Very slowly, I have been trying to digest Nassim Nicholas Taleb’s book “The Black Swan.” It’s an incredible piece of work about the impact of the highly improbable. Nassim explains that an improbable event has 3 characteristics: It is unpredictable; it carries a massive impact; and, after the fact, we concoct an explanation that makes it appear less random, and more predictable, than it was. The astonishing success of Google was a black swan event; so was 911 (you can add Microsoft and a host of other companies to this list, including any past bear market events). For Nassim, black swans underlie almost everything about our world, from the rise of religions to events in our own personal lives. Why do we not acknowledge the phenomenon of black swans until after they occur? Part of the answer, according to Nassim, is that humans are hardwired to learn specifics when they should be focused on generalities. We concentrate on things we already know and time and time again fail to take into consideration what we don’t know. For years, Nassim has studied how we fool ourselves into thinking we know more than we actually do. We restrict our thinking to the irrelevant and inconsequential, while large events continue to surprise us and shape our world. In his book, Nassim explains everything we know about what we don’t know. He offers surprisingly simple tricks for dealing with black swans and benefiting from them. This is not casual reading but very demanding, and it requires your full focus. If you like a challenge, and learn how to look at the world with a slightly different view, this book is for you.

Reader Nitin sent in a link to an article called “Protecting the Investments of the Bad Investor,” which was recently featured in Yahoo Finance. I agree with the overall premise that there are many investors who are not doing well, getting below average returns by buying, holding and selling at the wrong time. The article goes on to state that “the Pension Protection Act of 2006 is encouraging increased use of asset-allocation funds, such as target-date and lifecycle funds, particularly as defaults in defined-contribution plans.” I guess the idea is to protect investors from themselves, and their untimely decisions, by establishing a group of “default” investments. What that means is that someone decided that a default investment will do better than you could do on your own. This may be correct in some cases, but the problem is with the default investments, which are pegged to be asset allocation funds like target-date and lifecycle funds. However, the study admits that asset allocation funds severely under-perform equity funds, but they “have prevented significant losses due to fear-based selling.” Huh? I am simply dumbfounded by the fact hat one study can come up with that much garbage. Are you now supposed to invest in underperforming asset allocation funds, which then will lose as much or more in a bear market scenario? Translation: Get less of a return but lose more since the obvious conclusion is to Buy and Hope through any type of market environment. Don’t believe it? I wrote the article “Do Lifestyle Funds Provide More Security” in early 2003, just before the bear market ended. It clearly confirms that Lifecycle and other allocation funds suffer just as much in a bear market scenario as equity funds but, in a bull market, you don’t get nearly the upside potential. The article goes on to make other moronic statements like “this analysis shows that asset-allocation funds deliver what they promise -- lower risk, no switching and real returns for the investor.” Suuuure; and I have some subprime loans I’d like to sell you for top dollar… Let me make it clear again: The biggest danger to your portfolio is the re-occurrence of another bear market and not whether you are in the best performing fund during a bull market. If you can avoid the bear by being safely on the sidelines, your investment returns will beat just about any equity mutual fund, index or stock that was held to oblivion.

I touched on this last week, but the WSJ also had a blurb on Sowood Capital’s admission that its hedge fund had lost more than 50% of its value, or about 1.5 billion. I posted Saturday, that the loss at the time had been 25%. Oh well, things are happening so fast, what’s another 750 million? It’s only mad money. The hedge fund manager detailed how Sowood bet on senior debt positions and hedged itself by betting against stocks and more risky debt. However, the corporate debt tumbled in value and did worse than the stocks. Very concentrated positions along with leverage ended up crippling the fund. I’m sure they’ll be paying the hedge fund manager a big bonus out of remaining assets before he gets kicked out. Is there a chance that he will be banned from the securities industry for life? I doubt it because hedge funds are unregulated, and I believe that they may even be allowed to use certain zoo animals for selection of their investments. Continued failures of institutions/funds will increase fear that the current credit crunch may get worse, and I am sure that some have already looked towards the Fed for help (translation: bailout). Last week, however, St. Louis Federal Reserve President William Poole dismissed any Fed involvement to bail out the stock market by saying: “The Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment, or when financial-market developments threaten market processes themselves.” Hmm, let’s see if the Fed sticks to that game plan.

