“For decades, the name of the game for investors has been to make as much money as possible. From now on, Mr. LeBaron thinks, the prime directive will be to “lose as little money as possible…

In Mr. LeBaron’s view, the easy-money policies of central banks, including the Fed, have created what he calls ‘administrative markets’–in which prices are set at least partly by government policy rather than by market forces.

But, he worries, that can’t last forever. ‘In complex systems, the dynamics are predictable but the timing isn’t,’ he says. ‘It’s like adding a grain of sand one at a time to a pile: You can’t tell when it will collapse, but you know it will.’”

Dean offers great advice: “Look for the questions that are not being asked?” I try to think of these at least once per day.

http://blogs.wsj.com/moneybeat/2014/01/17/new-warnings-from-an-investing-pioneer/

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As Michael Mauboussin says, when understanding an investment idea, we should try take an outsider’s big-picture view in addition to our own expert view of the minutiae of the idea. I first came across the equity market return histogram a few years ago and I believe it offers perspective on the feasibility of return expectations.

The ranges at the bottom are the ranges of returns for each annual period. The years highlighted in blue are the years involving the recent Great Recession and those in orange involve the Great Depression. As you can see, there were many more outliers during the Great Depression. The Great Recession looks rather normal in comparison.

My opinion of expected returns is based on data obtained in the Graham-Shiller CAPE index and from Tobin’s Q ratio (plus several other metrics), so I expect low, single-digit equity market returns over the next eight- to ten-years. The CAPE, which measures long-term Price/Earnings ratios, and the Q, which measures Price/Replacement-Cost ratios for the market, are 39.1% and  40.6% higher, respectively, than their long-term averages.

But, if we believe past is prologue, then there is a 75.5% chance that returns this year will fall outside of the range of 0% to +10%. I believe I am rationally pessimistic for the near term (but a long-term rational optimist), but historically there is only a 13.9% chance that an investor will lose more than 10% of their capital in any year in the market. This kind of outsider’s perspective helps me temper my pessimism, but the best way to temper it is to invest with a MARGIN OF SAFETY. Unfortunately, few investments offer a Margin of Safety these days.

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The best way to describe the current market, then, is to say that there is “an unusually large herd of grey swans” about. It refers to an outcome–a single impactful event–that is quite possible and therefore should be anticipated but it is not because too much attention is focused on the low probability of each separate event occurring instead of the collective likelihood of any one event occurring. I guess it is another way of saying that we miss the forest for the trees. As the number of grey swans in the herd increase, the likelihood of an impactful event increases.

The conditions that make this market a herd of grey swans are as follows: The market is priced for perfection as the Graham-Shiller CAPE and Tobin’s Q ratio are near all-time highs, by which we can infer that investors are sensitive to momentum and are ignoring risk and values. At the same time, the number of low-probability events that could cause a major correction also seems to be high. This environment is different from one described by the adage that “rising markets climb a wall of worry” because those environments start at low prices relative to fundamentals. That is, there is always more worry immediately after a correction–such as in the first quarter of 2009–than after a significant rebound, which is where we stand right now (2/25/12) with the S&P 500 just 15.4% from its all-time high.

The large number of grey swans include (not in any particular order):

1. a sovereign debt default (either legally or de facto) by any one of Italy, Spain, Portugal, Japan, France, Ireland, or some other country not yet on the radar in addition to the default that has already occurred in Greece;
2. austerity throughout Europe and the US in order to pay the bills for previous overspending (US and Europe) and low productivity (Europe);
3. a collapse of the European Union or the Euro
4. a surge in inflation around the globe;
5. a war with Iran and its supporters or instability due to Iran’s development of a nuclear weapon (the collective probability of this must be close to 100%);
6. a Chinese economic implosion as inordinate government command of the economy cannot be sustained;
7. a collapse of the Russian banking system;
8. unrest in the US as a significant amount of promised public-sector post-retirement pension and health benefits must be cut or eliminated in order to balance state and local budgets;
9. significant instability in the Muslim world (excluding Iran) for many reasons, but particularly as US influence declines with US military withdrawals;
10. something unexpected from North Korea;
11. a less-than-peaceful transition of political power in the US in November; and
12. a large natural disaster–earthquakes, tsunamis, droughts, volcanic eruptions–(for example, see Nova’s excellent and recent “Deadliest Volcanoes.”  A preview:  http://www.youtube.com/watch?v=CEjnIPRuhvk)

Separately, these events are not black swans; they are grey swans–low probability events but not rare ones like black swans. Together they are a herd of grey swans where only one event need occur to cause major problems; imagine if two occur. On the surface most appear to be independent events, but what is to stop North Korea from doing something stupid if China is focused on a war in the middle east or its own economic collapse? What would happen to economic activity and political stability if lingering ash from volcanic eruptions caused a significant reduction in food production? If we add a black swan event that no one is even thinking about, the outcome could make us nostalgic for 2008-2009.

