In my colleague Michael Mauboussin’s terrific new book, Think Twice1, the opening chapter tells the story of Big Brown, the super looking colt who’d won such impressive victories in the Kentucky Derby and the Preakness, the first two legs of racing’s Triple Crown. This is a story with a lesson that directly relates to investing, and to understanding the kind of recovery that appears to be getting underway in the U.S. economy.

After winning all 5 of his starts by a combined total of almost 40 lengths, Big Brown was a 3-10 favorite to win the Belmont Stakes and become the first horse in 30 years to win the Triple Crown. Those odds indicated the “wisdom of crowds” putting a 77% probability on Big Brown’s winning the race and making horse racing history. Part of that was right: he did make horse racing history — by being the only horse to win the first two legs of the Triple Crown and finish last in the Belmont. That so many were so sure of Big Brown’s success was due to a common analytical error that manifests itself in investing as well as horse racing. That error is the neglect of base rates. Psychologists call it the “inside” view, in contrast to the “outside” view. As Michael explains in his book:

The inside view considers a problem by focusing on the specific task and by using information that is close at hand. The outside view…asks if there are similar situations that can provide a statistical basis for making a decision. The outside view wants to know if others have faced comparable problems, and if so, what happened. It’s an unnatural way to think because it forces people to set aside the information they have gathered.

In the case of Big Brown, taking the outside view would be to see how many horses in the past had won the first two legs of the Triple Crown and then went on to win the third. The inside view focused on Big Brown, his history, the competition he faced, the tracks he ran on and their condition, his time between races, and so on.

The outside view revealed that 29 horses had won the first two races of the Triple Crown in the 130 years it had been run, with 11 of those horses going on to win the third race. Parsing the data a little more finely showed a remarkable divergence in winning percentages. Before 1950, 8 of the 9 horses that had a shot at the Triple Crown won it. After 1950, only 3 of 20 were successful. Moreover, when Big Brown’s speed ratings were compared to the most recent 6 Triple Crown contenders (and not just to his competition in the race), he was the slowest by a wide margin. If those who were betting on the Belmont had used the outside view instead of the inside view, no one would have believed what everyone did believe, that Big Brown had a nearly 80% chance to win the Belmont.

Investors are faced with these sorts of problems constantly: if I put my money in bonds now, what rate of return should I expect over the next 5 or 10 years? What is the outlook for stocks over the next 12 months? What are the chances of a significant rise in inflation over the next few years? What kind of economic recovery will we have? Should I fire my active money manager and replace him with a passive index product? What are the chances we have a “double-dip” recession? And on and on. Faced with these sorts of questions, most people default to the inside view, and then augment its flaws with the usual assortment of behavioral biases long known to psychologists: they anchor on the most recent experience, they assume instances are representative of deeper patterns, they give more weight to vivid examples or dramatic outcomes, they place twice the weight on a dollar lost as on a dollar gained, etc.

The financial crisis that is now abating has created a near perfect environment for the admixture of all of the above, and that is perhaps why what Nobel winning economist Ken Arrow called the “clouds of vagueness” seem particularly thick and forbidding just now. Taking the outside view on some of the issues facing investors won’t make an inherently unknowable future predictable, but it can improve the odds of getting things right, or getting fewer things wrong.

The difference between the inside and the outside view is well on display in the different and in some cases strongly held views about what kind of recovery is now unfolding in the U.S. PIMCO’s Mohamed El-Erian is the most prominent advocate of the “new normal”, a term he coined to describe a recovery with real growth of 1-2%, persistently high unemployment, and much greater government involvement in the economy. He has recently warned of a big letdown from the “sugar high” we are now experiencing in the market and the economy as the effects of the abatement of the credit crisis and massive government stimuli, both fiscal and monetary, begin to wear off.

He may be the most prominent, but he is not alone. In fact, it looks like he is the leader of a not so silent majority. The current consensus growth rate for the U.S. economy in 2010 is 2.4%. This is way below “normal” for the first year of a recovery, yet even it is well above what most thought only 6 months ago. In April the IMF projected negative growth in world output of 1.3% this year, and only 1.9% growth in 2010. That included a projection of zero growth in 2010 for developed countries. Projections such as these follow the classic inside view pattern: they look at current conditions, current trends, anchor on the most recent data, and adjust from there. Since the economy bottomed in March, almost all time series forecasts of economic improvement have been adjusted higher as the year wore on. They are still well below “normal.”

