bizzXceleration: Performance, Value and Profit

 Bubbles to the Left, Right & All Around

Let's take another look at that question of widespread and endemic bubbles. There a a couple of things to notice here. First, that we are indeed riding into the valley of the Six Hundred Again and, second, that lots of folks have noticed. Though we think the first to really point to the problem are, not surprisingly, Roubini and Simon Johnson. But this week both the IMF and the World Bank issued major warnings.

Aside from Gold another really bad example is Emerging Markets, which have just roared ahead. But it's not the only one as the graphs of South Korean and Australian home prices show. Can you believe it? That might bring us full circle back to China and the now multiple stories about liquidity injections showing up in stock prices, real estate, and mis-placed investment in infrastructure investment (a point we won't dig into since we've been hammerring away at it so many times before, largely courtsey of Michael Pettis. NB: the world appears to have picked up on Michael's warnings and his themes are now widely written about and accepted but he's still the original and the deepest IOHO.). Here's you homework assignment - actually two, and they ARE for extra-credit. What asset class do you think is NOT part of all this? What happens when realities set in? Which they will sooner or later.

EM as Representative Futures

Lest you think we're picking on Emerging Markets too much rather than treating them as representative let's take a sideways segue and look at the Strategic Outlook. Emerging Markets crossed a cusp point at least five years ago where they've moved onto entirely new footings with regards to stability, security and safety and returns. Many have noticed that recently but have still not adjusted their investment strategies. A state of affairs we think is well-captured in this graphic.

In our reading the top chart shows both the double-bubble in EM stocks, which anticipated the inflow of investment funds surge, and the continuation of that surge after investors discovered the cusp point crossing. BUT...the bottom half perfectly well proves the other point - allocations to EM stocks relfect the old realities not the new ones. Which calls for major re-structurings of portfolios and investment strategies. The question is when and based on what information?

Which leads to the really critical point. There is no substitute for actually understanding what's going on. Too many folks have substituted "invest in the BRICs" for actually digging even the slightest into the underlying realities. Now in several previous posts we've tried to apply our Vulcun methodology of evidence-based analysis instead of relying on ideological shibboleths by pointing out that Brazil appears to solidly grounded, then India, then China and way behind, Russia. On a 1-10 scale we'd rate Russia as at best a 3, China a 4-6, India a 5 and Brazil a 7 from a long-term perspective. Anticipating a burst bubble though we'd apply a systemic downgrade that would take everybody down several notches. In other words if you're interested in protecting your investments it's time to start getting out, or getting prepared to get out and re-position yourself for the anticipated future.

Warren Is a Vulcun: Lessons From the Master

One of the interesting, among many, West Wing episodes is the one in which one sub-theme is about a bunch of Chinese Christians who fled persecution and are seeking asymlum in the US. President Bartlett proposes to test their Faith by testing them for Shibboleths, a label we've often used repeatedly. A shibboleth is, as the Chinese leader says, an outward sign of an inward Faith. The catch is that one can't apply evidence and analysis on this topic but one can and must to questions of investment strategy or decision-making in general.

One of the most startling learnings for us over the last year is the extent to which people let their hindbrains entirely dominate their thinking and realy on their forebrains as engines of rationalization to justify the conclusions they've already reached. Warren Buffett is famous for his results, for his folksy wisdom and for his principles. What almost all the commentators ignore is that Warren DOES NOT make his decisions in 15 minutes of gut-level response. Instead he invests enormous time and effort, which he doesn't talk about very often, on acquiring a detailed knowledge of how things really work. The most difficult of his principles is never invest in anything where the intrinsic value is not far less than current market value, preferably by at least 25% if not more. The difficulty of course lies in determing  that value, which is where careful investigation is required. If you're not willing to Pay the Piper then go to the Dance. The other, among several key lessons, he follows is not to let ideology substitute for thinking. It's all right to have emotions and principles. It's not all right to let them dictate your decisions - they are ideals and goals.

