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Armageddon Revisited
By Jon Nadler

Oil at a 22-month low. Loses $3.43 on the day. Best Buy turns into Worst Buy. GM stock at $3 and labeled 'too big to fail.' The Dow drops more than 360 points. The US Treasury pulls away from buying illiquid mortgages and cozies up to supporting auto, student, and credit-card debt. Get the picture? Sure you do. The dollar takes off to near 87.50 on the index, and gold skids to near the $700 level on resurrecting fund liquidations. We even got an explanation of why gold is not at the $2,200 level - from none other than Steve Forbes. Speaking on CNBC this morning, Mr. Forbes pointed out that practically every dollar being dropped from the Bennycopters in the US skies is quickly being taken off the scene through the back door. The Fed is doing a simultaneous giveth and taketh act.

All of this is starting to look like a replay of Japan circa the 90's. Our good friend Simon Constable, over at Dow Jones took a page (okay, only the title) from our October 30 commentary and came up with a fascinating little documentary on the Nipponization of America: http://online.wsj.com/video/is-america-turning-japanese/DC548F9B-B868-4A93-9570-C70115EFAB17.html

Excellent educational bit, Simon.

World market conditions remained glum as little in the way of positive catalysts emerged overnight to help buyers jump in with cash. A Bloomberg global user survey reveals that confidence levels about the planet's economy are at basement levels. Disinflation (or worse) has gripped the collective psyche and is still squeezing it hard. Witness the BoE whose Governor, Mervyn King, said he and his team are prepared to apply the rate scalpel as often and as deep as needed to avoid you-know-what. The threat of an outright default by Russia now looms larger, as capital is leaving the country faster than you can say "Do svidaniya!" Finally, the International Energy Agency took the fears of "peak oil by 2030" and threw them where they belong: on the trash heap of failed theories. That said, oil is within ten bucks of having lost $100 off its former...peak.

Gold prices remained under pressure in NY all day, and aside from one feeble attempt to gaining lost ground, it instead gave various stubborn perma-bulls yet another chance to send 'imminent turnaround' comments urging the backing up of trucks again, to the financial media. Spot prices were off by $22 in the afternoon hours at $709.50 and the morning's chatter among participants that fund selling could reignite proved to be valid. Thus, the risk of a fall to the $680's in the near-term has revived again. Silver lost 46 cents to drop to $9.29 at last check. Platinum was the lone gunman today, advancing $8 to $822 and palladium was off $4 at $211 per ounce. The greenback first fell under 87 on the index, but made a midday u-turn and decided that 87.50 looked more attractive. The euro was cowering near $1.25.

Not far behind oil prognosticators are doomsday scenario script writers. Why, some of them have been calling for this year's developments to have taken place in....1981. Also in 1987, 1991, 1999, 2001, and 2006. The 'prefect storm' was knocking on the door each and every time. Only it never rang the bell. As a result, some interesting investment results came about. Marketwatch's Mark Hulbert fills us in on the details (and dangers) of calling the End of Days one time too often:

Sometimes you can't win for losing.

Just ask Harry Schultz. Or Howard Ruff. Or Jim Dines.

All three advisers, each of whom has been editing an investment newsletter at least since the 1970s, have built their investment careers by questioning conventional wisdom's trust in the soundness of the financial system. Not surprisingly, all three have been vociferous champions of gold and other precious metals.

You'd think that they would have cleaned up over the last year, since the disintegration of the financial system in recent months is almost exactly what they have been warning us about for decades.

But you'd be wrong.

Of the 181 newsletters on the Hulbert Financial Digest's monitored list, these three advisers' newsletters are in 173rd, 175th, and 176th places for year-to-date performances through October 31, with losses ranging from minus 64.9% to minus 70.0%.

How can this be?

The easy answer is that these advisers didn't put into their model portfolios the securities that would benefit from the financial collapse that they envisioned. But that's not a very satisfying answer. Why didn't they construct their model portfolios around investments that would rise when the rest of the financial world was going down?

The answer, as I see it, has to do with how difficult it is to forecast when a collapse will actually take place. It's one thing to know that the financial system is shaky, and quite another to forecast when it actually will crumble. And these advisers would have lost even more over the last several decades had they bet aggressively on a collapse every time they thought that one was imminent.

In essence, these advisers came face to face with John Maynard Keynes' famous pronouncement that "the market can remain irrational longer than you can remain solvent."

In fact, it turns out to be surprisingly tricky to construct a portfolio to profit from an anticipated collapse. You can't just own securities that will skyrocket during such a collapse, for example, since they will lose huge amounts during the months and years you wait around for that collapse to occur.

As a result, advisers who worry about a collapse sometimes end up constructing portfolios that are not all that different from those of other advisers who are more sanguine about the health of the financial system.

The ironies are many.

Researchers refer to the consequences of these dynamics as the "limits to arbitrage." One famous study conducted in the mid 1990s by Harvard economist Andrei Schleifer and University of Chicago professor Robert Vishny, for example, found that arbitrageurs more often become momentum players rather than hedgers: Rather than betting against an apparently obvious mispricing, they often will bet that a mispricing will continue and become even more extreme.

That's the theory, at least. And it only partially applies in individual cases such as the letters edited by Schultz, Dines and Ruff.

But, clearly, these three advisers would have constructed far more profitable model portfolios this year if they had known that the financial collapse they have so long warned us about would happen in 2008."

One could easily add some other familiar names to the trio, but let's not dwell on the obvious. More importantly, the lesson from the above-mentioned dynamic is that anyone telling you today that "this is the turning point" has about as much of a chance of getting it right as the three wise men in question. Just accept the market. You might miss the bottom by as much as you likely missed the top (on average, 5 to 10 percent, if you are lucky) but you won't be blindsided by missing it altogether by stubbornly sticking to shopworn predictions.
 



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