Free-Riding Investors Set up Markets for a Major Collapse

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Free riding is one of the oldest problems in economics and in society in general. Simply put, free riding describes a situation where one party takes the benefits of an economic condition without contributing anything to sustain that condition.

The best example is a parasite on an elephant. The parasite sucks the elephant’s blood to survive but contributes nothing to the elephant’s well-being.

A few parasites on an elephant are a harmless annoyance. But sooner or later the word spreads and more parasites arrive. After a while, the parasites begin to weaken the host elephant’s stamina, but the elephant carries on.

Eventually a tipping point arrives when there are so many parasites that the elephant dies. At that point, the parasites die too. It’s a question of short-run benefit versus long-run sustainability. Parasites only think about the short run.

A driver who uses a highway without paying tolls or taxes is a free rider. An investor who snaps up brokerage research without opening an account or paying advisory fees is another example.

Actually, free-riding problems appear in almost every form of human endeavor. The trick is to keep the free riders to a minimum so they do not overwhelm the service being provided and ruin that service for those paying their fair share.

The biggest free riders in the financial system are bank executives such as Jamie Dimon, the CEO of J.P. Morgan. Bank liabilities are guaranteed by the FDIC up to $250,000 per account.

Liabilities in excess of that are implicitly guaranteed by the “too big to fail” policy of the Federal Reserve. The big banks can engage in swap and other derivative contracts “off the books” without providing adequate capital for the market risk involved.

Interest rates were held near zero for years by the Fed to help the banks earn profits by not passing the benefits of low rates along to their borrowers.

Put all of this (and more) together and it’s a recipe for billions of dollars in bank profits and huge paychecks and bonuses for the top executives like Dimon. What is the executives’ contribution to the system?

Nothing. They just sit there like parasites and collect the benefits while offering nothing in return.

Given all of these federal subsidies to the banks, a trained pet could be CEO of J.P. Morgan and the profits would be the same. This is the essence of parasitic behavior.

Yet there’s another parasite problem affecting markets that is harder to see and may be even more dangerous that the bank CEO free riders. This is the problem of “active” versus “passive” investors.

An active investor is one who does original research and due diligence on her investments or who relies on an investment adviser or mutual fund that does its own research. The active investor makes bets, takes risks and is the lifeblood of price discovery in securities markets.

The active investor may make money or lose money (usually it’s a bit of both) but in all cases earns her money by thoughtful investment. The active investor contributes to markets while trying to make money in them.

A passive investor is a parasite. The passive investor simply buys an index fund, sits back and enjoys the show. Since markets mostly go up, the passive investor mostly makes money but contributes nothing to price discovery.

The benefits of passive investing have been trumpeted by the late Jack Bogle of the Vanguard Group. Bogle insisted that passive investing is superior to active investing because of lower fees and because active managers can’t “beat the market.” Bogle urged investors to buy and hold passive funds and ignore market ups and downs.

The problem with Bogle’s advice is that it’s a parasitic strategy. It works until it doesn’t.

In a world in which most mutual funds and wealth managers are active investors, the passive investor can do just fine. Passive investors pay lower fees while they get to enjoy the price discovery, liquidity and directional impetus provided by the active investors.

Passive investors are free riding on the hard work of active investors the same way a parasite lives off the strength of the elephant.

What happens when the passive investors outnumber the active investors? The elephant starts to die.

Since 2009, over $2.5 trillion of equity investment has been added to passive-strategy funds, while over $2.0 trillion has been withdrawn from active-strategy funds.

The active investors who do their homework and add to market liquidity and price discovery are shrinking in number. The passive investors who free ride on the system and add nothing to price discovery are expanding rapidly. The parasites are starting to overwhelm the elephant.

There’s much more to this analysis than mere opinion or observation. The danger of this situation lies in the fact that active investors are the ones who prop up the market when it’s under stress. If markets are declining rapidly, the active investors see value and may step up to buy.

If markets are soaring in a bubble fashion, active investors may take profits and step to the sidelines. Either way, it’s the active investors who act as a brake on runaway behavior to the upside or downside.

Active investors perform a role akin to the old New York Stock Exchange specialist who was expected to sell when the crowd wanted to buy and to buy when the crowd wanted to sell in order to maintain a balanced order book and keep markets on an even keel.

