Tuesday, September 1, 2009

Reader Mailbag: Why Such A Focus?

Reader TH asks a very relevant question with regards to the focus of my attention over the past year or so.

Paraphrased, TH wanted to know why I spend so much time deliberating over the potential forces of inflation and deflation rather than focusing my attention of some of the more prospective new technologies and investment opportunities of the future. He contends that there are opportunities to make money in any market environment and wonders if my time would be better spent searching for those, as opposed to trying to "predict the future actions of madmen."

TH raises some very good points here. Indeed, there are many new technologies that I am very positive on. Nanotech would probably be at the forefront of this. There are unlimited applications for a technology that literally allows one to rearrange the building blocks of life (molecules) to conform to one's needs. This is not a new concept. But the underlying technologies have become much cheaper than the two previous speculative booms that the sector enjoyed (and then suffered through) in 2000 and 2004. Very much like the concept of the computer was posed decades before it became a useful tool, in time nanotech will gradually begin to make waves on our lives and economy. The companies that are able to be at the forefront of this will likely become some of the better investments of the next few decades.

Additionally, I still believe there are advancements to come in communications and networking. The recent introduction of "smart phones" is probably the most notable manifestation of this. Network speeds and accessibility are enjoying exponential growth. With it, they are redefining what people are able to do "away from the office." Often seen as a gimmick for text messaging friends and other social networking time-wasters, the open source nature of these things are enabling people to do away with numerous other burdensome tools and making us more productive in the process.

Another area that I see new and exciting growth opportunities are in so-called "new media." I am already invested heavily in this industry - via this blog. I don't think anyone can honestly say what the next medium will be for the transmission of news media, entertainment, or advertising. But it is apparent that it will be far more customizable and "on demand" than previous versions. There will be little bubbles along the way - for the life of me, I can't figure out what draws people to Twitter. And yes, I'm aware of the irony that blogging is itself a potential bubble.

So back to the original question from my reader TH. Why don't I spend more time talking about this kind of stuff?

The short answer is because even though I want to be invested in these technologies, I firmly believe I can do so at a fraction of the price in 2-5 years down the road. And this belief is best conveyed with an understanding of our current deflationary situation. If it were inflation that I saw in the near or intermediate future, I wouldn't care much for valuations or balance sheets. I would be buying assets on margin in expectation of their imminent explosive growth.

As I began my research into financial markets, the first area of interest for me was in understanding the history of markets. I suppose it would have been easier if I became enamored with the impressive growth of homebuilding stocks, but that seemed all too short term and frivolous to me. I was after the big picture. The more I began to research this, the more it became clear to me that successful investing rarely had much to do with picking stocks. Rather, it had more to do with making the right decisions in asset allocation once every 10-20 years. That's all that seemed to matter.

Think about it this way. Among those who were entering midlife in the late 60's/early 70's, how many managed to fully benefit by buying real estate and commodities with borrowed money at a low fixed rate of interest? And later on in the 70's how many had the acumen to sell those assets and buy stocks? And in 1999, at the height of the tech bubble, who in their right mind would sell everything and buy government bonds - and hold them for a decade?

The answer to all those questions is "not many." However, anyone who did make even one of those decisions was likely made very wealthy for the remainder of their lives. Any further decisions would have been irrelevant to their overall financial standing. For anyone else, the likely outcome was breaking even at best, bankruptcy at worst. Even those that managed to pick the best stocks through the 70's lost out to inflation. Those that held real estate into the early 80's were eventually forced to refinance debt at interest rates of 20%.

It is my contention that the environment for owning companies is poor, as it has been for 10 years. I could attempt to pick the best among the industries that I mentioned above. If I happen to be wrong - or early - I lose. Take Juniper Networks (JNPR) as an example. I like this company. They provide networking solutions for many of the new technologies I talked about above. They don't have as much risk as the underlying technologies because they simply service the needs of other companies. But they are trading at 22x their forward projected earnings and pay no dividend. Twenty two times! Of course those projected earnings could be affected by exogenous risk factors that have nothing to do with the company itself. How can I buy this with a 10 year horizon if I think there is a realistic possibility of it dropping 60%? I encounter the same conundrum in nearly every business that I feel has good growth prospects.

So we come back to the question at hand. Inflation or deflation. If it's inflation, I hold my nose and buy 'em. If it's deflation, I remain patient and wait for that 60% correction or more - yes even from these levels. It is a binary outcome. Hence, the focus of my blog and my attention is in determining this outcome.

Managing this will prove to be the single most important determinant of the future financial health of myself and my readers.

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Anonymous said...

I believe this is the right strategy. This high cost structure and low savings rate is holding back the development of these technologies. At present, it's too expensive to start a business, any business, and that's all that matters. The burn rate is too high due to excessive cost of wages, rent, regulation, and everything else. Those who started these businesses too early and used debt to finance the burn rate as is almost always necessary will be in severe trouble once deflation hits with full force. Entrepreneurs who step in at the right time will be able to buy the assets of these businesses for pennies on the dollar or start from scratch with great cost advantage.

Matt Stiles said...

Couldn't have put it better myself. Nice post.

alexcanuck said...

