# Why No One Will Every Win A Million Dollars on “Deal, or No Deal”

No one will ever win a million dollars on the game show, “Deal, or no Deal.”  I make this statement with certainty because to do so would require a very odd type of person with exceptionally good luck.  The creators of the show were brilliant in that they make it look like people are playing for a million dollars, but in actuality they’re playing for \$500,000, or maybe even \$50,000.

The reason a person would need to be very lucky is obvious.  There are 26 briefcases, so the first thing you would need to do to win the million dollars is to choose the million dollar briefcase as your case.  This means that your chances of choosing the right suitcase at the start are 1/26, or about 3.8%.  Not great odds.  This would mean, however, that probably by the time the 26th contestant came along, and almost certainly by the time the 50th of 75th contestants came along, someone would choose the million dollar suitcase.  You would then think that you would see a couple of million dollar winners a year, which you don’t and you won’t.

The reason is the second factor, and that factor makes the odds far lower.  This second factor is human psychology, and human psychology causes most people to choose the certain thing over the chance at something more if the risk/reward ratio is not great enough.  Most people, if given a hundred dollars and told that they could keep the hundred dollars or risk it for a chance at \$150 would hold onto the hundred dollars.  The gain they could get was not worth the risk of losing the sure thing.  Many people, however, would play the lottery and put down \$5 for a chance to win \$300 million dollars, even though their chances of getting killed in a car accident on the way to buy the ticket is much better than their chance of winning.  They do the math instinctively and realize that the gain was enough to justify the risk, partly because the amount risked is so little and it would not affect their lives very much if they lost it, so it makes sense to take the risk for the chance at great rewards.  The penalty for losing is low but the gain from winning is astronomical.

And this psychology works against people playing “Deal, or No Deal.”  If the show were simply a matter of choosing suitcases and then seeing if you could make it to the end and have the million dollar case, there would be a winner or two a year.  The reason they have the “banker” making offers as they go is to make people have to make the choice of trading a sure thing for a chance at the million dollars.  (Note the offer is just the average value of the cases, minus a small amount.  It is not made by the guy in the shadowed booth who supposedly is rooting against the player.  Why would someone make their money available to be given away in the first place?)  This puts people who have the million dollar case, a \$300 case, and a \$10,000 case in the position of giving up a \$300,000 offer and risk ending up with \$300 if they want a chance to actually win the million dollars case.  Not many people would make this choice.  If you combine the chance of choosing the million dollar case with the percentage of people who would give up a sure \$300,000 for a chance of winning a million dollars, you can see why no one will ever win.   The only time that they might have a chance of winning is if they had a large amount whether they won the million dollars case or not.  For example, if the only two suitcases remaining were the million dollar case and the \$500,000 case. In that case someone might be willing to risk it since they would still win \$500,000 if they didn’t have the million dollar case.

And what does this have to do with investing?  Well, while plugging the average long-term investment return of 10%-12% into a financial calculator will show you that you can end up with \$5M, \$10M, or more by putting money away regularly into a retirement account and letting it grow in the stock market, few people will ever see these kinds of sums.  The reason is that the biggest gains are made near the end when you are getting near retirement.  For example, compounding at 10% per year, someone would see their nest egg double about every 7 years.  Someone at 50 who planned to work until he was age 70 would therefore see the potential for his \$750,000 portfolio to grow to  \$6 M before he retired, with gains of several hundred thousand dollars per year during the last few years.

The trouble is that there would also be a risk of seeing a big decline during that period that, if it happened during the last few years before retirement, could leave the individual without enough money to make it through retirement.  This drives people (for very good reason) to become conservative with their money – shifting into bonds and cash – during the periods when they could see the biggest gains by being wholly in equities.  The only way to overcome this (justified) fear is to save enough for retirement early in life to have enough of your money for security in secure investments when nearing retirement while still having enough money in equities to still perhaps “hit the jackpot.”  For example, an individual who had \$2 M in retirement savings by age 50 could move \$500,000 into large, dividend paying stocks (income stocks) and bonds while still leaving \$1.5M in growth stocks, moving a portion of the growth stock portfolio into income stocks and bonds as she neared retirement age until she had \$1 M or so in income stocks and bonds at retirement.  She would therefore still have the potential to see her portfolio grow to \$12 M or more but still have enough for critical expenses during retirement even if half of the equity portfolio were lost due to a market event.