Right now all the evidence points to almost all assets being vastly over-valued based on reasonable analysis of the best available data, the Spockian approach. What does that tell you? Especially when so many are are arriving at their conclusions based on ideology instead of analysis and converting the resulting conclusions into Shibboleths. Your hindbrain will win if you let it so it's up to you to substitute thinking and discipline. Easy to say of course and very hard to do - and not something we've found many (sadly including ourselves) are willing to do in all circumstances (cf. Cognitive Dissonance, Double-Bind).

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Previous Posts

Markets

• Where's the Money: Markets, Outlooks & ReThinks
• Markets Away: Run Baby Run? Or Stumble? Or What?(Updates)
• Really Different This Time: Liqudity, Rates, Markets & Risks
• Surprise, Surprise:Not a Rally and It's Still Different
• It's Still Different: Refreshing Policy and Market Info

Mythologies

• Debt, Wealth, Finance & Outlook: Sixty Years of Bubbliciousness
• From Mythologies to Realities: Economy, Employment, Credit & Trade
• More De-mythologizing: a Little Markets, Some Economics, Lots of Policy
  

Rates vs Recovery

Fed Keeps Rates Low, Leaves Statement Largely Unchanged  The Federal Reserve affirmed its plan to keep interest rates "exceptionally low" for a long time despite signs of economic recovery. But the Fed began to lay rhetorical groundwork for an eventual shift in its stance, suggesting that when the unemployment rate falls or if expectations of inflation turn up, it could change course. "Economic activity has continued to pick up," the Fed said in a statement following a two-day meeting. It noted that consumer spending has improved, housing activity has increased and businesses were retrenching at a slower pace. Fed officials voted unanimously to maintain their target for the key federal-funds interest rate -- at which banks lend to each other overnight -- near zero and said they expect to keep it there for an "extended period," which suggested increases are at least several months off. Central banks in smaller economies -- such as Australia, Israel and Norway -- have started raising interest rates. But the Fed made clear the U.S. economy isn't nearly strong enough to begin moving in that direction, even though the economy grew at a 3.5% rate in the third quarter and is expected to keep growing into 2010. While consumers are spending, the Fed noted they were "constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit." Meanwhile, "businesses are still cutting back on fixed investment and staffing, though at a slower pace."

• Parsing the Fed: Statement changes
• MarketBeat: Game on for the Carry Trade
• Stocks and bonds take away different messsage from the Fed

Two easy-money pieces As regular readers know, I’ve been growing increasingly concerned about the buzz saying “the recession’s over, let’s raise interest rates”. I think the ZIRP — the zero interest rate policy — needs to stay in place until unemployment has declined a long way, probably below 7 percent. And that will probably take years. A couple of recent pieces reinforce that argument. One is this recent post at Macroblog on “trimmed” inflation. The concept is this: when we’re trying to assess inflation trends, what you really want is the sluggish, “inertial” part, not the short-run fluctuations. The usual technique is to exclude traditionally volatile prices — food and energy — to get “core” inflation. An alternative, however, is to “trim” all big price changes, and look at the middle of the distribution. What you get depends on how much you trim. This suggests that disinflation is proceeding rapidly. And a falling inflation rate, possibly even deflation, means that a zero interest rate is less expansionary than it seems. I do want to beware of the ECB syndrome, switching my preferred inflation rate as needed so as always to justify the same policy, but I think there’s something there. Next up, a San Francisco Fed study that tries to capture how the Fed funds rate relates to the interest rates that matter for spending. Basically, this says that much of the Fed’s loosening has been offset by troubles in the financial system, so that actual credit hasn’t gotten much looser at all. And this in turn means that the zero-rate policy isn’t nearly as expansionary as it might seem. That doesn’t mean that the Fed funds rate has no effect; it means, rather, that you need a lower Fed funds rate to get any given effect. If credit-market troubles persist, this adds up to another reason to keep rates at zero for a long time — possibly even after a Taylor rule suggests they should finaly start going up.