Hi, Matt. I've been following your blog with great interest. There is such a lack of good Canadian-focussed financial blogs out there, nice to have you.
Inflation/deflation is such an important question, I can't get enough of it. Status quo (circa 2007) is the one possibility I have ruled out.
My biggest question is are we as Canadians tied to the same outcome as the US? I lean heavily to the deflation scenario for the US as so well put by Mish and Denninger, but will the $CAD remain (very roughly) tied to the $US? Our economies are so intertwined it's hard to think of a break, but if one comes it will for sure be with a mighty SNAP. From my view inflation is rather more likely in Canada IF viewed alone, we are not nearly so indebted as the US, but the degree of connection between us may well be more powerful. Tail and dog theory. I'd love to read your views on on the differences between us and the States.

Regards, Alex.

Matt Stiles said...


Historically, Canada has followed in lockstep with their older sibling - and throw in an auto-immune disorder for good measure (they sneeze and we catch a cold).

I don't see how any of that changes. There are some differences, yes. And most observers won't hesitate to point out "but we've got commodities!" Which is natural, considering we've been in a commodity boom for nearly 10 years now. That can work in the other direction as well.

But we do not have the benefit of the world's reserve currency, hence we run the risk of runaway prices of imports coincident with a major US deflation.

So I do see deflation in Canada if defined as a contraction in credit and falling asset prices. However, goods and services not manufactured in Canada could help keep the price level high thus preventing official acknowledgement of the "D" word.

Additionally, we are still susceptible to the same social mood trends and demographic influences as is the US. And as those two factors are causal, they should both prove importance in any outcome.


alexcanuck said...

But we do not have the benefit of the world's reserve currency, hence we run the risk of runaway prices of imports coincident with a major US deflation.

Not to put words in your mouth, but does this mean that in the event of the $US suffering a major devaluation against other world currencies, energy prices, gold, other commodities, you would expect the $CAD to (very roughly) follow the $US down? Rather than to remain roughly level with regards to the yardsticks above.

alexcanuck said...

Re-reading, I don't think I was clear.
IF the US succeeds in re-flating the currently deflating $US, (not too likely, there is an awful lot of crappy debt still hidden) I see the chances of runaway inflation as very high. Utter disaster for a nation as dependent on imports, especially oil, as the US is.
In the event that scenario comes to pass, I really wonder about the behavior of the $CAD.
If deflation and debt default is the route to work off the excess bad debt in the system, then yes, the $CAD will probably remain roughly tied to the $US, and both will slide somewhat against TROTW. The deflation I refer to will be mostly in asset values, of course. I'm sure not expecting much price declines in daily living costs, if anything the opposite.

Matt Stiles said...


I don't think reflation is a viable possibility (see: Hyperinflation Is Impossible). However, if it were to happen, I suppose the initial result would be a rising Loonie (as well as other currencies) and a falling US dollar.

But if the US dollar's devaluation was the cause of a genuine currency crisis (ie. lack of faith in paper currency), then there is no reason to believe the CAD would escape the same fait.

Again, I don't think that is a possible outcome due to the credit based nature of our monetary systems. With contracting credit there is not the extreme oversupply of dollars chasing assets that typify such currency crises.

alexcanuck said...

Thanks, Matt.
I quite agree re the deflationary nature of the outcome, but the Americans are being so crazy reckless with the bailouts I wonder sometimes.
I have no formal training in finance or economics, and really question myself at times.
(Not such a bad idea even with "credentials")
Inflation seems to be such an overwhelmingly popular view, I feel nervous not joining in. Mish makes such a strong case for deflation I can't help but agree, but why is it such a rare viewpoint? Credit bubbles deflate, monetary bubbles inflate. We sure do appear to be in a credit bubble by any reasonable yardstick. Not too hard to figure out.

Do the people "in control" only want to rescue the credit bubble for another round until they can pass it on to someone else's watch, or do they honestly believe we are on a sustainable course if they can only get the whole thing back on balance.
Boy, I'd sure like to get Bernanke on some scopolamine!

Matt Stiles said...

Inflation seems to be such an overwhelmingly popular view, I feel nervous not joining in. Mish makes such a strong case for deflation I can't help but agree, but why is it such a rare viewpoint?

I'll answer your question with a question:

Cui bono? Who benefits?

How many people that engage themselves in the financial markets can benefit from a deflationary outcome? Inflation (and hyperinflation) are relatively easy to game. All you have to do is buy assets. All the better if you already own them! Think about the resource types we have dominating our financial media here in Canada. All they have known in their lifetimes is inflation. They know how to benefit from it. That is what they want. Thus, that is what they choose to see.

Linear thinking: extrapolating past experience over the distant future.

Now think of those that benefit from deflation. People that have no debt, few assets and a pile of savings. Are these the types you will find on television being interviewed by BNN? CNBC?


alexcanuck said...

LOL. That is exactly how I answer when my wife points out yet another cheerful pablum article in the MSM.

Anonymous said...

Hey Matt,

I appreciate your blog and thoughts on the financial markets. It appears that the greatest question everyone wants answered is whether we are heading for a deflationary or inflationary environment and depending on who you want to believe on any given day, there are good arguements for both and in fact, it may be both that we experience. The time frame is what may need some tweaking and having read many posts from people all over the world on this topic (Marc Faber, John Maudlin, Bob Prechter, Nouriel Roubini, and a few others that I found to be worthy of following) my personal belief is that the next direction of the market and economies world wide will be determined by a market driven event. Something that is big enough to trigger a massive market sell-off, followed by a deflationary environment. This could be a geo-political event, a terrorist act, or a country that chooses to go to war, not withstanding a series of significant bank failures followed by another series of bailouts.

Until then, the govey's of the world will continue to re-inflate as this is the only path that will reduce debt and keep the grease on the wheels of capitalist bus from getting stuck in the mud.

keep writing

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