A recent Bloomberg story noted how in the second quarter of 2009 almost 75% of companies in the S&P 500 beat consensus expectations, which were then revised upward. Now, the consensus is for profits growth in 2010 to be up about 25% from 2009. Yet economic growth is expected to be only 2.4%, a ratio of profits growth to GDP2 growth of about 11. The outside view would show that the ratio has historically been around 6x, indicating either profits expectations are way too high, or growth expectations way too low. The outside view would favor the latter, as both time series have been steadily revised higher, and the early indications are that third quarter earnings are also coming in better than expected. What does the outside view say about what we should expect? In an article in The Wall Street Journal (“From Bear to Bull,” Sept 19, 2009) Jim Grant quotes economist Michael Darda as follows: “The most important determinant of the strength of an economic recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-1939 period.” In the first year of the recovery from the bottom of the Depression, the economy expanded 17.3%. If one adjusts for the drop in output in this recession, the outside view would put 2010’s expected growth rate at around 8%. Is the ‘new normal’ wrong? No one knows, yet. The core of the argument in its favor is an inside view: the consumer is over-leveraged, savings rates have risen from negative to positive and may stay elevated or go higher, balance sheets have been shocked by home price declines and the stock market collapse and need to be rebuilt. A mountain of corporate debt has to be refinanced, banks are not disposed to lend and capital requirements are going higher, and corporations will be cautious about hiring or expanding due to pervasive uncertainty.

A variant of the argument has it that with consumption elevated at 70% of GDP and the consumer retrenching, growth must be sluggish, profits will disappoint, and it will be hard for the stock market to make any headway. The outside view helps here too. In 1933, consumption as per cent of GDP was even higher than today, at 83%, and the savings rate was negative. The consumer deleveraged aggressively, pushing consumption as a percent to 73%, while the savings rate rose. Yet unemployment fell sharply, output grew rapidly, and the stock market went up over 100% from 1933-1937. There have been 8 times the consumer has deleveraged, and the market rose in 6 of those periods, with an average gain of 39%. Since the bottom in March, the S&P 500 is up over 60%, and year to date returns exceed 20%, yet skepticism (if not downright pessimism) remains high. This judgment is not based on sentiment readings, or surveys. As market veteran John Mendelson often points out, it is not what people say that matters, it is what they do. And what they are doing is buying bonds and selling stocks.

Through the first 9 months of this year, domestic equity funds had net outflows of $8 billion. During the first week of October, another $5 billion was redeemed. Bond funds, in contrast, had inflows of nearly $300 billion in the first 9 months of this year. Of the top 10 selling funds in America this year, 9 are bond funds and only one is a stock fund, and that one is the Vanguard 500 index fund. Stocks are pretty unpopular, despite having had a decent year so far, and why not? “Riskless” Treasuries have trounced stocks over this decade, having risen 85%, while if you’d bought the S&P 500 at the end of 1999 and held it through Sept 30 of this year, you’d have lost 14% over the same period. No profits at all for a 10-year period of investing in the biggest US stocks! Buy and hold is dead is a common refrain. Who wants to own a risky asset that does not go up, and one denominated in a currency that will surely go down? (We “know” the dollar will go down because it is on the front pages of the financial papers and magazines that it will do so. Everyone knows that—the only question is how far and how fast and will it collapse?)

That is the inside view, anyway. The outside view provides a different perspective. According to data compiled by Jeremy Siegel at the University of Pennsylvania, stocks have provided average annual real returns (after inflation) of 6.66% for all 10-year periods going back to 1871. (It is a curious coincidence that stocks bottomed on March 6, at 666 on the S&P 500). There have been 14 10-year periods where stock returns have been negative, including this one. In every one of the previous 13, the subsequent 10-year returns have exceeded 10% real, about 50% more than average, and more than double the return of government bonds. So every time stocks have performed poorly for 10 years, they have performed better than average for the next 10 years, and they have beaten bonds every time by an average of 2 to 1, yet investors can’t put money fast enough into bond funds, and continue to redeem equity funds.

As we sit at our desks pondering the myriad questions we’re faced with as investors, questions of great complexity, and ones of undeniable importance to our future well-being, it probably makes sense to get up and go outside, where the view is likely to be different, and clearer, and better.