Passive investors may be enjoying the free ride for now but they’re in for a shock the next time the market breaks, as it did in 2008, 2000, 1998, 1994 and 1987.

When the market goes down, passive fund managers will be forced to sell stocks in order to track the index. This selling will force the market down further and force more selling by the passive managers. This dynamic will feed on itself and accelerate the market crash.

Passive investors will be looking for active investors to “step up” and buy. The problem is there won’t be any active investors left or at least not enough to make a difference. The market crash will be like a runaway train with no brakes.

The elephant will die.

Regards,

Jim Rickards
for The Daily Reckoning

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3 Critical Factors for Your Investing This Year

This post 3 Critical Factors for Your Investing This Year appeared first on Daily Reckoning.

Although the S&P 500 is still up almost 10% year to date, it’s dropped roughly 5.7% in the last month.

So as we approach 2019’s halfway mark, you might be feeling like things are turning a bit and it might not be another “sit back and relax” kind of year… one where things just keep going up on autopilot.

Well, here’s how I look at it…

What Can You Control?

As investors, we should always remember that we CAN’T control the markets, the Fed, geopolitics, or other big-picture forces affecting our portfolios.

At the same time, we CAN control what expectations we have as well as the strategies we use to get where we want to be.

It really boils down to balancing a few important factors:

#1. TIME HORIZON

#2. RATE OF RETURN

#3. RISK UNDERTAKEN

Each of these elements needs to be combined in a way that makes sense for YOU.

For example, if you don’t mind waiting a long time for your wealth to really grow, you can easily get lower, steadier rates of return without taking on lots of risk.

Investing in quality dividend stocks – which I’ve been consistently recommending for two decades now – is a perfect example of this type of balance.

When the Dow jumps 30% in a year, your portfolio still surges in value.

When the market dips or goes sideways, your dividend payments keep flowing into the portfolio or buying you additional shares.

And ultimately, over a decade or two, your nest egg will likely end up having increased something like 10% a year on average.

Buying and Holding Assets

The same can be said for buying and holding other assets for the long-term – whether it’s real estate or precious metals.

In contrast, someone who wants better, faster returns is naturally going to have to take on a little more risk to get it… but even in this market, doing so is not impossible.

One way is targeting various shorter-term moves in various stocks and exchange-traded funds (ETFs).

In fact, you can even use ETFs to target moves in plenty of areas beyond stocks and related investments.

For example, there are widely-known ETFs targeting gold, silver, oil, and other commodities.

There are also ETFs and exchange-traded notes (ETNs) that are designed to rise when stock sectors, indexes, or various commodities fall in value… even some that produce two or three times the moves!

Again, you should expect some losers when you follow a more active approach… but the overall result can still give you a more rapid compounding effect even in choppy markets.

And if shorter-term gains of 5% or 12% still aren’t enough? Then you can simply slide the risk scale a bit further out and use greater amounts of leverage!

Using Leverage Isn’t Always a Bad Idea

Contrary to popular belief, using leverage isn’t always a bad thing nor does it even have to involve borrowed money.

For example, some of the funds I just mentioned use a limited amount of leverage to amplify moves in their underlying benchmarks.

Similarly, buying options to speculate on various up and down moves can do the same thing with even more dramaticeffects… while still never exposing you to unlimited risk like short selling, futures trading, or other leveraged approaches do.

And as I’ve proven over and over again, selling options can also help investors get extra investment income while actually LOWERING their portfolio’s overall risk in many cases!

As the market is dropping, selling put options on companies you wouldn’t mind owning is a terrific way to collect upfront payments while possibly getting you into the type of solid long-term investments I mentioned a moment ago.

Likewise, if you sell some covered calls against stocks you already own, you simply stand to collect extra income on top of any regular dividends you’re already earning.

And as long as you write contracts that have higher strike prices than your entry prices, the worst thing that happens is you book some additional capital gains. 

Bottom Line

Even if the major markets keep falling from here… or bouncing up and down without really going anywhere for the rest of the year… there’s no reason to get frustrated or sit on the sidelines.

You have plenty of ways to continue building your wealth whether you want to stay very conservative… get very aggressive… or split the difference with a more active approach like option selling.

