Is the market a scam?

We are told, “the market always goes up”, but this statement ignores a few things that we might want to consider if we are going to be betting our savings on this “fact”.

First, there is the survivorship bias. This is the idea that when a company goes out of business or is purchased by another company, that company is no longer counted in the indexes. A poor company being dropped from the indexes raises the average value, so it looks like the market went up to anyone looking at the market’s history. But this understates the chances of an investor investing in a company that will later go bankrupt.

Second, it is possible that the increases in the value of the indexes are solely due to inflation. If the market was actually producing value, then the value of the market should be increasing compared to commodities.

Take gold for example. Technology makes it easier to mine gold now than it was in the past. Gold also does not decay or get used up, so the more gold that is mined the more gold there is. That means the supply of gold goes up every year. And further, there are no longer any gold backed currencies, so all the gold that used to back the currencies has also been sold to the market, further increasing the supply. Taken all together, this would imply that gold should actually be getting cheaper each year in real value terms.

Now take a look at the graph below. A dollar worth of gold in 1929 is worth $40 today. A dollar worth of the Dow Jones Industrial Average (DJIA) is worth $42 today. The values obviously haven’t moved in lock step, but they do seem to be tracking each other. But we already said that gold should be actually decreasing in value because of technology and increased supply, and that stocks should be increasing in value if they are actually producing value. What we’re seeing here is only a 5% difference, when gold should have been going down from the start, and businesses rising in value from the start.

Now think about this in terms of the companies that you’ve worked for. Have you ever seen a company that did not waste money? And who are the worst offenders, the big companies or the little ones?

In my experience, the bigger a company is the more likely someone in it is to exchange company profits for personal comfort and get away with it. The employee, manager, or CEO would rather ignore a problem and just sweep it under the rug than try to fix it.

In a smaller company these costs are harder to hide. But in a larger company the costs can be papered over and covered by some other income, like the proceeds from selling stock. And it would be prudent to point out that the indexes are really made up of the largest companies. So it’s not so far fetched now to believe that the stock market, or at least the indexes are only representing the effects of inflation and not any real added value.

When the music runs out

If this is correct, and the continuously rising market really is just a scam, then eventually the scam is going to end and reality is going to take over. Eventually the pyramid scheme will collapse.

I don’t know when this is going to happen, but inflation is probably speeding up, not slowing down, so it might be getting here faster than we expect. The $700 billion bailout bill will likely push the market higher because it will cause inflation.

I’ve been rereading Taleb’s book “The Black Swan”. In it there is a discussion about a Thanksgiving turkey. For 1000 days the turkey is fed like clockwork. Each day the turkey is fed the turkey comes to feel safer and safer. Each day brings the now regularly expected feeding. Then on day 1001, the day before Thanksgiving, the turkey gets the axe. Notice that the day the turkey felt safest was the most dangerous day.

If the situation you’re in is safe, then each day should confirm for you that you are safe and that your safety will probably last even longer. If the situation you’re in is not safe, then each day should tell you that you’ve pushed your luck just a little farther and it might give out all that much sooner.

The problem is it’s difficult to tell the difference when you’re in the situation. But one way to figure it out is to look for things that don’t follow physics or human nature. The turkey should have suspected something was wrong when he started getting “free lunches”. We should be thinking the same about the “free lunch” of a rising market and start looking for ways to protect our necks.

Exploit the loophole

With inflation and the markets, government has created a loophole. When a loophole exists you can temporarily get more than you would otherwise be able to. But the more the loophole is exploited, the faster it will close. So the longer and more extensive that government inflates the money supply, the closer we get to the loophole closing. The closer we get to “Thanksgiving” and the “axe”.

My opinion on this is that we should look to benefit from the loophole, but make sure we don’t end up paying later for the freebies that we got from the loophole. So taking a look at the chart above of gold and the DJIA crossing over each other tells me that I should be setup to take advantage of the rising prices of the DJIA, but also avoid losing the value I gained when the price of the DJIA falls back down. Personally, I do this with the No Lose Stocks strategy, so my profits climb with the stock, but don’t fall because of the Put.

A further way to exploit this loophole and/or protect yourself from the eventual fall is to short the dollar. I’m not saying to buy other currencies because I think they are all basically linked to each other. My advice is to buy the companies that are capital efficient as I explained in the last article.

Another protection would be to not lend value. Any time that you hold dollars you are lending the value of those dollars to someone else. Someone else is borrowing the thing you would have purchased with the dollars. But if inflation destroys the value of the dollars before you get to buy that thing, then you will have lost that value. So don’t hold dollars, don’t lend money (hold dollar denominated debt like CDs or bonds or personal loans), don’t sell Call options, and don’t sell cash covered Put options.

Selling Call options limits your upside. Basically you are letting someone else borrow your dollars to buy a stock. If inflation takes the stock to the moon, then your dollars will be worthless. Selling cash covered Put options is very similar because you are lending your dollars to someone else. You can’t put the dollars to work buying some commodity or stock, and again if inflation takes prices to the moon, your dollars will be worthless.

(I realize not selling call options goes against the Inflatable Dividends strategy, but this is my honest opinion. However I also realize that I can’t know everything and the strategy of using inflation to continue our economy may last for a lot longer, during which time the Inflatable Dividends strategy would be racking up profits.)

On the flipside, taking the opposite approach to these tactics would be good ideas in anticipation of high inflation. If you can buy commodities or stocks with your dollars, borrow money to invest, buy call options, or buy put options on stocks you own, then these would all be in line with profiting from inflation.

For a while I had an article up on how to use 0% credit cards to get cash advances and then deposit those in a high yield savings account. This is a nice way to generate some small “free” income. But from the perspective of inflation, it would be a better idea to take that same 0% loan and buy a No Lose Stock, or take the interest from the high yield bank account and buy a call option. I’m not advocating risking any of the money that was actually borrowed since you have to pay all of that back. I’m only advocating getting some one-way exposure to the effects of inflation.

Lastly, if you wanted to you could just buy gold or silver bullion coins and then buy gold and silver puts on those to protect the dollar value. There would be a cost (unlike with NLS where the stock’s dividend pays for the put option), but you might consider it like paying for insurance.

I’m just saying that we should be even more cautious now that we have pushed our luck as far as we have. The free lunches might soon be at an end.

Pay only for profits

After writing the post on HNZ the other day I started thinking about the idea of stop losses. Many of the gurus that I’ve read advocate using a stop loss. They advocate any where from 8% to 25%. The HNZ position that I have on has to rise 17% before I see a profit. But I only lose that 17% if I first gained it. If I was maintaining the same position with a 17% stop loss, I would stand the chance of losing the 17% even if I didn’t make any gains. I much prefer the idea of paying only for my profits and never paying for my losses.

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