Source: “Think Twice,“ by Michael J. Mauboussin, Copyright 2009, Michael J. Mauboussin;

Bloomberg; and “From Bear to Bull,” by James Grant, The Wall Street Journal, September 19, 2009.

To Rise, Inflation Faces an Uphill Climb

Inflation numbers might soon start to look scarier, but any inflation flare-up should be short-lived, and might even sow the seeds of its own demise.

The Bureau of Labor Statistics releases its producer- and consumer-price indexes for October. October PPI, due Tuesday morning, is expected to edge higher from September on rising food and energy prices.

Economists estimate consumer prices, due on Wednesday morning, also rose from September. "Core" CPI, which strips out food and energy prices, was up 1.5% last month from a year earlier, according to economists' forecasts, well below the 2% the Federal Reserve generally considers a tolerable inflation rate.

Those figures won't set off inflation alarms. But coming numbers could mark the start of more-notable upward pressure on year-over-year inflation growth, warns David Ader, head of government-bond strategy at CRT Capital. The reason: For the next few months, inflation will be measured against the worst depths of the recession, when prices fell across the board.

The numbers could be fodder for those on hyperinflation watch, particularly with commodity prices rising and the dollar fragile. But this "baseline effect" will only be temporary and won't faze the Fed.

Prices have clearly rebounded, but consumers haven't borne the brunt of those higher prices as much as producers have. Producer inflation has outpaced consumer inflation consistently since February 2008.

Companies have responded to their higher costs, along with generally weaker demand, by slashing their payrolls in the greatest numbers since the Great Depression.

A weak labor market can keep inflation in check, even if commodity prices rise. Petroleum-related costs account for just 2.3% of U.S. production costs, according to an analysis by Capital Economics. Employee compensation, on the other hand, accounts for 30.3% of production costs.

In fact, if rising commodity prices lead to more corporate cost cutting, then that will put more downward pressure on inflation.

To the extent that already-cash-strapped consumers, facing 10% unemployment, cut back on other items to pay for higher food and energy prices, that will also hurt demand, and prices, for everything else.

In other words, don't look for today's inflation pressures to last.

Thursday, November 19, 2009

Leading Economic Indicators Losing Strength

The AP details the "best in 25+ year" run of the leading economic indicators that still somehow managed to disappoint:

A private forecast of economic activity over the next six months edged up less than expected in October, signaling slow, bumpy growth next year.

The Conference Board said Thursday that its index of leading economic indicators rose 0.3 percent last month. Economists polled by Thomson Reuters had expected an 0.5 percent gain.

The index climbed 1 percent in September.

"We're still getting some positive momentum, but it looks like things are slowing down again," said Jennifer Lee, economist at BMO Capital Markets. "A lot of the economic growth has largely been driven by the government stimulus packages."

The government's Cash for Clunkers program boosted the auto sector and consumer spending, while tax credits for homebuyers have propped up the housing market.

Still, the indicators have risen for seven straight months. The Conference Board said last month that the 5.7 growth rate in the six months through September was the strongest since 1983. That ticked down to 5 percent growth in the six months through October.

Another disappointment is the performance of the indicators less the HUGE contribution of the interest rate spread (i.e. the steepness of the yield curve), which actually printed a negative number in October.

Why exclude interest rate spread? While the spread still relays the current monetary policy (i.e. when the yield curve is steep, the Fed is typically adding liquidity to the system which drives growth), this becomes less relevant when individuals and business aren't utilizing that liquidity (i.e. borrowing) to invest in "actual" economic activity. Instead we see that the liquidity is just being used to drive up prices of already rich, but not yielding 0% assets and/or to recapitalize a beaten down, but not yet out banking system.

Source: Conference Board

The GOD (glut of distillate) delusion

Could the world finally be catching on to the distillate glut problem? (Despite the Daily Mail getting completely the wrong end of the stick on the story).

We note even the normally media-shy physical trader Trafigura warned about the matter via Reuters on Thursday:
SINGAPORE (Reuters) - European oil trader Trafigura Beheer BV said on Thursday the worst of the credit crisis was over, but cautioned that the oil market was still grappling with severe oversupply and current prices were too high.