In the very long run, I am a rational optimist. In the near term, I am a rational zoologist. If you can buy cheap insurance, do so. On that note:

http://finance.fortune.cnn.com/2012/02/16/is-japan-next/

While the Japanese debt bomb isn’t expected to go off tomorrow, Japanese CDS is now 50% higher than where it was a year ago. Wall Street involvement in the Japanese debt market has grown in the last few years, which could bring increased pressure on the government to try and solve its debt dilemma. Eventually, though, the Wall Street bond vigilantes could drag Japanese bond yields up to levels that could cripple the government’s  ability to pay off its debts, setting the stage for one of the most prolific sovereign debt defaults in history.

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http://www.voxeu.org/

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The extraordinary events we’ve seen these past months are now threatening the euro project, and calls for its dismissal, which were laughable a year ago, are becoming more mainstream. Risk aversion has increased dramatically and we are arguably in as bad a shape as in 2008/2009. Peripheral bond yields are now much higher than they were back then, as are all sovereign CDS. The low yields of the safe haven bonds (Bunds and US Treasuries) also highlight the sharp risk aversion in the markets and while the tensions in the money markets are not as bad as they were back then, they remain at extreme levels.

Kyle Bass on CNBC today essentially said the following:

“Europe is trying to fix a solvency crisis with liquidity. Liquidity is not the problem. No one is saying the payments system will fail; it did not fail in the US when Lehman went under, either. However, bills are coming due in Europe that no one can pay.”

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I do not believe Bass is a permabear like Roubini and Shilling. I think he has thoroughly analyzed developed western economies, sees a disaster coming, and is willing to place a large bet on his convictions. Enjoy…

http://watch.bnn.ca/the-street/december-2011/the-street-december-13-2011/#clip584881

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Lewis writes, almost smirkingly, that Bass was so concerned about a financial collapse that he was literally buying nickels–TWENTY MILLION of them–because the value of the metal in the coin was worth more than five cents. The implication being that there may be little else that retains as much value as such hard assets after a collapse.

Four years later Lewis wonders how Dallas resident Bass got almost everything so right, while experts in financial centers around the world got everything so wrong.

They are still not getting it:

H/T for pointing to the video: Santangel’s Review (Resources to the right)

It would be hard to guess given his mild and erudite demeanor in this video, but Bass is a shotgun-toting Texan who lives in a “fort” and drives a Hummer with a bumper sticker that says: “God Bless Our Troops, Especially Our Snipers.” God Bless indeed.

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MARKET TALK: It’s 1931

DOW JONES NEWSWIRES

5:20 (Dow Jones) “I have been complaining for some time now that Reinhart and Rogoff think that the time is always 1931 and that we are always Austria,” Brad DeLong writes on his blog, “that the great fiscal crisis is about to erupt and send us lurching down toward Great Depression II. Well, right now guess what? The time is 1931, and we are Austria. The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip.”

(paul.vigna@dowjones.com) (http://delong.typepad.com/sdj/2011/11/time-to-spread-foam-on-the-runway-the-federal-reserve-needs-to-act-now-to-firewall-off-the-eurocrisis.html)

I thought Mr. Market was finally coming to his senses in the third quarter, only to see him lose his mind again in October. Was that the last hurrah? The world is in too precarious a position to have equity markets rally as they did. And, we as contrarian value investors need Mr. Market to come back to reality (and perhaps get depressed again) before we can become net buyers. Today was a good day in that regard, but there is a long way to go.

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Today, the G-20 closed with no plan and little hope for one. The markets’ reaction? Yawn. Mr. Market is an unusual animal.

European Union Leaders Emerge With Little From G-20

By CHARLES FORELLE and
DAVID GAUTHIER-VILLARS
Of THE WALL STREET JOURNAL

 CANNES, France — The European Union had hoped to come to a meeting of the Group of 20 large economies here with a grand plan to rescue the euro zone from its debt crisis and leave with the firm support of its international peers.

Instead, it departed the two-day summit Friday with precious little to show. No G-20 country committed to help seed the euro zone’s bailout fund, and the nations resolved only to continue talking about providing additional firepower through the International Monetary Fund.

Meantime, Greece’s political maelstrom swirled, shaking up the summit’s agenda. Friday afternoon, Prime Minister George Papandreou was holding on to his office by a thread ahead of a midnight no-confidence vote.

One step emerged, but it was small: Italy, the focus of substantial worries in European debt markets, agreed to permit the IMF to monitor its progress with fiscal reforms.

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