OK, so I’m sure that some of you have gone to Google by now and found out that someone actually did win the \$1 million on “Deal, or No Deal.”  And I’m not talking about the shows where they put three million dollar prizes on the board, effectively taking away the psychological factor.  There actually was one person who legitimately won the million dollars and you can (and should ) see the video here.  She was helped a little by having the \$200,000 prize remaining, meaning that by giving up the almost \$500,000 sure thing she was only risking \$300,000 for a possible gain of \$500,000.  I doubt she would have gone for it if she would have only won \$300 if she were wrong.

She also did something that was a very poor choice and she was very lucky that it worked out for her.  At the end of the show, if you get down to two suitcases, Howie Mandel offers to allow you to switch cases with the one remaining.  Believe it or not, if she had switched cases her chance of winning would have improved dramatically.  In fact, her chance of winning the million dollars would have gone from 1/26, or 3.8%, to 25/26, or 96%.

The reason is that “Deal, or No Deal” is the Monty Hall Problem on steroids.  In the Monty Hall problem, you are on “Let’s Make a Deal” and choose one of three doors.  One door contains a new car and the other two doors contain a goat.  Monty Hall then shows you one of the doors that has a goat behind it, then offers you the choice of staying with your door or swapping to the other, unopened door.  Because your chances of choosing the right door originally is 1/3, and because Monty Hall, who knows where the car is, eliminates one of the wrong doors, your chance of winning if you switch is 2/3, versus 1/3 if you stay with your original door.

With “Deal, or No Deal,” if you can somehow manage to get down to having only one suitcase and your suitcase left, one of which contains the million dollars, your chances are 25/26 of winning if you switch suitcases.  Your chance if you don’t switch remain 1/26.  This is because your chances of choosing the wrong suitcase at the start, and therefore the chances of the right one being the other suitcase if you know that the other 24 suitcases don’t contain the million dollars, is 25/26.

So why not make it easier psychologically to keep a good amount in growth stocks as you near retirement and maybe win the million dollars.  Make your own choice at retirement between having plenty of money for living expenses should things work out and an incredible fortune of they do instead of between having just enough and having nothing.  Put yourself in the position to take the risks.  Start when you are in your 20’s to build your fortune so that you’ll have five or ten million dollar suitcases instead of just one.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

# An Alternative to Raising the Minimum Wage

In a speech yesterday, President Obama challenged those opposed to his proposal to raise the minimum wage to offer their solutions to the problem of growing wealth disparity.  As his story line goes, the wealthy are getting far wealthier but the poor and middle class aren’t participating in the growth in wealth.  The question then becomes, what can we do to stop this divergence in outcomes?

The President is probably looking for a government solution.  Ironically, in this case the government may very well be the cause of the problem and therefore the best thing it could do is simply pull back out of the way.  Over the years it has become very expensive to have employees with all of the bureaucratic hurdles that must be passed.  Gone are the days of simply handing out paychecks on Fridays.  Now an entire HR department must be staffed to handle benefits, tax paperwork, and other regulatory compliance functions.  This has reduced the incentive for entrepreneurs to hire employees.

Existing minimum wage laws have also caused employers to replace employees with technology more often.  There are a lot of tasks that an employer would have been happy to hire out at \$4 or \$5 per hour.  At \$7 an hour or more, suddenly it becomes worth it to buy a new computer system or upgrade facilities to allow the tasks to be done with fewer people.  In some cases, tasks that were once done by employees are being given to customers (see self-service checkout at some grocery stores).  As the minimum wage is increased, this will happen more often.  At \$12 an hour or more, expect to see self-serve kiosks for ordering at fast food chains.  This would be easy now that most restaurants are taking credit and debit cards.