“As far as we can see, liquidity is back, and there’s a lot of appetite from existing banks and new banks. As they reposition their portfolios, commodities continue to feature quite highly on their agenda,” Trafigura’s Chief Financial Officer Pierre Lorinet told Reuters in an interview.

But he warned that given the ballooning stockpiles of oil products stored on ships, the current crude price of $80 a barrel was not justified.  “The level today seems too high compared to the pure fundamentals. But it goes back to how oil is trading today, and oil is trading like a financial asset.”  The severe oversupply would keep the market’s contango structure in place “for a while,” he added.

That, of course, follows near-term downside warnings from the likes of Goldman Sachs, Stephen Schork and BNP Paribas already.

But, we feel it’s Olivier Jakob at Petromatrix who really expressed the matter best on Friday. As he wrote (emphasis FT Alphaville’s):

As per our Tuesday ad hoc note on floating stocks; on a crude equivalent basis all of the OPEC and half of the IEA estimated oil demand growth for 2010 is already parked at anchor in floating stocks and these idled cargoes filled with oil are getting more and more attention.

By the end of the winter there is likely to be as much distillates afloat as in the total US at the end of winter 2007 and we expect that it will be more and more difficult for some of the Wall Street commodity banks to avoid mentioning the subject and to continue to hide the floating storage fill-up as “demand from emerging economies”.

The ICE Gasoil contango is currently widening and this will not work towards the reduction of these floating stocks. In an environment of spare refining capacity the only solver to the growing floating stocks of Distillates is a sharp reduction in OPEC supplies [ahem…Daily Mail], but only lower prices would trigger that.

The only answer that we see to GOD (Glut of Distillate) is a flat price correction sharp enough to force more OPEC supply cuts. Starting 2010 with WTI at 80+$/bbl and a contango in a low demand environment there will not be much returns to be expected from commodities by some of the largest financial institutions; hence with the evidence of the GOD being harder and harder to hide we would not be surprised if in a few weeks some of the Wall Street commodity banks start to change their tune and start to publicize the GOD. A flat price correction would anyway be needed in the first quarter to allow a repositioning from the large financial players at better entry levels.

Which, of course, doesn’t mean banks have been hoarding oil in a bid to drive the prices up. It means, if anything, they’ve been too slow to acknowledge the extent of the oversupply in the market and degree of muted demand, as well as depended too much on the idea that economic recovery will help spur demand by the year’s end.
Meanwhile, as Jakob states, the solution to the glut lies in Opec shut-ins — not more output .

Gladwell for Dummies

By Maureen Tkacik

This article appeared in the November 23, 2009 edition of The Nation.

November 4, 2009

That success is in the eye of the unsuccessful would seem to be the great unspoken dilemma dogging critics asked to consider the work of the rich and famous author and inspirational speaker Malcolm Gladwell. No matter how well intentioned or intellectually honest their attempts to assess his ideas, the subtext of Gladwell's perceived success, and its implications for their own aspirations in the competitive thought-generation business, obscures their judgment and sinks their morale. Nearly a decade has passed since the New York Times dryly summarized Gladwell's first book, The Tipping Point: How Little Things Can Make a Big Difference (2000), as "a study of social epidemics, otherwise known as fads," and yet, each Sunday, it still taunts perusers of the paperback nonfiction rankings, where it currently sits in sixth place. Gladwell may be merely "a slickster trickster" who "markets marketing" (as James Wolcott put it), or a "clever idea packager" who "cannot conceal the fatuousness of his core conclusions" (science writer John Horgan); he might even be an "idiot" (Leon Wieseltier). But one thing is clear: Gladwell is no fad. He is a brand, a guru, a fixture at New York publishing parties and in the spiels of literary agents hoping to steer writers toward concepts that will strike publishers as "Gladwellian."

A gaggle of irate critics, seeking to right this injustice, came charging, pens bravely brandished, only to watch themselves sink into the quicksand of Gladwell's infuriatingly memorable--"sticky," in Gladwellese--concepts and jargon. "Why does spending a weekend with Mr. Gladwell's best-selling books...lead to unhappiness and a pathological fixation on writing in rhetorical questions?" wailed Tom Scocca in the New York Observer. So discombobulated was Scocca by this critical game of pin-the-tail that when he finally stopped spinning, he stuck his sticker straight into a tautology. His solution to the Gladwell question was to posit that Gladwell's style had simply gotten too Gladwellian. "The problem with the Malcolm Gladwell Piece," as he put it, "is that it always seems to contain phrases like 'the problem with the Malcolm Gladwell Piece.'"