The madness of the monetary hawks (wonkish) Well, let’s use the Taylor rule estimated by Glenn Rudebusch at the San Francisco Fed. (Yes, I know that John Taylor himself likes a different rule — but like Brad DeLong, I find Taylor’s argument more or less incomprehensible.) The Rudebusch version of the rule is: Target fed funds rate = 2.07 + 1.28 x inflation - 1.95 x excess unemployment where inflation is measured by the four-quarter change in the core PCE deflator, and excess unemployment is the difference between the actual unemployment rate and the CBO estimate of the NAIRU, which is currently 4.8 percent. This rule describes past Fed policy quite well. Applied to current data, the rule says that the Fed funds rate should be — drum roll — minus 5.6 percent. You can’t do that, of course, so we’re very hard up against the zero lower bound. And if you think the Taylor rule was a good guide to policy in the past, the Fed shouldn’t start to raise rates until the rule starts, you know, yielding a positive number. So when will that happen? Will it happen any time soon? Not if you believe conventional forecasts. Predictions from the Survey of Professional Forecasters, say that unemployment late next year will still be only marginally lower than it is now, and core inflation will have fallen; the implied target rate for fourth quarter 2010 is around minus 5.5, barely changed from the current situation. By late 2011 the forecast calls for modest reductions in unemployment — but I still get a target Fed funds rate well below zero.

When should the Fed raise rates? (even more wonkish)  Right now, this rule says that the Fed funds rate should be -5.6%. So we’re hard up against the zero bound. Suppose that core inflation stays at 1.6% (although in fact it’s almost sure to go lower.) Then we can back out the unemployment rate at which the target would cross zero, suggesting that tightening should begin: it’s an excess unemployment rate of 2.2, implying an actual rate of 7 percent. That’s a long way from here. If inflation drops to, say, 1 percent, the Fed shouldn’t tighten until unemployment drops to 6.25%. What would it take to get to that range of unemployment? Okun’s Law suggests that it takes 2 points of GDP growth in excess of potential to reduce unemployment by 1 point. Potential growth is probably around 2.5. So say we have 5 percent growth for the next 2 years — which would be hailed as a stunning boom. Even so, unemployment should fall only 2.5 points, to 7.3. In other words, even with a really strong recovery (which almost nobody expects), the Fed should keep rates on hold for at least two years.

Credit vs Velocity: NOT

Credit woes continue A recent Bloomberg article was titled”Pandit “near death” hoard signals lower bank profits “, and stated that Citigroup Inc. and JPMorgan Chase & Co. were hoarding cash as if another crisis were on the way. Also, a Wall Street Journal article entitled “Jittery Companies Stash Cash“ showed cash on the balance sheets of S&P 500 companies was the highest in 40 years. The chart below, courtesy of economist David Rosenberg of Gluskin Sheff & Associates, shows that credit is still contracting as banks go through the painful process of repairing their balance sheets. As indicated, bank lending has now declined for 21 weeks in a row and over this entire period a total of $216 billion (15% at an annual rate) of loans and leases has vanished. “The contraction in bank credit is broad based across all lines of business - consumer, real estate and companies - and seems to be motivated by both the bank and the borrower. This is a dead-weight drag on aggregate demand and it goes to show that the real story in Q3 was not that it was so wonderful that real GDP expanded at a 3.5% annual rate but that the number was so low in view of the massive dose of government stimulus and that the contraction in credit is ongoing and acting as a tourniquet on private sector spending activity,” said Rosenberg. Meanwhile, the US Depository Institutions Aggregate Excess Reserves continue their ascent at levels far in excess of the amount banks need to keep on deposit to meet their reserve requirements (see chart below). The level indicates that the balance sheets of banks remain under pressure, especially in view of the fact that the value of some assets is not known. A definite peak in the Excess Reserves graph should coincide with a turning point for banks getting back into the business of making loans.