Also expect to see the door to these jobs closed for many of the entry-level workers if the minimum wage is raised significantly.  Beyond investing in technology to reduce costs, restaurant owners will need to pass the costs onto their customers as much as they can.  This will require increasing the quality of the food and the service since there is a limit to how much you can just raise prices for the same quality.  Since, at higher wages, there will be a lot more people interested in the jobs, including people coming out of culinary school, employers will only be interested in the most skilled and the most efficient employees.  It will be very difficult for those with no experience to get a job and there will be no tolerance for anything but exemplary work performance.  So then you’ll have lots of people out of work and the price of restaurant food rising.  Not a good combination.

This has gotten far worse with the passage of the Affordable Care Act.  There are now strong incentives to cut people to 30 hours per week or less, or keep employment below 50 employees.  Employers who go over those levels will see their costs per employee rise dramatically since they must then provide expensive healthcare coverage.  This has already resulted in some lay-offs and reductions in hours.  It will get far worse this summer as the employer mandate deadline gets closer.

So what can the government do to address this issue if putting new requirements on employers is not the answer?  Here are some suggestions:

1.  Drop the minimum wage to \$5 per hour.  This will slow the process of job elimination through technology upgrades and provide more people with the entry-level job they need to learn good work habits and start building a resume.

2.  Approve the Keystone Pipeline, remove the new EPA regulations requiring carbon dioxide sequestration for coal-fired power plants, and get the government out of the energy business in general.  Increasing the costs of energy and closing power plants and coal mines only reduces the number of good paying jobs available.  Pumping billions of taxpayer dollars into plants to build solar panels and other green energy initiatives has also proven to be fruitless because the market does not exist for these technologies.  Instead, fund energy production research and let the market decide when technologies are ready to build in scale.

3.  Examine and cut regulations on businesses where possible.  Reduce the hassle of starting a business and the cost of running a business so that money can be put into more productive places.  In particular, eliminate the certification requirements that are enacted mainly to protect existing businesses from competition.

4.  Eliminate the Affordable Care Act and replace it with a system of Health Savings Accounts and major medical insurance tied to the individual, not to employment.  This would remove a lot of the employment-killing rules that have kept employers from hiring over the last five years.

5.  Replace the income tax with the Fair Tax.  This would eliminate the unproductive use of time to reduce taxes and comply with tax regulations.  It would also reduce the tax burden in general since there would be less fraud in the tax system.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

# The Affordable Meals Act

In a country far away, people often went out to restaurants to eat on Saturday nights.  Some people liked steaks and therefore would go to the steakhouses and get a porterhouse or a rib eye.  Others prefered to do other things with their money, and therefore would opt for chicken.  A small percentage of the population – about 15% – did not go out to eat, instead opting to stay home.

Of those who stayed home, there were some who wanted to eat lobster but were not able to afford more than chicken.  There will others who did not really like going out, and therefore decided to stay home instead and spend their money on other things that they did enjoy.

The king of the country was troubled by the fact that 15% of the people did not go out on Saturday night.  He spoke to the ones who wanted lobster, and they told him that they should be able to get lobster if they needed it.  He felt this was unfair that they could not afford to get lobster and devised a plan.

The king sent out a decree called the Affordable Meals Act, which declared that every citizen had the right to meals at reasonable prices and that if everyone were required to go out and buy meals, we would all be better off.  The people who wanted lobster heard this and understood it to mean that they could get the lobster they wanted for free, or at least at chicken prices.

The others who were buying chicken were worried that the Affordable Meals Act would make them pay more for their meals or that they would not be able to keep getting chicken.  (The ones who chose not to go out ignored the decree entirely, but liked the king because he they felt he was “hip.”)  The king assured the steak eaters and the chicken eaters that if they liked their meals, they could keep getting them.  Nothing would change and they could continue to go out and get those same meals.  He told them that this was just a program for those who wanted lobster but were unable to buy it.  He also said that the prices of all meals would go down overall due to the Affordable Meals Act.  This satisfied many of the chicken and steak eaters.

In the dead of night, the king and his royal council prepared the specifics of the Affordable Meals Act.  It declared the following:

1)  Everyone must go out and buy a meal on Saturday night, or sacrifice 1% of his gold to the king.

2) Every restaurant meal must include steak.

3) Those that could afford steak must pick up part of the cost of the meals of those who could only afford chicken.