That Gladwell's most recent blockbuster monograph, Outliers: The Story of Success, actually purported to be about success only accelerated the vicious cycle of maddening self-reference, begging as it did a critical Gladwellian case study of Gladwell's own "success." The book's premise can be distilled to a single sentence: success is the result of many variables, most of which lie outside the control of a particular individual. Gladwell illustrates this point through various anecdotes and case studies that teach us a great many things we already know. For instance, hard work and education are important. Also: Culture Matters. Know Thyself. Practice Makes Perfect. Or, in the words of the Observer's Alexandra Jacobs, Outliers is about "how super-achievers like--well, like Malcolm Gladwell!--get where they are." And sure enough, in The New York Times Book Review, David Leonhardt took the bait, writing a brief alternative history of Gladwell's life crediting said "success" to his parents' professions. His mother, a psychotherapist, and his father, a mathematician, "pointed young Malcolm toward the behavioral sciences, whose popularity would explode in the 1990s," wrote Leonhardt; in addition, his mother, who "just happened to be a writer on the side," taught him "'that there is beauty in saying something clearly and simply.'"

But in examining Gladwell's success concurrently with his prescriptions for achievement, even his harshest reviewers damned themselves with faint criticism. When Michiko Kakutani dismissed Outliers for employing the patented Gladwell "shake-and-bake" recipe "in such a clumsy manner that it italicizes the weaknesses of his methodology," she still granted him a coherent method; when The Economist embraced the book's "engaging" and "intriguing" case studies while wryly enclosing the overarching "big idea" in quotation marks, it overlooked Gladwell's refusal to engage meaningfully with the world of ideas at all.

The Economist was astute to observe that the sheer obviousness of Outliers' core ideas, which were "unlikely to take even the least reflective reader by surprise," marked a departure from The Tipping Point. But when the magazine described The Tipping Point's chief attraction as its title concept's capacity to lend "the power of apparent inevitability to almost any argument," it failed to mention that the concept was central to Outliers as well--this despite that the purported aim of Outliers was to remind readers that "success," for most of us, is anything but inevitable. Such are the contradictions that seem to riddle not just Gladwell's thinking but the thinking on Gladwell's thinking, and perhaps even the thinking on thinking on that, and it is precisely these slippery but substantive contradictions that have allowed Gladwell to tout his revolutionary "big ideas" without couching them in anything so mundane as a logical, well-supported or otherwise sound argument. In this failing, he is not unique among either media mavens or the intelligentsia, but he is, perhaps, outstanding. "I don't really think of myself as an outlier," Gladwell told New York magazine late last year. "At the end of the day, I'm just a journalist."

In 1996 The New Yorker hired Gladwell as a staff writer after first publishing an essay he wrote for the magazine's "Black in America" special issue. He had spent the previous nine years at the Washington Post, where he covered health policy and science. In his rumination on the nuances of prejudice (which is the basis of the last chapter of Outliers), Gladwell defenestrated the fallacy that Canadians are less racist than Americans with an anecdote describing a coffee date with an old college acquaintance. The man launched into a tirade about the threat Toronto was facing from Jamaican immigrants, Jamaica being the outpost where all the most "troublesome and obstreperous" slaves had been sent. "I have told that story many times since, usually as a joke, because it was funny in an appalling way," wrote the half-Jamaican Gladwell. "I tell the story that way because otherwise it is too painful."

"Somebody," he concludes, "always has to be the nigger."

That Gladwell would rarely again end a story with such a downer of a line is in evidence in his new book, What the Dog Saw, a collection of his articles from his tenure at The New Yorker. The collection provides an archive of just a fraction of the stories he's written since the mid-'90s, when, under the employ of the magazine's famously buzz-obsessed former editor Tina Brown, Gladwell began studiously scrubbing his sentences of the mildew of the old, liberating his readers from references to anything that might dirty undiluted all-newness with the dourness of precedent. Gladwell focused his sights on the more vacuous anxieties of the heirs and heiresses of American affluence. In 1999 he wrote a story called "Running From Ritalin," about the wildly overprescribed drug for attention-deficit disorder, which he claimed was merely the modern answer to a widespread dopamine deficiency that previous generations had treated with cigarettes and cocaine, "a drug," he explains helpfully, "that people thought would help them master the complexity and the competitive pressures of the world around them." Soon after, Gladwell would tackle college admissions, shopping, parenting, standardized testing, corporate culture and transformative household inventions of the twentieth century, often all in the space of a few dozen column inches, and in the template that he had fashioned in the Ritalin story: a cheerful, conversational voice deployed in a perfectly paced dopamine prose that had the palliative effect of nullifying whatever concerns readers might have about this product or that problem.