The Subprime pig strapped on his wings this week and feasted at different troughs in a variety of countries. While the countryside varied, much to the pig’s delight, the food was identical: Same old leftover slop from irresponsible subprime lending procedures primarily designed to feed somebody’s corporate bottom line no matter what the long-term outcome might be. Affected countries, besides the U.S., included Australia, Germany and France. Yes, even the French saw their culture invaded by having to interrupt their wine and cheese desert to come to grips with the fact that some of their own U.S. exposed hedge funds stopped redemptions. The European Central Bank injected some $130 billion into the financial system to provide liquidity, a step which was followed by the Fed a day later. Once the subprime pig is on the move, there is no way of knowing where it might stop and feast next. And that is a big problem because there is no transparency as to which financial institution has how much exposure. There is a good chance that far more companies have invested in these loans through a variety of schemes, and fear of redemptions may keep them from disclosing their true risk exposure until the heat is really on. If this trend continues, it will be an absolute certainty that the stock market rally of the last 10 months will come to an end. And don’t kid yourself into believing that there are asset classes that will resist the subsequent downdraft. The only safe position will be in money market—until the subprime pig has found its last meal.

A recent article in the WSJ talked about the fact that larger stocks are finally starting to take the lead in regards to performance when compared to small cap stocks. “Megacaps,” with a stock market value of at least $50 billion, have picked up speed this year through July. For that period, the Russell 1000 Index, which includes the largest 1000 U.S. stocks, had gained 3.9% compared to a decline of 0.8% of the Russell 2000 Index. While this maybe news to many investors, it shouldn’t be to you, if you follow our weekly StatSheet. There you can easily spot those orientations with are performing better than others. The article fails to point out that Mid-Cap Growth stocks purchased via ETFs have been near the top of the list and have outperformed most large caps. My point is that making the latest StatSheet your weekly companion can pay big dividends when it comes to spotting trends. It does not mean, however, that you should constantly adjust your portfolio. What it does mean, is that you should adjust your holdings when an orientation is obviously slipping towards the bottom of the list

One of them addressed Janus Capital’s recent financial comeback. It hasn’t been front page news but Janus had suffered years of fund outflows after investors left in droves. Why? During the bear market, Janus was hit hard with losing billions of dollars in assets. To be clear, they really lost billions of dollars of clients’ (your) money by being invested in growth companies during a bear market. Yes, they are the modern model of Buy-and Hold. The beef I still have with them is that, when the after-hour trading scandal broke a few years ago, they were the first ones to distort the facts by supporting that timing in general causes all kinds of problems and should not be allowed when it comes to mutual fund trading. Additionally, they promoted minimum holding periods to force investors to stay with a fund family. How do I know? I was a Janus shareholder at the time and received communication from the president of Janus about market timing, which totally distorted the facts of the real problems uncovered in the after-hours trading scandal. That one-sided, self serving approach did not sit well with me, and I sent a letter of complaint to Attorney General Spitzer who was making a name for himself by trying to clean up Wall Street. Why bring it up now? My point is that the Janus Company and their funds maybe on their way back towards the spotlight (because investors have short memories), but don’t be fooled into complacency; when the next bear market strikes, it will be deja vous all over again.