4)  People who chose not to go out and pay the fine instead could opt into the plan at a later date, should they decide they need lobster.

The ones who needed  lobster, without ever reading the decree, rejoiced at learning that they would now get lobster and there was great celebration throughout the land.   As the Affordable Meals Act began to be implemented, however, there arose great anger.

First, the king’s court, who were used to getting lobster but paying for chicken, protested when they realized that they were going to need to pay for their lobster and some of the steak dinners for some of the chicken eaters.  The king, who realized his mistake, quickly decreed that his court, many of whom made far more than the steak eaters, would continue to receive lobster at chicken dinner prices.

Next, the chicken eaters discovered that the decree required they buy steak dinners.  “We like our chicken dinners, and don’t want to pay the price of a steak dinner”  they said, “and you promised us that we could keep buying our chicken dinners if we wanted to. “

“It is true you are paying more than you are now, but that is not a fair comparison,” said the king.  “You were getting chicken dinners before, but  now you are getting steak dinners, which are better.  You should be happy to get steak dinners – you were missing out when you were getting chicken.  Trust me, I know what is best for you.”

“Besides,” said the king, “it isn’t the Affordable Meals Act that caused you to lose your chicken dinners.  The restaurants just chose to stop serving chicken – restaurants change their menus all of the time.”

“But the restaurants said the Affordable Meals Act said that they were no longer able to serve chicken,” protested the chicken eaters.  The king ignored them, just talking about how nice it was that people who want lobster would now be able to get it.  Some of the chicken eaters reduced some of their other spending to raise enough money and went ahead and started purchasing the steak dinners.  Others couldn’t afford steak dinners, but made too much to receive a subsidy, so they decided to stop eating out.

Next the steak eaters, who had supported the Affordable Meals Act, got their bills for dinner and saw that the cost had gone up, to the point where lobster used to be.  “We want people who want lobster to have it, but we didn’t know that we would be paying for it,” they said.  “We thought you said we would be paying less.”  The former chicken eaters laughed at this, with a ting of Schadenfreude.

“You can’t be so selfish,” chided the king and his court.  These people need lobster and can’t afford to pay full price.  They need to be subsidized.  Most of the steak eaters went ahead and paid the higher price.  Some could not afford to pay and decided to pay the tax and eat at home instead.

Part of the king’s plan was to coerce some of those who were not eating out to get on the dinner plan and pay for the steak dinners.  He reasoned that would reduce the price for everyone since they would now be paying steak dinners too, but still not going out very often since they hadn’t in the past.  Many of these individuals, however, decided they did not want to pay the high prices for the steak dinners and decided instead to pay the fine and keep eating in.  This caused the prices to increase still more.  As prices rose, more and more of the chicken eaters started eating in or getting subsidies from the smaller number of people still paying full price for the steak dinners.

Now that they could get lobster for the price of steak, many people now asked for lobster.  The first few indeed got hot, fresh lobsters.  The restaurants soon ran out of lobsters, however.  In addition, since the steak eaters were  now paying more, and the chicken eaters were now paying steak eater prices, many more people were going out more often to “get their money’s worth.”  The restaurants soon ran out of steak as well.

The people complained to the king.  “We are paying for steak and lobster, but there is not much of either.  In addition, we are paying far more than we used to for either steak or chicken.”

The king, worried that the crowds were becoming restless, came out to the balcony of his palace to address the crowds below.  “It is not the Affordable Meals Act that is causing the problem,”  he said. “It is the restaurant owners who are charging too much.   Give me what you were paying to the restaurants, and I’ll see to it that there is steak and lobster for all.”

The king secretly planned to take all of the money, buy lobster for himself and his nobles, and then give the people hamburger and say it was steak.  Any who complained would have their hamburger withheld once he controlled all of the restaurants and thereby had power.

Some in the crowd cheered, saying the king was wise and kind, and that everyone should give their money to the king so that he could provide steak and lobster to them.  Others said they should go to the restaurants, burn them down, and hang the evil restaurant owners from the light poles.

In the crowd, raging towards a frenzy, stood a small boy.  The boy rarely said anything, many thought him to be a mute.  This boy, however, climbed up upon a wagon seat and shouted to the crowd.