Gladwell promised readers mastery of the complex and competitive world around them, if only they would accept the facile conclusions he extrapolated from the findings of the many endearingly eccentric, iconoclastic scholars and researchers who were busy applying the scientific method to the investigation of everyday living. These scientists tended to share a universal message: contrary to our latent anxieties about modern life, everything is all right--or can be, with a few minor psychopharmacological tweaks--so come on, get happy! From a stammering "retail anthropologist" we learn that shoppers are not nearly so slavish and easily manipulated as the chain stores believe them to be. From a "heroically counterintuitive" historian of loopholes we learn to appreciate, rather than resent, tax cheats, smut peddlers and sources close to the investigation who exploit the letter of the law to undermine its spirit. From a series of surprisingly sincere marketing executives we gain a nuanced appreciation for both the fullness ("amplitude," in industry parlance) of the taste of ketchup and the subtle subversiveness of early Clairol commercials. "In writing the history of women in the postwar era," Gladwell wonders in this last piece, "did we forget something important? Did we leave out the hair?"

Gladwell's protagonists are generally intelligent but ordinary folks who have imbued their work with a passionate practicality. Their laboratories are courtrooms and high-concept shopping malls, office parks and African villages, but whatever their locale, they are always buried in data, endless stacks and reams and massive videotape libraries full of tens of thousands of hours of footage documenting their findings, their desks buckling under thick piles of "carefully annotated tracking sheets." With this abundance of evidence they espouse theories that Gladwell depicts either as regrettably naïve or courageously counterintuitive, depending on whether he is debunking conventional wisdom or advancing a hitherto unknown experimental truth. He takes pains to skewer, for instance, the delusion that the Central Park jogger was saved by a "miracle" and the misconception that the Challenger explosion revealed a hideously corrupt species of neglect at NASA. Particularly vexing to Gladwell and his data marshals are overblown health hazards scaring the consumptive populace off such marvels as breast implants, estrogen therapy, newfangled birth control pills and products containing the fat substitute Olestra, the famed and feared "stool loosening" side effect of which Gladwell expends many sentences likening to that of bran cereal.

A recurring straw man for Gladwell is misguided evangelism, generally the kind that rallies around fringe causes, though his aversion to strident moralism usually keeps him from fixing on a villain. A notable exception is the late diet guru Dr. Atkins, upon whom he loosed his most withering scorn in a comprehensive takedown of the diet industry published in 1998. Otherwise Gladwell seems to regard his intellectual foes as somewhat pathetic figures. He wants to love, for instance, Dr. Susan Love--the charismatic but suspiciously shrill critic of estrogen therapy he profiled in 1997--but the data just don't support her claim that the treatment dramatically increases women's risk of developing breast cancer. Estrogen, however, does cause breast cancer, we learn three years later in "John Rock's Error," the cautionary tale of another wayward evangelist, the Roman Catholic doctor who helped develop the birth control pill. Rock lobbied the Catholic Church to lift its ban on the pill and, having failed, eventually lost his faith in God and drank himself to death.

In a 1998 article called "Do Parents Matter?" Gladwell championed the findings of one Judith Rich Harris, a "fragile, elfin" and grandmotherly editor of child-psychology textbooks who had published a groundbreaking study purporting to show that parents are rarely to blame for screwing up their kids. Harris had formulated her hypothesis while editing a book on juvenile delinquency that offhandedly credited the motivation for such behavior to the desire to be more like adults. "Adolescents aren't trying to be like adults--they are trying to contrast themselves with adults," she explained to Gladwell. But like a fickle teenager, Gladwell would casually shrug off the wisdom he had gleaned from Harris in a piece that appeared several months later. Here he contrasts the television show Beverly Hills, 90210, which "played to the universal desire of adolescents to be grownups," with its spinoff, Melrose Place:

"Melrose" was the opposite. It started with a group of adults--doctors, advertising executives, fashion designers--and dared to have them behave as foolishly and as naively as adolescents. Most of them lived in the same apartment building, where they fought and drank and wore really tight outfits and slept together in every conceivable permutation. They were all dumb, and the higher they rose in the outside world the dumber they got when they came home to Melrose Place.
 In the mid-nineteen-nineties, when a generation of Americans reached adulthood and suddenly realized that they didn't want to be there, the inverted world of Melrose was a wonderfully soothing place. Here, after all, was a show that ostensibly depicted sophisticated grownup society, and every viewer was smarter than the people on the screen.

But for all this vapidity, Gladwell finds something to admire in the melodrama: restraint.

The wonderful thing about "Melrose Place" was that just when you thought that the show was about to make some self-consciously postmodern commentary on, say, the relationship between art and life, it had the courage to take the easy way out and go for the laugh.

The publication of Gladwell's first book, The Tipping Point, proved his courage to be of a similar character. The Tipping Point was named for an epidemiological phenomenon that he had introduced to the public when he covered healthcare policy for the Post. Healthcare reporting is a beat that notoriously leaves journalists disillusioned by the destructive influence of money and markets on the public welfare; in Gladwell's case, it provided the central metaphor for a book that applied the observations of health officials to the business of "want creation," otherwise known as branding. Gladwell describes the genesis of the book in detail in a "Q&A With Malcolm" on Gladwell.com:

The word "Tipping Point"...comes from the world of epidemiology. It's the name given to that moment in an epidemic when a virus reaches critical mass. It's the boiling point. It's the moment on the graph when the line starts to shoot straight upwards. AIDS tipped in 1982, when it went from a rare disease affecting a few gay men to a worldwide epidemic. Crime in New York City tipped in the mid 1990's, when the murder rate suddenly plummeted. When I heard that phrase for the first time I remember thinking--wow. What if everything has a Tipping Point? Wouldn't it be cool to try and look for Tipping Points in business, or in social policy, or in advertising or in any number of other nonmedical areas?

The product of this endeavor was what Gladwell calls "an intellectual adventure story," a genre-crossing book that whipped up a "little bit of sociology, a little of psychology and a little bit of history," tossed in some epidemiology and "examples from the worlds of business and education and fashion and media," and hocked the resulting mishmash of soft social science and hard cases to help readers make "sense of the world, because I'm not sure that the world always makes as much sense to us as we would hope."

The temptation to try to calculate The Tipping Point's own tipping point seems thus far to have been resisted, but there is no doubt that the book reached a great many Mavens, Salesmen and Connectors and eventually became a phenomenal success. To what was that success attributable? Surely encoding the principles of bestsellingness and infection by word of mouth in the book's DNA did some of the work, but there were other contributing factors, not the least of which was what has become Gladwell's signature style, which projects the expertise of a scientist and the easy helpfulness of the guy who delivers the local television station's "news you can use" segment at 6:25.

In searching for an anecdote or image with which to convey the ultra-absorbency of Gladwell's book as compared with that of his soggier-sentenced peers, I found myself remembering a story Gladwell wrote in 2001 about the technology of diapers. In this story, Gladwell reported that "those in the trade" refer to the waste that diapers are engineered to retain as "the insult," and this image seems to me as useful as any for thinking about Gladwell's success. His masterful maneuver was to engineer a style that artfully conceals "the insult," honing it in his articles before finally unleashing it in book form with The Tipping Point.

What made The Tipping Point remarkable was not the diagrams or axioms or anything it includes but rather what it left out: that is, any discussion of the real risks of business at a moment when its sexiest sector, technology, was increasingly uncertain about how it was going to survive once it had burned through its remaining seed money. Instead, Gladwell celebrated the way certain personality types can, given a hospitable set of circumstances, or "context," conspire with extraneous forces to profoundly alter human behavior--without ever dwelling on how this might be a bad thing or bothering to provide a clear definition of the word "context." In the "Q&A," Gladwell says he hopes readers will use the "new set of tools"--"brain software"--he provides them to create "'positive' epidemics" of their own. Dr. Atkins is nowhere to be found, nor is Susan Love; instead, he populates his book with a nonthreatening cast of folksy, relatable characters--behavioral psychologists, petty criminals and criminologists, effusive socialites and seminarians, Big Bird and Peter Jennings--and tells their stories in a manner so adamantly engaging that it reads suspiciously as if it had been focus-grouped. In conversation with Tom Scocca, Gladwell characterized his style as one that screams "Please, please, don't leave me," and indeed his stories often seem designed to do nothing more than to keep people reading.