Money Magazine Interview, Part 2  The current crisis and the Great Depression are the only two that took place under deflationary conditions. In the Depression, the economy fell into what economists call a liquidity trap. The money supply shrunk, banks closed, money wasn't circulating. When you're in a liquidity trap there's no question that the government has to step in with fiscal policy to drive spending in the economy upwards so that money will circulate. You have to have an activist fiscal policy. Fast-forward to the present time, and a lot of conservative economists said, "Well, we can't be having a repeat of the Great Depression because the money supply did not shrink." But what they forgot is that insofar as the money supply affects the economy, it depends not only on the amount of money but on the velocity, that is the rate at which the money turns over. DF: And people aren't spending money, banks aren't lending money. BB: Exactly. For years, spending was inflated because of the housing bubble. People tend to spend anywhere between 5 and 10 cents of each additional dollar of increase in their wealth, so if housing wealth goes up by, say, a trillion dollars, you're going to get perhaps as much as a hundred billion dollars per year of additional spending. And so the decline of many trillions of dollars in housing wealth causes the reverse effect, with people spending less. This decrease in spending reduces velocity, and a decline in velocity is identical economically to a decrease in the money supply. DF: And the deflation that results from that has been especially pernicious, discouraging people from spending money, because they know that if they wait, things will just get cheaper. BB: That's absolutely right, most particularly with the housing market. Nobody wants to be a sucker and spend $300,000 for a house today and find out you could have paid $275,000 if you'd waited a week or two. Now, the Fed tried to compensate, but spending declined too fast. And they ran into the same problem we had in the Great Depression - a liquidity trap. The stimulus package may have been oversold by the Obama administration, but the basic principle - that we needed government spending to get us out of the liquidity trap and make monetary policy effective - was absolutely correct. With the benefit of hindsight we can say that the stimulus could have been better targeted, better designed. But you know, the house was on fire, and we were spraying water on the house. And you can't worry about water damage when the house is burning down.

• What Links the Great Depression and the Great Recession
• Supply-Side Economics, R.I.P.

Arrogance, Ignorance Recurring in Economic History  PAUL SOLMAN: In a new book, "This Time Is Different," Rogoff and co-author Carmen Reinhart document the long history of financial crises. And we do mean long. If you looked at financial crises across virtually every continent for something like 800 years, is it just something in the nature of human beings that we go through these cycles? KENNETH ROGOFF: There's no doubt about it. I mean, the recurring theme is arrogance and ignorance: ignorance that this has happened before in other places, in other countries; and arrogance thinking we're special, this time is different. We have financial globalization. We're running our economy better. "They're lending us a lot of money because they love us and we're doing a good job." That's what the officials think. PAUL SOLMAN: Co-author Carmen Reinhart: CARMEN REINHART, coauthor, "This Time Is Different: Eight Centuries of Financial Folly": "Whatever rules of the game are, they just simply don't apply to us." And that is the essence of the arrogance that dominates the boom phase. And it is. The seeds of the crisis are sown during the boom. PAUL SOLMAN: They say they tried to warn a convention of economists in a paper they gave in January 2008. But you didn't say to your colleagues, look, it's time to sell, sell, sell? KENNETH ROGOFF: No. We didn't say, sell, sell, sell. But our paper said that the United States will be lucky not to have a deep financial crisis. CARMEN REINHART: You know we're not seers, but it allowed us to say, if history is any guide, we're lucky if that doesn't happen here and now. PAUL SOLMAN: Lucky, we were not, which would have come as no surprise to the data. KENNETH ROGOFF: When you have a big inflow of foreign funds -- and we had a massive one -- you're at risk. When you deregulate your markets rapidly, which we did in the states, that also very often happens that you have a deep crisis. The real killer is short-term debt, debt that has to be refinanced all the time. Well, that's what the subprime was. You had to refinance it. PAUL SOLMAN: And, so far, it turns out, the recovery, too, is typical, housing prices, for instance. KENNETH ROGOFF: They tend to collapse and stay down for a long time. PAUL SOLMAN: And the stock market? KENNETH ROGOFF: Well, believe it or not, it goes back to where it was after two to three years. PAUL SOLMAN: And unemployment? KENNETH ROGOFF: Unemployment lingers. It goes on almost five years from the beginning with unemployment rising. CARMEN REINHART: It takes a little under two years to go from peak to bottom, which is roughly where we are right now. But it takes about another two years, on average, to get back to your income level before the crisis.