“Stop!” he shouted.  “What are you doing?  It is not the restaurant owner who is causing the shortage of steaks and lobsters and the increase in price.  It is the Affordable Meals Act, which the king proposed.  Now you want to give all of your money to this king that created this act that has caused you so much misery.  If you give him your money, you’ll need to beg him for the steak and chicken that you used to provide for yourselves.  He’ll be using your own money to control you.”

“Why don’t we try something different.  How about we require everyone to set aside enough money from their wages to pay for steak, plus a little extra in a pool to pay for those who will need lobster but cannot afford it from their wages.  We will not require anyone to buy steak, however, letting those who want to just buy chicken, and save the extra do so.”

“Many people will opt just for chicken or to eat at home for a while, such that when they do want steak or lobster, they will be able to pay for it themselves from their savings.  They will have saved so much they’ll be able to buy all  the steak and lobster they want.  Those who need lobster but do not have time to build up a savings will be easy to cover because they are few in number compared to the whole population.  Most people will be paying for their own meals, so the burden from those who cannot will be small.  Those who want to spend their money on steak instead of chicken can do so, understanding that by doing so they would probably never be able to afford lobster.”

The people tried the suggestion of the little boy.  They found that by eating in and buying chicken when they were young, rather than paying for steak every week, their savings grew rapidly.  They were able to easily pay for lobster later in life – something they would have never been able to afford had they been spending all of their money on steak.  They also found that the few people who needed lobster before their savings could build were easily taken care of since there were few of them.

The people realized that they did not need to king to control their restaurant spending.  They just needed to save while they were still content with chicken, so that they could have lobster later in life.  They discovered that it was better when everyone who could was saving for steak and buying chicken, rather than paying out all of their money for steak all of the time and the being dependent on others to provide for them when they needed lobster.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

# Three Reasons Wall Street is Booming; Three Reasons Main Street is Dragging

Investors on Wall Street have been doing very well over the last few years.  Even over the last few weeks, as the government shutdown took effect and various commentators warned of a “default on the economy” if the debt ceiling were not lifted, the market held up relatively well.  The average worker on Main Street has been doing less well.  This clearly shows that the stock market and the economy are not always correlated.  In fact, they often act independently of each other, or even are negatively correlated – one goes down when the other goes up.

The stock market looks at corporate earnings, future values, and factors such as inflation.  Consumers and workers look at job stability, the level of spending or business, and how valuable they feel to the company for which they work when judging their confidence in the economy.   The markets are also often concerned with predictability, so the markets may rally after taxes are raised. for example, because there would no longer be a question of whether taxes would be raised.  The consumer, on the other hand, may feel poorer when taxes rise and reduce his take-home pay.

To understand the current economy and markets, let’s look at three factors affecting the stock market and three factors affecting the consumer markets.

Factors Affecting the Stock Market:

1.  Federal reserve Policy is inflationary and stimulative.  There is an old saying to “never fight the Fed.”  This means when the Federal Reserve is keeping interest rates low to encourage borrowing and growth of the economy, it is good to be long stocks.  Likewise, when it is raising interest rates and taking money out of the economy, it is wise to take some profits and raise cash, or even go short stocks.  Low interest rates can also have the effect of causing inflation, which will eventually lift stock prices in dollar terms as dollars become less valuable.  The Federal Reserve has been keeping interest rates low and, with the economy going nowhere fast, is unlikely to be raising them anytime soon.  This has helped drive the market boom.

2.  Corporations have become more efficient, raising profits.  Because business dropped off during the last recession, businesses laid off all but their best workers.  Unable to hire workers back due to the slow economy, they have purchased technology and improved their processes to allow them to get by with fewer workers.  As the economy has come back somewhat, they have been able to produce more profit per worker, thereby increasing their profits.  Higher profits per share has caused share prices to advance.

3.  Low interest rates have forced savers into stocks.  Normally savers and people in need of current income (like retirees) would be invested mainly in CDs and Treasury bonds.  The very low interest rates, however, have forced these savers to take on more risk, buying dividend paying stocks, large cap funds, and the likes.  This has caused the price of equities to rise.