In a previous post, I had mentioned the fact that breakaway gaps, that occur on charts as a result of overly confident investing behavior, will be always be closed. That simply means a market pullback will correct prices to the downside. Here’s an enlarged version of the Trend Tracking Index (TTI) chart: You will note that the gap (red arrow), which was created earlier in the year, has now been closed due to market weakness over the past couple of weeks. As I also pointed out at that time, this event may very well coincide with the TTI breaking through its long-term trend line, which is exactly what happened. This puts us at a crossroads. I have seen charts, where the closing of the gap signaled a turn around in the trend back to the upside, and I’ve seen charts where heading further south was the direction of choice. In other words, no one knows for sure. Since the TTI only broke through its trend line to the downside by -0.10% (as of 8/15/07), I will wait for further confirmation based on market activity before pulling the all-out Sell trigger and heading for the sidelines. In the meantime, I will follow my sell stop points and eliminate only those positions that have been affected. After I wrote the above and checked today’s market, it appears that we will definitely have an all-out sell signal, unless some (unlikely) miracle turnaround pulls the major indexes out of the doldrums.

Mark Twain said it best in this quote: “When you find yourself on the side of the majority, it’s time to pause and reflect.” To my way of thinking, this certainly holds true when it comes to handling your money. There are few advisors and others who don’t believe in the Wall Street induced herd instinct type of investing. It has proven to be one a sided “win” situation with the masses of investors usually being left stranded on the street licking their wounds after another failed attempt to stay fully invested during a bear market. If you are new to investing, these words may not mean much to you because you haven’t lost enough money to appreciate them. If you’ve been around the block for a while (translation: a severe bear market), you should have learned (hopefully) how to adjust your investment approach. One of the books I referred to in a recent post to on this subject was Al Thomas’s “If It Doesn’t Go Up, Don’t Buy It.” While Al covers a variety of investment areas, the book is easy to understand and contains words of wisdom from over 40 years of exposure to the financial industry. He has no ax to grind and no allegiances. He calls it as he sees it, which is very rare, nor does he care if anybody is offended, which makes him my kind of a guy. I have gone through his mutual fund section, which advocates trend tracking, and picked out a few gems that you might consider adapting: 1. Mr. William O’Neil, on of the market technicians and found of Investor’s Business Daily, did a study that found that between 1953 and 1993, 67% of the move upward in any stock can be credited to the positive advance of the Industry Group of the Market Sector to which it belongs. A more recent study shows 49% of the move of any stock is due to the industry itself, 31% to the general market movement and 20% to the company itself. This is ‘proof’ that research is nonsense. Just because the research report on a company is good doesn’t mean it’s going up unless the entire industry group catches fire. Birds of a feather flock together. 2. You leave the picking of the individual stocks to the mutual fund manager. That is his job. You want the best mutual fund manager on the street “at that time.” You can find him not by name because his name is unimportant, but by performance of his fund. You want the fund that is outperforming all the other funds. You want get on the ‘up escalator’ with him and follow him to the top. When he doesn’t seem to be able to go any higher, you get off. Take the next escalator to the higher level following another fund manager. I have no idea who is managing the funds I own and, you know what—I don’t care. That is the way I want you to picture the stock market—you riding gently, easily and steadily up to a level where you get off one mutual fund which has leveled off and choosing another one for the ride to the next higher level. That’s what rotation is all about. 3. Another great fallacy of the mutual fund gurus is “expense ratios.” They tell you not to invest in any fund that has expenses over 1-1/2%. Who cares what the expense ratio is if that fund makes 40% or more annually? The same for 12b-1 expenses. Who cares? Show me the bottom line. That’s all that counts. Basic rule: Follow the money! Even though Al’s book was written years ago, his wisdom gained by years in the trenches is simply timeless. It advocates exactly what I have been saying in my weekly updates and in my blog: Focus on being invested only during up trends in the markets, avoid the bear at all costs and disregard Wall Street’s self serving stories.