Carry, Markets & Bubbles

Fears of a New Bubble as Cash Pours In Concerns are mounting that efforts by governments and central banks to stoke a recovery will create a nasty side effect: asset bubbles in real-estate, stock and currency markets, especially in Asia. The World Bank warned Tuesday that the sudden reappearance of billions of dollars in investment capital in East Asia is "raising concerns about asset price bubbles" in equity markets across Asia and in real estate in China, Hong Kong, Singapore and Vietnam. Also Tuesday, the International Monetary Fund cited "a risk" that surging Hong Kong asset prices are being driven by a flood of capital "divorced from fundamental forces of supply and demand." Behind the trend are measures such as cutting interest rates and pumping money into the financial system, which have left parts of the world awash in cash and at risk of bubbles, or run-ups in asset prices beyond what economic fundamentals suggest are reasonable. Prices are surging across a host of markets. Gold, up about 44% this year, soared to a record high Tuesday. Copper is up about 50% in the past year. In the U.S., risky assets are rising rapidly in price: The risk spreads, or interest-rate premiums, on low-rated junk bonds have narrowed to about where they were in February 2008, before Bear Stearns and Lehman Brothers fell, according to Barclays Capital. Policy makers from Beijing to London, seared by the fallout from burst housing and credit bubbles, are searching for ways to head off new ones. How to handle a bubble "is one of the big two or three unanswered questions at the end of this crisis," says Adair Turner, chairman of the U.K.'s Financial Services Authority. Bank of Korea Governor Lee Seong-tae hinted last month he would raise interest rates, if necessary, to prevent Seoul's housing market from lurching out of control."This is the beginning of another big and excessive run-up in asset prices," said Simon Johnson, a former IMF chief economist.The symptoms of a frenzy are most evident in Asia and the Pacific, where economies are recovering most quickly.

• Econ: Swift Asian Recovery May Fuel Bubble
• Hong Kong Asset Prices Draw Concern

Did We Learn Anything? Carry Trade Edition  While many hedge funds make claims that they don't have any equity beta and the returns are alpha driven, as a group that is certainly not the case. That said, over the long term these funds have done exceptionally well, providing equity like returns when equity markets were up and dampening the downturn when equities sold off. The problem for hedge funds comes when the correlation among all risk assets approaches one (i.e. the EVERY strategy performing in line issue - see the reverse of the top chart from last November). When 'all assets' sold off in the Fall of 2008, leverage became an investors worst enemy as it meant forced selling to meet liquidity needs. It was only the MASSIVE injection of liquidity from the Fed that stopped the risk asset sell-off downward spiral that had the potential to take out any and all levered investors (along with hedge funds, we can throw banks, endowments, and even homeowners in the mix). My concern now is that it appears we haven't learned anything from the turmoil that happened all of 8-12 months ago. As Nouriel Roubini recently pointed out, the correlation of all risk assets has approached one as all assets have all moved in one direction... up. Why? One reason is the world's investors are turning to the US dollar for their carry trade currency of choice (if you haven't read it yet... READ IT). At a high level it goes like this... the dollar's decline is a one way bet. The issue is that at some point the dollar may not even reverse its decline, but will stabilize, increasing the "real" cost of borrowing the dollar. BUT... if the correlation of assets purchased is near one on the way up, it is sure as hell going to be that high or higher on the way down. And what happens to all these investors that are attempting to leave the same exit door at the same time? Massive re-purchasing of the dollar and massive selling of any risk asset... joy.