Factors affecting main street:

1.  Businesses have been slow to expand and hire more workers because of low growth rates.  The economy has been growing at a very anemic rate, causing businesses to delay expansion and hiring until the economy appears to be picking up.  In addition, the efficiency improvements and technology investments which have helped corporate profits have allowed companies to get by with fewer workers, reducing the employment rate.  Note that while the employment rate has been declining, the labor participation rate has been dropping as well.  This means that individuals are simply giving up, rather than that people are finding jobs.

2.  Regulations in the healthcare law and elsewhere are discouraging hiring.  The Affordable Care Act requires that companies that have 50 or more full-time workers provide health insurance or pay a fine.  Employees working 30 hours or more per week are considered full-time.  This has caused businesses to either not hire or convert workers to 29 hour per week schedules or less to avoid the jump in costs, which in some cases would make the workers cost more than the amount of money they produce for the company.

Beyond the healthcare law the government has been far more activist than it has ever been.  With new environmental regulations being enacted that regulate CO2 production, new wage limits being discussed, government voiding of contracts (for example, during the auto bailout) companies are leery of hiring and expanding.  They have instead taken a wait-and-see attitude, waiting for the dust to settle so they can pick the best path in  the new regulatory environment or perhaps simply waiting for the next Administration.

3.  Fewer people are working, meaning that there is less being produced to go around and people feel poorer.  During his speech at the Democratic National Convention, President Clinton spoke of how employment rates dropped significantly during his second term after Newt Gingrich and the Republican Congress passed welfare reform which he signed into law.  This caused people who had never worked before to enter the labor market.  Because there were more people working, there were more goods and services being produced, which in turn could be traded, causing the economy to grow.  This lead to consumer confidence, resulting in more spending and a more rapid expansion of the economy.

We have seen the opposite effect since the 2008 crash with welfare rolls expanding and fewer people working.  Because a large number of people are not producing anything, there is less wealth to trade even though they are receiving benefits from the government.  This means that businesses expand slower and there are fewer jobs created.  This all leads to a weakened outlook from the consumer and, consequently, less spending.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

# Why the National Debt is a Bubble

In the previous post, I discussed the symptoms of a bubble and talked about some of the recent bubbles we’ve seen in the US.  Today I wanted to talk about another bubble that has been growing since about 1981 – that is the US National Debt.

Like other bubbles, the US debt is using credit – in this case in the form of government bonds and money created by the Federal Reserve, to create a false sense of wealth.  Just as homeowners used the rapidly growing value of their homes in the 2003-2008 period to buy all sorts of things, the government is using debt to fund programs, employ people, send money to other nations, and perform other functions.  The level of spending has become so large that things that once would have been thought of as extreme, such as the President travelling to Africa on a trip that cost more than \$100 million dollars, are suddenly excepted with little opposition.

This spending has outstripped revenues brought in through taxes, with revenues equal to about \$2.5 T and spending equal to about \$3.5 T.  In 2014, revenues are expected to increase to about \$3 T as the economy continues to recover (and inflation from the quantitative easing of the Federal Reserve devaluing the dollar), but federal spending is likely to increase as well to \$4T or more.  This means that about 30% of the spending that occurs is with money that does not really exist.  In other words, about \$1 T of the spending for services provided and goods purchased by the government cannot continue indefinitely.

Eventually, when the government is no longer able to borrow more, all of this spending will need to come to an end.  This means that there will suddenly be \$1 T less spending in the economy.  The jobs for all of the people who perform those functions will vanish.  The people who are receiving some of that money from the government will stop receiving payments.  The suppliers who are developing things for the government on that money will no longer have a customer.  The castle in the cloud will fall back to earth, leaving people to wonder where it all went.  It could go on for a few more years, or even a decade or more, but it will burst eventually just as all bubbles do.

So when this happens, will it cause a nother Great Depression and send the whole world into depression as has been proposed?  Probably not.  Here’s why:

1.  While the amount that the government borrows and spends is a lot, is still not that much compared to GDP – about \$1 T on a \$18T US economy.  It is true that defense contractors will be hurt as some programs are cut and that others who depend on the government will have less to spend, but much of the economy will continue on as normal.  The fact is, in the US, unlike in the USSR, the economy really doesn’t depend on the government that much.

