60,000 factories and workshops were shut. Unemployment was unofficially estimated at 80% of the civilian workforce. Salaries were not linked to inflation and wages were frozen, so Cass estimates the average Iraqi was earning less than $3.00 per month.

Furthermore, anyone who studied Saddam in any detail was well aware of the many atrocities he had committed. Reportedly, Saddam killed as many as one million Iraqis, and he wanted each Iraqi family to bear the scar of one of his murders. It was also well known that Saddam based his regime on that of Stalin, who was the most brutal dictator in modern history.

Why would the Iraqi people not welcome the end to such tyranny?

Also, while there were many protests against the war around the world prior to the invasion, there was not a single one in any country in the Middle East, nor was any American citizen or American institution attacked during this period. This was a sign that the Arab Street was not going to rise up and revolt as so many feared and expected.

Now the same negative, media hoopla surrounds the reconstruction in Iraq. Clearly, the administration made errors, but an unemotional evaluation of the facts would produce a much different assessment than the highly politicized view that one reads in the popular press.

First, not one of the rulers of the 22 member states of the Arab League has been freely elected. Six Arab or Middle Eastern countries (Afghanistan, Iraq, Saudi Arabia, Libya, Sudan and Somalia) were ranked among the world's eight most repressive regimes in 2001 by Freedom House. All but one of the world's remaining military regimes are in Muslim countries.

Of the 30 active conflicts in the world, 28 involve Muslim governments and communities. Nearly two-thirds of the world's political prisoners are held in Muslim jails, where 80% of the world's executions are carried out each year.

Less than 1% of foreign investment to developing countries goes to the region and almost one-third of its 300 million people live on less than $2 a day. The combined GDP of the 22 Arab economies in 1999 was $531 billion, or 70% of the GDP of Texas.

Was there ever a region more ready for change?

MY THEORY ON CHANGE

I can honestly say that I love change. Dozens of times in my life, I detected the first inkling of change and then quickly embraced it. But, when I argue the case to entrenched and linear thinkers, they generally have a hard time letting go of the old shibboleths.

I am agnostic about change. Neither good nor bad--it's simply inevitable, and if you fight it, you will be crushed.

How do I recognize change?

--Kiril Sokoloff