Turbulence, Shibboleths & Illusions

Setting free the bears, THE STOCK MARKET'S astounding run from its March lows has finally run into a real ceiling. After outpacing most, if not all, post bear-market rallies over the past century the inevitable is finally here. But is it part of another correction or something more? The urgency of the sell-off suggests the latter. That said, I don't see the danger of the market testing its March lows any time soon. Previous bouts of selling in August and September gave indications that the top was finally in, prematurely it turned out. While the underlying fundamentals didn't appear to justify such a huge rally of more than 50% from the lows, the technicals weren't negative enough to satisfy the bears. But now, both of these factors have been reversed. The rising trends in the major market indexes have been broken to the downside, and industry group after industry group is now rolling over, including banks, transportation and apparel stocks.  On the sentiment side, the widely followed Chicago Board Options Exchange volatility index -- a.k.a. the VIX -- spiked up to levels not seen since July, when financial media was rife with talk of a major reversal pattern on the charts. Back in the summer, the sudden attention paid to technicals underscored the anxiety that was growing. But the market continued to climb that proverbial "wall of worry." But with the VIX topping the 30 level Friday, many technical analysts now believe that the bears have taken control.

• Former bears’ take on the market’s future
• World stocks drop amid economic recovery doubts

Chances of a deeper correction are rising: Chris Wood, Global equities have surged about 70% in six months on hopes of a rebound in the US economy. However, with valuations getting stretched, central banks raising the drumbeat on policy tightening, and fear that governments may withdraw their stimulus measures, the road ahead looks bleak for global equities. Chris Wood, Equity Strategist, CLSA, says the chances of a deeper correction in global equities are rising. Jim Walker, MD, Asianomics, too doesn't see a V-shaped recovery in global equities. "If you look at the level of activity across the world from Europe to America to Japan to Asia, it is weak. It's a very weak recovery so far and as governments withdraw stimulus over the course of the next year, it is going to get weaker still."

• Why I think this is only a correction The last leg of this rally has been built almost solely on speculative cash flows in my opinion. Borrowing in the global dollar carry trade—where traders borrow U.S. dollars at interest rates near 0% and then use that cash to buy commodities, commodity stocks, commodity-backed currencies, and emerging market equities—has been the biggest source of that cash. Which is why I don’t think the rally that started on March 9 is over yet.
• Have stocks moved from dip to consolidation already? And is the next move up? With the Federal Reserve set to speak on the economy and interest rates later today, November 4, and with potentially market-moving numbers on unemployment due out on November 5 and 6, it is certainly too early to say that the dip, correction, whatever, is over. The news in the next few days could certainly send investors back into worry mode and extend the losses of late October into early November. But the stock market indexes are showing signs of moving from a potential correction to consolidation.
• Is gold the new dollar? The U.S. dollar does, indeed, seem to be in a long-term decline. Many of the countries with large currency reserves such as China are heavily over-weighted toward the dollar and are known to be looking for alternatives. The currency alternatives to the dollar have their own problems ranging from low trading volumes to fiscal deficits at home. Gold, in contrast, looks like a stable store of value for the long term.
• Gold bullion surging in all currencies
• Pincers Here is a weekly chart of the SPX showing the 20-week (red) and 100-week (blue) moving averages (click to enlarge): The 100-week halted the rally, while the 20-week has been supporting the rally. So, as these two pincers converge, we are getting volatile ping-pong action. This will build to a boil until prices explode out of the apex. Traders are obviously keyed into the FOMC announcement on Wednesday, and the big jobs report Friday. I would expect a breakout, one way or another, by the end of this week.
• Turnarounds As is always the case with the yellow metal, there are a dozen stories and theories offered for its performance, and per the usual it is difficult to distinguish fact from fantasy. However, an Occam's Razor analysis might well suggest that someone is taking an (informed?) punt on either financial stability, the maintenance of globally easy liquidity conditions, or both. If the latter, in particular, one would have to posit that the dollar would come under renewed pressure after the Fed (unless punters wish to wait for payrolls).

