Furthermore, if you can align your strategy with the overall environment and can shift your strategy to fit that environment when it changes, you can profit from nearly any set of circumstances. So, how do we discover the factors that can help us analyze the current investment environment and identify potential investment gains. We want to monitor all sorts of investment vehicles while watching for signals of success. Add those components to your arsenal after you have fully analyzed their strengths and weaknesses, paying particular attention to determining the environments they are vulnerable in.
And finally, seek constantly for understanding. The more you understand about markets, about how people succeed in markets, and about human nature, the more successful you will become in the markets yourself. Achieving consistent investment gains is a constantly changing quest, an exploration of self, human behavior, and the world itself. As stressed in Chapter 1, not only must investors have reliable tools, they must also acquire insight and understanding. Investors who understand the markets and the logic behind strategies will be able to adapt when a critical aspect underlying their success suddenly changes.
They will be able to consistently profit in any environment. After decades of research and real-time trading and investing, we have found that the study of the Austrian interpretation of the Liquidity Cycle ALC can help give investors both rules of thumb and insight into future investment gains. Once you understand it, you will find it hard to believe that anyone could invest without knowledge of the Austrian Liquidity Cycle, because it is based on cause and effect.
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In addition, it is one of the easiest and simplest methodologies for improving long-term profitability and cutting risk in investing in equities, bonds, and other asset classes. We will be discussing Austrian economics in more detail later on in this book. There is, however, a critical aspect of the Austrian Model that investors must grasp to better understand, interpret, and utilize the Liquidity Cycle. An artificial obstruction to such forces leads to a dichotomy between real unencumbered supplyand-demand forces and artificially manipulated supply and demand forces.
This dichotomy results in a misallocation of true underlying incentives and resource utilization. The larger this dichotomy grows, the more severe the ultimate correction of resource allocation must eventually be, when free market forces ultimately prevail by forcing realignment in the long run.
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Rent control provides an example of how the Austrian Model interprets an artificial manipulation. Under an unencumbered free market, if demand grows strongly for housing in a particular area, prices for rents and property rise sharply. That rise in price sets in force a signal to producers that the market is demanding more production of housing.
If real estate is scarce, skyscrapers are built because they are profitable. Higher prices create an incentive structure for more supply to come on line. There may be a lag between building completions and demand, which will cause prices to move up sharply, but the higher the prices rise, the greater the incentive becomes for builders and owners of buildings to provide housing, and the more the supply expands.
On a macroeconomic basis, the higher the profit margin to property development compared with other industries, the more the percentage of total resources that will be allocated to property development by the economy as a whole. Thus excess demand sets in motion a process that naturally pulls resources to the area, and eventually leads to a more equitable alignment of supply and demand again.
High demand leads to higher prices, which leads to higher profit margins for supplying, which leads to higher supply. What if we throw rent control or price controls of any kind into the mix? Rent control advocates see prices rising and lament that poorer people may not be able to afford living in an area.
They attack the symptom of excess demand, higher prices, by locking prices at a particular level. But this action has a negative effect on the supply-and-demand forces that underlie the higher price symptom.
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Prices begin to rise, reflecting excess demand. At some point, however, the government arbitrarily writes a law that says to property owners, "You can charge no more than 'x' price for rent, or we will put you in jail or take your property. And the threat of rent-control makes housing supply a dangerous business because the participants' profits could be limited even more in the future.
So supply dries up and there is no incentive to increase it.
Meanwhile because prices have been locked below freemarket levels, demand increases not only by the free-market amount, but by a higher level because those individuals who would not ordinarily seek high-priced housing are able to demand it at artificially low prices. So excess demand increases while supply slows down. Rationing of some sort must take place to deal with the demand after all, rationing is what higher prices were doing in the first place.
In addition, property owners have little or no incentive to maintain their property; since demand is in excess, there is not enough competing supply to weaken the demand for rundown property, and maintaining property does not increase profits. In fact, maintenance cuts profits since rents can be raised an arbitrary amount whether the property is upgraded or not.
