Don't Confuse Me With the Facts By John Mauldin December 3, 2004

"Unfortunately, this format--from the left, from the right--capitalizes on a design flaw in the human brain. We have a tendency to believe what we want to believe. We seek information and draw conclusions consistent with what we want to be true. I've been studying this kind of emotion-driven political thinking over the last several years, and the results are sobering. For example, during the disputed election of 2000, we could predict whether people would believe that manual or machine counts are more accurate just by knowing their feelings towards the two parties and the two candidates.

"When people draw conclusions about political events, they're not just weighing the facts. Without knowing it, they're also weighing what they would feel if they came to one conclusion or another, and they often come to the conclusion that would make them feel better, no matter what the facts are.

"An experiment completed right before the election shows just how powerful these emotional pulls can be. Here's what we told the participants. A soldier at Abu Ghraib prison was charged with torturing prisoners. He wanted the right to subpoena senior administration officials. He claimed he'd been informed the administration had suspended the Geneva Conventions. We gave different people different amounts of evidence supporting his claims. For some, the evidence was minimal; for others, it was overwhelming.

"In fact, the evidence barely mattered. 84% of the time, we could predict whether people believed the evidence was sufficient to subpoena Donald Rumsfeld based on just three things: the extent to which they liked Republicans, the extent to which they liked the US military, and the extent to which they liked human rights groups like Amnesty International. Adding the evidence into the equation allowed us to increase the prediction from 84% to 85%.

This is the reason why contrarian investing can be so profitable, and at the same time why it is so hard. Our emotions help dictate our investment decisions. We are long the market because we need the market to go up so we can retire. Even thinking about a bear market and it consequences is so upsetting that we do not contemplate it until it is too late.

In 1995, some 37.5% of those surveyed said the trade deficit was important. By 2000 only 10% thought it was important. What happened in that time? The trade deficit was going up and the dollar continued to rise. How can trade deficits be so important if the dollar was rising? Traders therefore changed their views of fundamentals to square with their trading positions.

Today, however, I think it is fairly obvious that a much larger number, perhaps back to that 37.5% (or more), would say that trade deficits matter. Times change, and we change our interpretation of the facts to meet our current views.

Is there anyone left who is bullish on the dollar? Even Greenspan and other Fed governors openly suggest the dollar and the trade deficit are too high. If the United States is borrowing to finance its trade deficit, then somebody must be lending, which means someone is saving. Everyone knows that the United States trade deficit, at 6% of GDP, takes around 83% of total world savings to finance (International Monetary Fund). The US government deficit soaks up a huge amount of our own national savings.

The reality is that the trade deficit cannot go much higher because the world is running out of the ability to lend more money. Someone somewhere must start to save more or the deficit must begin to come down. The classic ways are for the dollar to drop or for a recession to appear. What politician or Fed governor in his right mind would deliberately induce a recession? The answer that is left is for the dollar to drop, and that is clearly the way the Fed and the Treasury are leaning.

Given the boomer retirement coming all too rapidly down the road, it is hard to imagine a longer term scenario which yields growth in consumer spending, increased savings and a stable dollar, all at the same time.

Fundamentally, the dollar has not dropped all that much on a trade weighted real basis, and given the trade deficit, government debt and other factors, it still has a way to go, in my opinion. Further, the current short position of traders is a small percentage of the huge ($1 trillion a day) currency markets. There is still plenty of room for more short-selling.

The Wall Street Journal reports: "Total flows of Foreign Direct investment (FDI) have collapsed since 2000 - from a peak of $314 billion in 2000 to [a mere! - JM] $29.8 billion in 2003. That's down 90%.

Summers' recent speeches are amongst the best arguments I have seen over the current account for ages. As Summers notes:
"'Inevitably, dependence on foreign governments for short-term financing has to raise questions and create vulnerabilities in both the economic and political realms. The question can fairly be asked: How long should the world's greatest debtor remain the world's largest borrower? I have previously used the term "balance of financial terror" to refer to a situation where we rely on the costs to others of not financing our current account deficit as assurance that financing will continue.'"

Falling foreign direct investment, huge trade deficits, a world working actively to no longer be forced to rely on the American consumer for growth - these are all bearish on the dollar over the very long term. These are all events and facts which can change. Certainly the trade deficit is reaching its limit, but the longer we delay in creating balance, the worse the correction is likely to be.

One final thought. In 1971, the yen was at roughly 350. (Today it is at 102). In the 80's, Lee Iaccoco, the CEO of Chrysler, stated something to the effect that "Give me a 150 yen [to the dollar] and we can beat the Japanese." It fell soon after to 120. Japan and Toyota are still taking market share from Ford, GM and Chrsyler.

Those who take comfort that a falling dollar will make our companies more competitive, who yearn for a floating Chinese Renminbi, should be careful for what they wish. They might get it.

As noted at the beginning of this letter, we are going to do a Christmas Special Offer. For those of you looking for that perfect Christmas gift for that investor in your life, or for your clients and customers, I will personally autograph a copy of Bull's Eye Investing, the book that some call the most important investing book of 2004!

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Larry Summers, former US treasury secretary, now President at Harvard University

Rolf Englund: Why people do not understand