Game Theory 101

Many moon’s ago, the Mathematics Department of various Universities, came up with the notion of “Game Theory”. The theory dealt with games from Business to Monopoly. The results of those studies were profound. The basic principals of the theory centered on the concept of “fair games”. That is, a game is “fair” when the player has a 50% chance of winning, and a 50% chance of losing. Thus, “fair” produces no winners or losers.

In investing, the propositions of Game Theory are:

(1) Never play fair games (other than for amusement). Find games that have a higher probability of success than failure.

(2) Never play games unless you understand the rules. The rules must be articulated in an understandable way. The rules cannot change during the game. Do over’s etc cannot be allowed.

(3) Make sure you know the players in the game, and their skill level. Your skill set should be as good, or better, than the other players in the game.

(4) You must understand the game. Life is short – If you don’t understand the game, find another one. If there are no games you understand, become a spectator.

In the current crisis, most players in the game are under 50 years old, and have never seen a “game” this tough. Folks under 50 did not play the bear markets of 1969-1970, 1973-1974, and 1976-1978. In business school they probably did not even study the Depression of the 30’s. Currently, there is no game you can play (other than Gold), that gives you a fair chance of success. Stocks, Real Estate, Commodities, Foreign Currencies, Bonds – they all suck! Why?

(1) BECAUSE THERE ARE NO RULES, AND THE RULES CHANGE DAILY.

(2) Who are the players? You, me, the Federal, State, and Local Governments, Banks, Other World Sovereignties, Finance Companies, Special Interest Groups, the Unemployed, etc. In short - everyone on this planet.

(3) The Game today is totally incomprehensible. Do-overs are now allowed. Without understanding the game or rules, you must sit on the sidelines and allow the other players to fail.

There is a major war going on between Deflation, and Inflation. We all know that there is a credit collapse. The market value of assets is under siege. Liabilities against those assets in many cases exceed the asset value. The collapse of asset values and credit is clearly deflationary. Wait – here come our favorite rule changers, the US Federal Government. The Fed’s always gets us with taxation and inflation.

Our Governments boondoggle (TARP, Stimulus Plan, etc) is presumably going to “get our Economy back on its feet”. As of this writing I have seen nothing that will materially stimulate the Economy. In fact it appears that most of the money has been thrown at Banks and Auto Companies that are Bankrupt and social programs that provide no stimulus. Our beloved leaders, (President Obama, Nancy Pelosi, Barney Frank and Harry Reed) are running amok. The package totals $819 Billion, and may run up to $900 Billion.

There is: $345 Million for the Agriculture Department computers; $650 Million for TV converter boxes; $15 Billion for college scholarships; $1 Billion to deal with the Census problems; $88 Million to help move the public Health Service into a new building next year; $2.1 Billion to pay off a looming shortfall in public housing accounts; $870 Million to combat the flu; $400 Million to slow the spread of HIV and other sexually transmitted diseases such as chlamydia; $380 Million for a rainy day fund for the Women, Infants and Children (WIC) program that delivers healthful food to the poor (this group got $1 Billion last fall), $87 Billion to bail out the States providing Medicaid, Bee Keepers Insurance, and Medicare funds for Illegal Aliens.

Also everyone that has an Income Tax ID card (which includes those that do not have a Social Security Card) will receive a tax rebate of $500 if single, and $1,000 if married. People that do not pay taxes get the tax credit too. Remember the last Tax Rebate program didn’t work because people saved or paid bills with the windfall.

There is more nonsense in this package, but you get the idea. Upon being questioned on the bill, Rep David Obey, D-Wisconsin, one of the chief authors of the house package and chairman of its appropriations committee said, “If the house is burning, you’re not going to worry about which hose you grab, so long as you get water on the fire.” Is he crazy? The printing presses are going wild. As Richard Russell the guardian of the Dow Theory (www.dowtheoryletters.com) said (tongue firmly in cheek), “buy Paper Stocks.”

The forces of Deflation have been strong. Yet Gold and TIPS (Inflation indexed US Bonds) are rising, suggesting that: (1) There is an Inflation expectation over deflation, or (2) There is a major fear that the Worlds paper currency will become worthless or (3) both of the above. The Worlds currency today is referred to as fiat currency or fiat money. By definition fiat money is currency or money whose usefulness results not from any intrinsic value or guarantee that it can be converted into gold or another currency, but instead from a government’s order (fiat) that it must be accepted as a means of payment. For example the US $100 Bill is only worth $100 because our government says it is. Obviously there is no intrinsic value of the bill except maybe the value of the paper (5 cents?)

The game is now very complex. Stocks in my opinion are not cheap but overvalued considering where we are in the economy. A SP 500 Index to be cheap would be 600 or less (currently at 850). US Government Bonds are not cheap (a 10 year yield of 2.842%, is not my idea of a risk justified return). Income producing Real Estate is not cheap, due to vacancy rates rising and a substantial oversupply of rental space. Housing isn’t cheap, since you can’t buy a house today and rent it out at a profit. All other investment alternatives are in a state of uncertainty, because of the absence of rules.

In my opinion to make money over the next three years, the proper investment game to play will be decided on the direction of the price level, and the “real” value of the Dollar and other World paper (fiat money) currencies. If the “people” ever figure out that the current mass flooding of paper money causes inflation, and that our currency is really worthless, we will have the largest Economic and Political crisis ever faced in modern times. Below are some of the charts I use to follow the Deflation/Inflation, worthless US dollar sentiment. Below are three charts that indicate the ratio of Gold Prices divided by: the Ten Year US Treasury Bond Price; the Inflation Indexed US 10 Year T-Bond (TIP); and the US Dollar Index. Also there is one chart indicating the ratio of TIP to the 10 Year T-Bond Price.




Note that the TIP is also rising against the 10 Year T-Bond. Like all market data (that reflects investor sentiment), this could all change tomorrow morning. What’s interesting about the TIP to Bond chart is that it shows the initial Deflationary sentiment (dropping ratio). Currently however the TIP shows strength, and with it confirms the other Inflationary sentiments. My opinion is the stimulus package will stimulate very little except Inflation. It seems likely we will continue our credit and asset collapse followed by high rates of Inflation.







It is prudent to be very risk adverse today. Invest in Federally insured Cash Instruments, and some Gold. If you have a Mortgage that has an interest rate of more than 3.673%, make extra principal payments. Stay liquid, and out of debt. This economy and the Federal Solutions thereon will not have a happy ending.