A Canadian financial columnist illustrates the 'Principle of Maximum Ruin' - 7-May-07 - Generational Dynamics

He discounted the effects of the subprime mortgage situation alone on the overall economy, saying that they would cause "plenty of misery" for individual homeowners and lenders. "It will be a very big problem for those involved, but I think it is unlikely that factor alone triggers anything in the larger economy," he said.

Instead, Buffett indicate that the widespread use of derivatives will be the trigger. Buffett once called derivatives "financial weapons of mass destruction." On Saturday he said:

Buffett's partner, Charlie Munger, made a technical point when he said that accounting rules for derivatives were a big problem: "The accounting being deficient enormously contributes to the risk," allowing executives and shareholders to get paid on "profits that don't exist."

Buffett added that existing accounting conventions allow parties involved in derivative transactions to value the same contract differently, leading to an inadequate or incomplete picture of the contract's risk. "I will guarantee you, if you add up the marks on both sides, they don't add up to zero," Mr. Buffett said, referring to the accounting of a single derivative contract. "There is an electronic herd of people around the world managing an amazing amount of money" who make decisions based on minute-by-minute stimuli, he said, adding, "I think it's a fool's game."

He's not worried about any bubbles bursting, or any financial panics. Quite the opposite. Based on his vast 25 years of investing experience, he provides a set of rules for you to follow so that you can MAKE MONEY out of a panic.

"Panics and manias: Sure signs of market opportunities

The market is balanced between fear and greed. But occasionally one of these emotions goes wild and grips everyone around you. If you learn to recognize such moments and act against the herd, you can make a lot of money. To help you identify such profitable gut-wrenchers and withstand the emotional pitfalls, here is a sample related from my own experience – plus an example of a current mania.

My first experience of massive market fear was in August, 1982, when the then TSE [Toronto Stock Exchange] 300 plunged to about 1,300, interest rates soared to 20 per cent and a famed Bay Street restaurant was boarded with plywood. But stocks were incredibly cheap, and so I gave a bullish talk to a Toronto civic group that had expected to hear me talk about bank certificates of deposit. In that audience was also one Tom Stanley of today's Resolute Performance Fund, who was then just starting out.

Next day he invited me to lunch to hear why I thought it prudent to buy in selling panics, and we have remained friends ever since. In those days I was starting out myself, so I couldn't buy much. But next time when panic-selling hit, on October 19, 1987, I was primed.

I still recall how my partners at Gordon Capital stood around the trading desk, faces white as the screens flashed red. Luckily Gordon had gone into cash the month before, based on the research department's warning, so the traders had the cash to buy – which they did the following two days.

The next panic, in January, 1991, the first Gulf war, was already my third. So the moment the first cruise missile left, I was already writing my buy tickets. When yet a fourth panic occurred on 9/11, in the midst of the horror I recalled my previous three selling panics, and was ready to buy the moment the markets reopened.

How about a more recent selling panic? In July last year, as the Lebanon war erupted, this column pointed out that it was a good time to buy. Look back and you'd see that this was the market's bottom.

How can you use this new skill? At present, a large American armada is gathering in the Mideast. I make no forecasts, mind, but if another conflict breaks out and the markets tumble, pull out a list of your favourite stocks, look up what had just gotten cheaper, clench your stomach, and buy more. ...

Hold on to [your] strong feelings. They are the surest sign of being gripped in a mania. Next time you feel them about any stock or industry or trend, sell and go look for a cheap stock – preferably during a selling panic."

So, Avner Mandelman has it all figured out. When everyone else panics, get ready to start buying, because the panic ends in a few days, and the worst is over. Then there are plenty of cheap stocks available, and the stock market will recover soon.

And why does he believe this? Because that's the way it's always happened before. Well, not "always always," since he's only been investing for 25 years. But at least, "always for Avner."

I've reproduced several paragraphs of his column because it's fascinating how it fits with the Principle of Maximum Ruin. The Principle of Maximum Ruin says that the maximum number of people will be ruined to the maximum extent possible, because of attitudes like those expressed by Avner Mandelman.

Or better yet, go back and read last year's article on "System Dynamics and Macroeconomics," which shows how mainstream macroeconomics has failed to predict or explain anything, especially since 1995, and how this failure can cause similar results as in 1929.

The Principle of Maximum Ruin was developed based on a description of what happened in 1929 in the book The Great Crash - 1929, by John Kenneth Galbraith.

Galbraith summarized the situation as follows, noting that economists and analysts of the day gave advice based on the relative painlessness of previous recent stock market panics:

Galbraith showed how, after the initial crash on October 24, 1929, "In the first week the slaughter had been of the innocents," in the second week it was "the well-to-do and the wealthy" who were slaughtered (p. 113), and then more and more people were sucked into ruin during the years that followed.

Galbraith particularly describes the doings of the Harvard Economic Society, a group of economists on the Harvard University faculty, possibly the most highly regarded economists in the world. This group kept predicting that the worst was over -- and repeated that prediction over and over for two years -- and they were proven wrong every time.

Exactly the same thing is happening today. This is the "generational" concept in action. People assume that nothing that's happened in their own lifetime can ever happen again, and yet the huge bubbles of the 1920s have already happened again. As soon as enough of the people with personal memory of those past disasters die off, then the disasters happen again. It's happened over and over again throughout history, and it's happening again.

Why will the next panic be like a 1929 panic, and not like a 1980s panic? Because the stock market is far overpriced by historical standards, as shown using both exponential growth forecasting methods and mean reversion techniques with price/earnings ratios. The stock market today is overpriced by a factor of 250%, same as in 1929; in the 1980s, the stock market was actually underpriced, and so a panic was not likely to be severe.

There are many other signs as well that I've discussed on this web site, and now Warren Buffet has said, "I believe we may not know where exactly the danger begins and at what point it becomes a super danger. We don't know when it will end precisely, but ... at some point some very unpleasant things will happen in markets."

It's not possible to predict when a panic will occur, but from the point of view of Generational Dynamics, we're now overdue for a generational panic and crisis. It could happen next week, next month or next year, but it's coming with certainty. It will destabilize densely packed populations in China, India and around the world, and will lead to the Clash of Civilizations world war. As usual, Generational Dynamics tells us our final destination, but not how we'll get there. (7-May-07) Permanent Link
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Generational Dynamics Web Log for 7-May-07
A Canadian financial columnist illustrates the 'Principle of Maximum Ruin'

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Generational Dynamics Web Log for 7-May-07 A Canadian financial columnist illustrates the 'Principle of Maximum Ruin'

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Generational Dynamics Web Log for 7-May-07
A Canadian financial columnist illustrates the 'Principle of Maximum Ruin'