2.  The government will also still be able to do 70-80% of what it was doing before the bubble burst.  It isn’t like all spending on defense, highways, health research, etc. will disappear.  It will just be cut.

3.  Interest rates may increase for the government, since it will likely default on some of its debts, but this does not mean other consumer and business interest rates will rise.  In fact, rates on corporate bonds and other investments may fall as people leave government bonds for the relative safety of corporate loans.  Increases in the rates the US pays right now only cause other rates to rise because US debt is considered safer than corporate debt.  This would reverse as the government debt gets unmanageable.

So, like all bubbles, this one may continue to grow for some time and there is no need to panic.  It would be wise, however, to not be overly dependent on the government.  Federal workers should save and invest so that they have enough resources to tide them over until they can find other work when the bubble bursts.  Those who are on government welfare should develop job skills and get financially independent of the government.  Those approaching retirement age should make sure they save and build a large nest egg since Social Security will probably not be there, at least at current rates.

There is always money to be made while bubbles grow and they can continue to grow for a long time.  The trick is to keep yourself on firm footing so that when the castle collapses, you are on firm ground beside it instead of buried under it.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

# Castles in the Clouds – Understanding Market Bubbles

The United States government is currently in a bubble.  With  \$16 T in debt and spending outstripping revenues by a trillion dollars or more each year, it has all of the makings of a classic bubble as we saw with housing in 2003-2008 and stocks in 1995-2000.  Today I thought I’d discuss the psychology and characteristics of a bubble.  In the next post I’ll discuss how the US Government is in a bubble and what the ramifications may be when that bubble bursts.

All substantial bubbles include the following:

1.  Credit

2.  Public blindness to market forces

3.  Escalating prices

Bubbles can be thought of as the building of “castles in the clouds.”  Creation of something that is perceived to be very valuable but for which there is no foundation, and therefore cannot last.  Often when a bubble pops and the castle comes falling down to earth there is a great sense of loss, or even a feeling of unfairness, but the truth is the perceived value was never actually there to begin with.  It was a false economy built on credit and not on work or resources.

Think of someone who builds a house on a cliff near the sea in California.  That house may sit on that cliff for years, and the residents may love the commanding views of the ocean and the sound of the waves crashing.  The cliffs are just sand, however, and eventually the ocean will rise during a storm, or torrential rains will wear away at the cliffs, causing the foundation to drop out from under the home, and the home will be gone forever and can never be rebuilt.  Often in that situation the homeowner will eye his neighbors’ homes across the road that now sits on the edge of the cliff and say he deserves that home since the edge of the cliff is his property.  The fact is, however, that his property was never on firm ground to begin with and will never return.

During the dot com boom of the 1990’s, companies that had no profits or even a business plan were having Initial Public Offerings (IPOs) where there share price would double or triple the first day.  Early employees who held company stock became paper millionaires over night.  They began to buy houses and take expensive vacations, often on money borrowed against their stock holdings which were locked up restrictions from the IPO for several months, preventing them from selling.  At one point Priceline, which sold excess seats on airlines, was worth more that the top three airlines combined.  Pets.com, whose mascot was a sock puppet, bought several ads at the Superbowl using cash from it’s IPO.  Perhaps the most amazing feat of all was AOL, whose shareholders were able to convert their fluffy shares to real cash when the company was acquired by Time Warner.  Time Warner soon regretted the purchase.

In this case only a few shares were available to trade – most shares were locked up by insiders.  Because of this, the few shares that did trade were bid up to astronomical heights.  People who had large numbers of shares simply multiplied the shares they held by the current price and thought they were millionaires and billionaires.  No one stopped to consider what would happen if the insiders actually tried to sell their shares, placing far more shares on the market.  As the required holding periods after the IPOs expired and insiders started to dump their shares on the markets, the true value of the companies was revealed.  For many companies, this value was zero.

In this case the credit was actually in the form of locked-up shares.  This caused the perceived value of the companies to far exceed the actual value.  People multiplied their million-share holdings by the current market price and believe that to be the value of their holdings.  Blindness to the economic fundamentals was pandemic, with even seasoned market analysts declaring that “the old valuations don’t matter anymore.”  Price escalations were commonplace, with hot new internet stocks routinely doubling in price every few weeks or even days.