The result of rent control is that there is more demand and less supply creating an even greater imbalance than existed before the price manipulation. Usually, properties become neglected by owners, and values fall slowly until it becomes cost-competitive to own property instead of renting it. Whereupon property prices soar and demand and supply can eventually realign. Legislators simply substituted some sort of government rationing scheme for price rationing, while destroying the mechanism that encouraged supply to meet excess demand.
The misalignment of resources away from housing production leads to a huge catch-up phenomenon once the artificial barriers are removed. In the meantime, those without the political connections to receive rationed housing are forced out of the market—and they are much larger in number than the population originally seeking rental units.
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An investor understanding the implications of rent-control laws on real estate would know to stay out of real-estate where rent control is possible, and also to buy in rent-controlled areas where repeal is likely. Here are some key rules of thumb concerning the impact of artificial interference: 1. Interference that attacks a symptom without addressing the forces behind the symptom usually leads to worse underlying problems and eventually worse underlying symptoms when the interference must be abandoned or corrected in the opposite direction.
In the long run, the cost of artificial interference often grows to a breaking point; whereupon free market forces usually prevail even though interference can be maintained for decades. The indirect effect of an artificial interference on incentives is usually much more important, in terms of ultimate effect, than the direct results of that interference because the forces of dynamic change in an economy are more powerful than existing resources over the long run.
For stock prices to rise, there must be excess demand for them, meaning money is flowing into the equity market. There are three main places for this money to come from: 1 increased savings and investment, 2 portfolio shifts out of other asset classes and into equities, and 3 new liquidity generated by the central bank. In a fractional reserve central bank banking system, such as that in the United States and most other countries of the world, the liquidity from the central bank far outpaces the liquidity from shifts in savings and portfolios.
For this reason, investors can learn much from studying the status of central bank policy and liquidity flows. A free-market economy might have a currency similar to that authorized in the original U.
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Constitution, where the government or a bank is permitted only to coin money in order to verify the weight and measure of a free market chosen store of value such as gold and silver. In such a system, individuals are allowed to freely choose such coinage as one of many possible forms of currency. However, using government force to create a monopolistic body that prints the only allowable legal tender without any backing whatsoever is both a distortion and manipulation of an economy and of the value of the currency used by all participants in that economy.
Investors need to understand not only the status of current policy, but also the implications of current policy distortions on future flows of funds and on the value of the underlying currency. One of the main determining factors in valuing a currency is its inflation rate. An analogy will be helpful here. From the Austrian perspective, "real inflation" is simply an increase in the sum of the prices of absolutely everything in an economy.
Suppose you were taking a cruise aboard an ocean liner that sank and left you stranded on a deserted island with nine of your fellow survivors and a few items you were able to bring aboard your life raft. There was no "real inflation" because the sum price of absolutely everything in the economy remained the same. After a long meeting in which the islanders all tried to get the guilty party to come clean to no avail, they decided to appoint one of the group to be an economic analyst. This person would study prices to determine when inflation was occurring.
Several islanders offered to take on this task, but the job went to a man who proposed monitoring the price of coconuts as the means for watching inflation.
He reasoned that it was too difficult to monitor the price of everything in the growing island economy, but that coconuts were an absolute staple being a source of liquid, a fruit, a plate for fish, a critical component of clothing, and an ingredient in virtually every meal. Monitoring inflation with a Coconut Price Index CPI for short seemed to be a sensible way of gauging when any islander spent money beyond the initial pool of cash that had been agreed on and declared.
About this time, the cash finder decided he had better cut back on spending any new money for a while.
However, he also decided to scan the island for any further debris. So, when the other islanders were laboring and not looking, he went on a scouting trip to see what he could find. The person who found this extra cash had an odd name—Central Bank—CB for short.
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