To a richer life,

Nilus Mattive

— Nilus Mattive
Editor, The Rich Life Roadmap

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Bill Gates is 100% Correct About Climate Change…

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Today I bring to you an interesting story of two billionaires…

Both of whom have terrific intentions for helping the human race combat global warming.

What you’ll find interesting about these two men is that despite their good intentions, both have very different views on how to solve the problem.

However, after some thorough research myself, I’ve uncovered that only one of these men’s views actually makes sense. And as informed investors, we have the ability to (continue) profiting as these two men fight to save our planet…

In This Corner — Billionaire #1 Jeremy Grantham

Maybe you have heard of Jeremy Grantham. Maybe you haven’t.

What you need to know about this billionaire is that he is one of the best macro-level investors of the past half century.

Grantham is especially prescient about sounding the alarm bells on dangerous financial market bubbles before they pop. Investors listening to Grantham would have avoided the crash in 1987, the Dot.com crash in 2000 as well as the real estate and stock market crashes of 2008.

His track record is one that proves his opinions should be considered carefully.

Today, Grantham is ringing the alarm bell again. This time Grantham doesn’t see a bubble in the financial markets, he sees a bubble in the number of human beings on this planet.

Grantham believes that planet Earth will soon have an unsustainable number of mouths to feed.1

World population throughout history

Grantham’s view is based on his belief that global warming is going to cause serious food shortages.

According to Grantham, rising sea levels are going to flood key rice growing farmland in several enormously populated river areas. That hit to global food supply — combined with a rapidly growing population in those same areas — will be catastrophic.

Grantham’s investment response to this was to divest anything that he owns tied to the oil and gas industry. His belief is that the transition towards renewables is going to happen with shocking speed in the coming years due to the growing seriousness of global warming.

For some perspective on Grantham’s conviction level, consider the fact that he is donating 98 percent of his net worth to save the Earth from the consequences of climate change.

In The Other Corner — Billionaire #2 Bill Gates

You know Bill Gates. I know Bill Gates. Everybody knows Bill Gates.

When you have a net worth of almost $100 billion, your name gets out there!

Like Jeremy Grantham, Bill Gates believes that climate change is a problem.

And like Grantham, Bill Gates is trying to help stop climate change through a $1 billion investment fund that is seeking solutions.

Unlike Grantham, however, Gates doesn’t believe that the oil and gas industry is going away anytime soon.

In fact, Gates believes that the energy provided from oil and gas is going to continue to be quite important. Gates views intermittent renewable energy sources like wind and solar as not even close to being a realistic solution.

According to Gates, the problem with these renewable energy sources is that they simply aren’t reliable. When the sun isn’t shining and the wind isn’t blowing there isn’t any power. Because they provide intermittent power, these sources of energy require storage and according to Gates, current battery storage capability for them is “woefully deficient.”

To be a real replacement for oil and gas, Gates believes that renewables need a miracle.

Gates is Right… And He’s Got the Stats to Back It Up

Bill Gates desperately wants the world to wake up and realize that finding renewable energy is just part of the equation.

That’s because as he astutely points out, greenhouse gas emissions actually come from several sources:

  • Electric Power Generation – 25 percent
  • Agriculture/Cattle – 24 percent
  • Manufacturing – 21 percent
  • Transportation – 14 percent
  • Buildings/Air Conditioning/Refrigerators – 6 percent
  • Other – 10 percent3

These numbers are revealing.

If the oil and gas industry is a target because of their greenhouse gas emissions, then everyone that eats hamburgers should also be a target because the methane gas released from cattle contributes as much greenhouse gas as all electric power generators.

But we can’t stop there. Other targets should include everyone who uses anything manufactured (steel, plastic, cement, etc.), runs an air conditioner, or takes a vacation.

If you are buying a Tesla to save the environment, you should also be eating vegan and living in a tent. That is a bit dramatic, but you get my point.

Your takeaway today is that no matter what you think of climate change, what you should know is that the Gates view is much more realistic.

We are miles away from not needing the power provided by oil and gas and therefore the drillers, refiners and pipeline companies whose stocks have performed so well this year should still serve a valuable service well into the future.

Further, the people pointing fingers over climate change — like Jeremy Grantham — need to start directing those fingers in many more directions than just energy producers if they really want to make a difference.