A whole new world for emerging markets, Pension fund executives around the world are putting their faith — and assets — into emerging markets to provide more investment bang for the buck. But some consultants and money managers believe pension funds still have a long way to go and need to increase those allocations closer to 35% of total assets — or roughly the weighting of emerging markets in the global economy — from the current allocation of about 5% or less for the average fund. The financial crisis has challenged several historical assumptions generally made about investments in developing nations, including the level of volatility, liquidity constraints and ability to withstand a severe global downturn. So far, emerging markets generally have fared better than major economies in weathering the storm, helping to attract assets at a record pace.  “We're in the midst of resetting the clock on emerging markets. Going into this (financial) crisis, the assumption that many pension plans — even the most sophisticated — made was that emerging markets would do less well than developed countries coming out of it,” said Cynthia Steer, chief research strategist and head of beta research group at consulting firm Rogerscasey Inc., Darien, Conn. “A whole new construct is evolving — driven by factors such as higher (gross domestic product) growth and lower impact from the banking crisis on emerging markets. This is a presage to a re-evaluation of the risk/return relationship between developing and developed markets” by defined benefit pension fund executives, Ms. Steer said. “I think it is long overdue.”

• Marc Faber: Buy emerging market stocks

It’s a Small World (of Illusion) After All! When Barry invited me to contribute a blog post this week, I thought it might be fun to think of the many forms of illusion we all frequently experience in our broad world of finance and economics. I’ll contribute a few of my own observations and perhaps you could add some of your own. Financial Plans: This may be unexpected coming from a CFP but financial plans, in general, are highly illusory in nature. The conventional planner gives the client exactly what the client (or what the client’s brain) wants – a neat and attractive package containing graphical displays and supporting data that illustrate the quickest monetary movement from point A to point B – in other words, unrealistic shortcuts. Most financial planning software still have default annualized returns of higher than 10%, which is simply an irresponsible assumption to make, to put it lightly. Heuristics: On the subject of illusions and brains, your brain is wired for pattern recognition, which is why the vast majority of investors are fooled by randomness. In my humble opinion, the fundamental cause of this financial crisis is heuristics. The core deadly assumption, based upon pattern recognition, made on all sides of finance preceding the crisis included the assumption that home values and personal income would continue rising in perpetuity. In summary, illusion is not just visual or optical in nature – it may be considered a distortion of reality, including the understanding (or misunderstanding) of any form of information received by the brain. Because the information available to the brain is rarely complete, it simply fills in the missing spaces, which opens the door to much opportunity for the illusionist to manipulate reality (and the potential peril for those lacking in self-knowledge and mindfulness). Without this awareness, we actually enable the illusion.

• "The Path of Least Resistance Is (Still) Higher," Schwab's CIO Says
• Small Investors Who Panicked in March Now Have No Clue What to Do
• Reports of 'Buy and Hold's' Death Greatly Exaggerated, Says Schwab CIO

Think Like the Master

Think Like Warren Buffett 1. Think of Stocks as a Business Many investors think of stocks and the stock market in general as nothing more than little pieces of paper being traded back and forth among investors, which might help prevent investors from becoming too emotional over a given position but it doesn't necessarily allow them to make the best possible investment decisions. 6. Recognize the Psychological Aspects of Investing Very simply, this means that individuals must understand that there is a psychological mindset that the successful investor tends to have. More specifically, the successful investor will focus on probabilities and economic issues and let decisions be ruled by rational, as opposed to emotional, thinking. More than anything, investors' own emotions can be their worst enemy. 8. Wait for the Fat Pitch Hagstrom's book uses the model of legendary baseball player Ted Williams as an example of a wise investor. Williams would wait for a specific pitch (in an area of the plate where he knew he had a high probability of making contact with the ball) before swinging. It is said that this discipline enabled Williams to have a higher lifetime batting average than the average player. Buffett, in the same way, suggests that all investors act as if they owned a lifetime decision card with only 20 investment choice punches in it. The logic is that this should prevent them from making mediocre investment choices and hopefully, by extension, enhance the overall returns of their respective portfolios.

• Warren Buffett: How He Does It
• A Baby Buffett Portfolio: His 6 Best Long-Term Picks

Masterclass: Buffett on Investing and Business Analysis At the end of the last post we laid down a, perhaps the, challenge for these interesting times:

"As this sorting goes on the real winners will be the firms and industries who have an effective business model or who re-invent one. Finding them will be the interesting challenge. "