A more recent bubble was the one in real estate.  This one actually traces its roots back to the Fair Housing act of the 1970’s that required lenders to make a certain portion of their loans to low-income borrowers.  Congress directed Freddie Mac and Fannie Mae to buy a certain percentage of these risky loans, which in turn meant the banks and loan agencies had large amount of cash they could only use to make these loans.

Banks and loan agencies thought they were insulated from losses since they bundled the loans together and sold them off, taking the loans off of their books.  Investors thought they could not lose money because they were investing in real estate, which never declined in price very much.  Home buyers saw prices increasing rapidly and began to bid up the prices, believing that they could easily flip the property in a few years for a large profit.

Borrowers, unable to afford a traditional 20% down-payment on loans, began using second mortgages to reduce the amount down to 5% or less.  Eventually, unable to pay the payments for a traditional loan, borrowers began taking out interest-only loans or even option-ARMs in which they actually paid less than the interest charged during the first year or two.  All of this leverage created an illusion of wealth that did not exist, which people used to take vacations, eat out, and buy things.  This created all sorts of jobs creating goods and services for people who did not have the money to pay for them.

In the investment banks where these bundles of mortgages were being purchased, a new insurance instrument called a Collateralized Debt Obligation, or CDO, was created to protect them from losses.  These option contracts allowed the investment bank to collect money from a second party if the value of the loan bundles they purchased dropped below a specified value.  The issue was that the second party didn’t have the money to actually insure the bundles.  Instead, they used some of the proceeds from the CDO’s they sold to buy offsetting CDO’s from other firms.  When the market collapsed, like a circular firing squad no one had the funds available to pay on the insurance policies they issued because they could not collect on the policies they purchased.

After this bubble burst, all of the businesses that were built and expanded during the boom collapsed because they were built on borrowed money rather than on money earned through labor.  Just as with the house on the edge of the cliff, there was never really anything of substance underneath to support them.  Still, the people running and working at those businesses felt a large sense of loss.  Like the homeowner on the cliff, however, the foundation for the business they built was never really there.

There is nothing wrong with making some money from bubbles while they are here, but it is always important to look around at your investments and even your business or employment and ask yourself if it has a sound foundation.  If it does not, be ready to move out when the sand beneath falls away.  And don’t leave anything too valuable inside.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

# My Stock Got Creamed Today. Now What?

Today my shares of BJ’s Restaurants Incorporated got obliterated by the market, losing more than 15%.  The opinion on the Motley Fool is that the stock should be avoided because the sector has slowed.  I have a relatively large position in the stock that I have been acquiring little-by-little for a while.

What will I do now?  Call my broker in a panic and sell everything?  Buy more to average down?  It is times like this that rattle the confidence of even the most seasoned investor.  Everyone knows what to do when the market is going up.  What about when it’s going down?

The answer is that I am going to stand pat.  The news on the stock is that earnings increased – the shares only fell because the earnings were not as strong as the market was expecting.  The company is still expanding and doing well.  The whole restaurant sector is just doing poorly – probably because the “recovery” is not really a recovery, and increases in gas and food prices are starting to take their toll on the restaurant going public.  Everyone is having trouble – not just BJ’s.

There is no reason to sell just because the price fell. I didn’t feel it was overpriced at \$38, so there is no reason to think it is overpriced at \$32.  I wouldn’t sell my home just because someone offered me \$20,000 less for it than I paid.  Unless I’m looking to sell, the current price really doesn’t matter.

Likewise, I have as many shares as I want to have, so there is no reason to buy more just because I want to lower my cost basis.  Who is to say also that it won’t fall further?  Buying when a stock is falling is called “catching a falling knife” for obvious reasons.

I think the company still has a lot of room to expand.  Because I am buying the business, and not trading the stock, these fluctuations don’t bother me.  So long as I still like the company, I’ll hold on.  IF BJ’s is strong like I expect, it will last through any sector weakness.  When the sector rebounds, it will have fewer competitors and be in an even better position.