Malthusian Mistakes

July 1, 2004

Dear Investor:

The greatest mistake an investor can make—besides punting a life savings on anyone’s idea of a “hot tip”—is to assume that any trend, bad or good, will continue. This error might best be explained by reference to its most famous exemplar, Malthus, the pedantic 18th century English economist who argued that there would never be enough food to feed the world’s expanding population.

Malthus looked at a nation with rising birth rates and static agricultural production and assumed those two trends would always continue: namely, birth rates would shoot to the moon while people would still thresh their wheat by calloused hand. Of course, Malthus was wrong on both counts. Not only did birth rates slow as England grew prosperous, but that same prosperity inspired unimaginable technological advances in farming.

A more modern example of a Malthusian Mistake is the clamber for Internet stocks in 1999. Once the trend of going up and up was established, very few could see that the trend could get derailed by an increasing equity supply and a lack of underlying profit.

Sometimes a Malthusian Mistake takes on a false hue of sophistication—as when it’s reflexively applied to a trend reversing itself. This contrarian error fails by assuming that a trend will, without doubt, turn on a dime—an equally dangerous assumption—and one that caused the collapse of the infamous hedge fund, Long Term Capital Management. This Fund bet that US Treasury prices would reverse their trend upward while Russian sovereign debt prices would reverse their downward spiral. They, like Malthus, were wrong on both counts.

The best protection against Malthusian Mistakes is a healthy appreciation that “things change.” Knowledge that things change requires a bit of imagination because it’s difficult to see change that doesn’t yet exist. Complicating things is the fact that some trends, on the whole, do not change. The human lifespan, for example, keeps extending and is likely to continue doing so. This dichotomy is best explained by the French dictum: the more things change, the more they stay the same.

How then to distinguish between those trends that change and those that stay the same? This analysis is at the moneyed heart of most successful investment.

One present day concern, namely oil, begs for an analysis in this context. Oil, as everyone knows, is at record prices. Due to Chinese demand, Venezuelan instability, Iraqi sabotage and al-Quaeda attacks in Saudi Arabia, this precious commodity has breached the $40/barrel level in recent weeks. Yet, against this backdrop, prices have recently started to back off, down into the $36 range. Why?

Professional traders, accustomed to trend reversals, are starting to see the possibility that oil bulls are invoking the error of Malthus in proclaiming that oil prices will always go up. After all, new technologies will someday make oil obsolete. Not in our SUV-dependent lifetime, but someday. If oil is too rare to be readily affordable, it will eventually be replaced. This is the genius of economic demand—something that very few politicians really understand, whichever side of the aisle they preach from.

On a more practical note, we have recently converted most of the cash positions held in our New York clients’ taxable accounts to the TD Waterhouse NY Municipal Money Market Fund. In accounts of clients in other states, we’ve also switched the balances to state-specific money markets where available. In a rare occurrence, these tax-free money markets are yielding a few basis points more than the taxable money market, making this change a no-brainer. Even with an equal or a slightly lower yield, the tax-free money market is a better option for anyone in a high tax bracket. If this yield declines to levels that make it less attractive than the regular money market, we will switch back the position. Like any Malthusian trend, this increased yield is vulnerable to reversal.