Here’s to looking through the windshield,

Jody Chudley

Jody Chudley
Financial Analyst, The Daily Edge
EdgeFeedback@AgoraFinancial.com

1 Investing Prophet Jeremy Grantham Takes Aim at Climate Change

2 https://www.gatesnotes.com/Energy/My-plan-for-fighting-climate-change

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World’s “Elite” Just Sent a Chilling Warning… But There’s a Silver Lining

This post World’s “Elite” Just Sent a Chilling Warning… But There’s a Silver Lining appeared first on Daily Reckoning.

Davos Switzerland…

Davos Switzerland

It may look like a peaceful winter wonderland. But if you visit the Davos ski resort in Switzerland this week, you’ll hear some forecasts that will chill your nerves as an investor.

Fortunately, there’s a silver lining. One that will set you up for luxurious gains on your 2019 brokerage statement. But to lock in these profits, you’ll have to be brave!

Let’s jump in and see what’s happening in this snowy winter summit.

Cold Warnings from the World Economic Forum

Each year, the most influential investors, business executives and world political figures visit the tiny ski retreat of Davos in Switzerland to attend the World Economic Forum.

It’s a time when these leaders can meet face to face and discuss the state of the world economy, and how to promote the best growth possible.

I’m always intrigued by this gathering because there are so many different opinions and agendas represented. While it is interesting to hear the different perspectives that are presented throughout the week, it’s important to remember that each perspective is influenced by the person’s experiences, professional role and personal biases.

So far this week, the conference has featured a number of ominous warnings when it comes to global economic growth.

After strong “synchronized” growth in 2017, last year featured an environment where the United States grew while the rest of the world faced economic struggles. A big part of the success here in the United States came from lower taxes and a healthy business environment that created millions of new jobs.

The question this year is whether the U.S. will join the rest of the world in struggling to grow, or whether our economy will continue to buck the trend and continue to expand.

Of course, the academic “analysts” presenting at the World Economic Forum are warning of a slowdown for the United States. They’ve been singing out of the same hymnal since the bull market first began 10 years ago.

But even in their dire warnings, there is a silver lining. Because the presentations that I’ve heard so far explain that the U.S. will likely experience a “slowdown in growth” rather than a full-out recession.

The difference here is key.

A “slowdown” in growth means that our U.S. economy will still continue to grow. We will add jobs, and corporations will grow earnings. Heck, we’ll likely see workers continue to get bigger paychecks and spend money on more discretionary purchases.

That’s far from a recession — which is when the economy actually contracts, people lose their jobs, and the environment becomes much more challenging. While recessions are a part of the overall economic cycle, the U.S. economy isn’t showing signs of entering that type of environment any time soon.

So despite the warnings of slower growth coming from Davos, the underlying data still points to a healthy U.S. economy. And that’s great news considering the picture for the rest of the world.

There’s Only One Place to Invest…

One of the most encouraging discussions I’ve been listening in on is the question of whether to invest in the United States or the rest of the world.

Even with the sharp pullback in the fourth quarter, the U.S. has been the best place for investors to put their capital. After all, our economy continues to grow and corporations are reporting record earnings!

Looking to the year ahead, there’s no reason to believe this year will be any different.

After all, China’s economic growth has been slowing dramatically. And yet stock prices for many Chinese companies still reflect optimism that the country will get back to the growth levels from a decade ago. That’s simply not going to happen.

Looking at European investments, the Brexit discussion has left European markets in a place of extreme uncertainty. And many European banks have financial risks that are becoming much more worrisome.

Elsewhere, the low price of crude oil has put governments and economies in energy-dependent countries into an uncomfortable place. And investors in those countries are looking for safer places to put their capital.

That leaves the United States as one of the few healthy places to invest. And thanks to the fourth quarter pullback, U.S. stocks are actually cheap compared to the earnings that these companies are generating.

That’s why here at The Daily Edge, we’re confident investing in thriving U.S. companies with growing earnings. We’ve had some volatility as stock markets have fluctuated. But investing in the best American opportunities has allowed us to weather the storms in late 2018, and should set us up very well for a profitable 2019.

So don’t listen too closely to the warnings from Davos. Instead, keep your capital invested in the safest economy for the year ahead.

Here’s to growing and protecting your wealth!

Zach Scheidt

Zach Scheidt
Editor, The Daily Edge
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