“Thanks for your rational take on the market & its current woes. I happened to mention the need for a look at what US Government lending regulation might have prevented & nearly got fired on the spot this week. I recall mentioning this in my College Economics curriculum years ago & the response was calmer, if stoic. However, if there were limits to the types of lending these institutions have been offering, such as there is concerning the use of fireworks on a local basis, perhaps not only personal safety would prevent loss, but financial as well as high hopes for the American Dream, might be limited. The most clear example is lending without restrictions on income as well as debt to income. Many more follow but at this time even the Fed wants to shore up lending confidence. Too bad is has to happen this way. It is entirely a reaction rather than an action which could have been helped by just a small bit of regulation. A bulwark if you will against massive individual losses in addition to institutional bankruptcy proceedings. I'm just fine, but I wonder how my children, were they of an age to sign onto one of these shady loans, might have ended up.” Rich’s arguments made me reflect back some years ago when interest rates dropped sharply and real estate prices started to head into orbit. For any asset to increase in value there has to be demand, which is reflected in the stock market via volume. Generally speaking, high volume translates into higher prices, while low volume reflects stagnation or lower prices. In real estate, demand starts at the entry level. Many first time buyers (volume) shopping for homes give existing home owners the opportunity to sell at a profit and move up in the housing food chain. Subsequent lax lending standards allowed mortgage companies to increase the volume of first time buyers by making “fog up the mirror” home loans and thereby adding a huge number of buyers to the market place, who previously did not exist. The result was an ever increasing price spiral until the point was reached where volume dried up—a classic Ponzi scheme. My thought is this. If we had had strict lending standards back then, I have to wonder if real estate prices would have ever reached the lofty levels that we ended up with. While no one has the answer, there is a chance, however, that prices might have hit a glass ceiling a long time ago. So, in some perverse way those of us that owned real estate were the unintended beneficiaries of the artificially created volume due to subprime loans. Otherwise, you might have never seen your home triple or quadruple in value. This is not meant to be a justification for subprime loans, just a reflection of what might have been. Why look at it now? Because once the total severity of the subprime debacle has been recognized, publicized and “fall guys” identified, you can be sure that, for the time being, marginal home loans will be a thing of the past. The pendulum always swings from one extreme to the other. The obvious conclusion is that real estate volume will be greatly reduced, which in turn will affect the ability of (average) people to sell their homes quickly to move on to greener pastures. Some will ‘have to’ sell due to job transfers and lack of demand will pull prices lower. How low, no one knows. My point is that we all have benefited from the subprime debacle and as long as we own real estate, we will be forced to participate in the unraveling. That’s my view, what’s yours?

CNNMoney featured an excellent article called “Why the private equity bubble is bursting.” It recaps the insane leveraged buyout fever of the past couple of years which caused some unintended consequences while fueling the stock market rise into record territory. It’s well written and gives you a better understanding of why the bubble is bursting. There is some focus on the effects of the subprime debacle and why hedge funds will be hit in a big way as the final paragraph explains: “The biggest losers, though, are likely to be the swashbuckling hedge funds that gorged on high-yield debt and did it in the most reckless way possible. To amp up their returns, they borrowed heavily to buy the bonds of already highly leveraged companies. That's piling risk on top of risk in a rickety structure that a slight bump can topple. Wall Street firms promoted the practice. Not only did they sell high-yield bonds to the hedge funds, they also lent them money through their prime brokerage arms to buy the bonds on margin. It wasn't uncommon for the funds to borrow 80% of the price of the loans. With that kind of leverage, for example, they could earn 18% or more owning bonds with a nominal interest rate of 10% or so. The same leverage that magnified their returns will multiply their losses, with potentially dire effects. Here's what the worst-case scenario might look like: As the hedge funds get margin calls from Wall Street, they're forced to dump their holdings of loans and bonds to raise cash. The glut of distressed debt for sale crashes prices and pushes yields to towering levels. Then everyone holding high-yield debt, from Asian banks to small investors with money in junk-bond mutual funds, will take a horrendous pounding. What we're seeing here is simply sanity returning to the market. And as always in the aftermath of a bubble, sanity returns the hard way.” The entire article, while lengthy, reads like a science fiction story and will definitely make you realize that, based on the bursting of the private equity bubble, the stock market may very well be the next victim. It’s hard to see at this time where the fuel for another rally will be coming from. Recent violent market activity could possibly indicate the end of the uptrend, but we will wait to be sure, via the guidance that our Trend Tracking Indexes provide, before taking final measures to protect our portfolios.