This is nowhere more apparent than in What the Dog Saw. The book is mostly old news, with the exception of a preface in which Gladwell attempts to justify the methodology behind his pieces, an explanation, it appears, that is also meant as a rejoinder to all those aforementioned heckling critics who have failed, fundamentally, to comprehend Gladwell's project. Complaining that his greatest frustration as a writer has been the angry reader who believes that Gladwell wants him to "buy" his argument, Gladwell asserts,

Good writing does not succeed or fail on the strength of its ability to persuade. Not the kind of writing that you'll find in this book, anyway. It succeeds or fails on the strength of its ability to engage you, to make you think, to give you a glimpse into someone else's head--even if in the end you conclude that someone else's head is not a place you'd really like to be.

One could quibble with the assertion that a writer's obligation to persuade begins and ends with keeping the reader reading, not in order to convince him of certain conclusions but merely to enable him to satisfy that basic human impulse to explore and temporarily inhabit other minds. But the critic's natural persuasion is to attempt to inhabit the mind of a writer, to evaluate how satisfying the stay was, even in the probable case that one wouldn't want to be lodged there permanently. And one thing that frustrates this reader of Gladwell is his obvious aversion to giving us any privileged access to his mind, encouraging us instead to inhabit more fully the consciousnesses of dogs and their whisperers, when one would hope that his mind is an infinitely more interesting place to be. But as Gladwell tells us, "self-consciousness is the enemy of 'interestingness,'" and so perhaps it is that impulse to protect the self from criticism that has so hampered his work, which he chronically undersells even as his books outsell his every rival.

"A book, I was taught long ago in English class, is a living and breathing document that grows richer with each new reading. But I never quite believed that until I wrote The Tipping Point," he gushed in the afterword to the 2002 edition, citing the "conferences and retreats and sales meetings" where he had mingled with his readers. "In a world dominated by isolation and immunity, understanding these principles of word of mouth is more important than ever."

Gladwell has said that of all the people he has interviewed, he most identifies with Nassim Nicholas Taleb, the polymath former derivatives trader turned "risk management" guru whom he profiled in April 2002, after Taleb published his breakthrough bestseller Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets. Taleb, now "distinguished professor of risk engineering" at NYU, writes chatty, nonlinear nonfiction books that are invariably described as intellectually "provocative...in the tradition of" Malcolm Gladwell. Taleb's follow-up, The Black Swan: The Impact of the Highly Improbable (2007), examined a phenomenon of the same genus as Gladwell's outlier: a "black swan," according to Taleb, is an unlikely but "consequential event" with profound transformative implications.

But if Taleb shares something in content and style with Gladwell, his books have a markedly different tone. Taleb considers himself a connoisseur of the "epistemic arrogance of the human race," and, unlike Gladwell, he rather conspicuously relishes the chance to hurl "the insult"--in all its freshness--at those aspiring bigwigs misguidedly combing his books for investment strategies. In Fooled by Randomness, he mocks his own youthful distrust of philosophy, which he considered "an activity reserved for those who were not well versed in quantitative methods and other productive things," and then describes turning to it later in life, after realizing he was "generally repelled by the wealthy, generally because of the attitude of epic heroism that usually accompanies rapid enrichment." He recounts his gradual recognition that

$10 million earned through Russian roulette does not have the same value as $10 million earned through the diligent and artful practice of dentistry. They are the same, can buy the same goods, except that one's dependence on randomness is greater than the other's.... Deep down, I cannot help but consider them as qualitatively different.

In The Black Swan, Taleb elaborated on what Gladwell has called Taleb's "heretical" idea. Cataloging industries on a spectrum between two poles, Extremistan and Mediocristan, where finance in the era of securitization and the art world in the age of digital reproduction hovered near Extremistan and dentists, mechanics and community organizers were still largely anchored in Mediocristan, Taleb closed in on a flaw in the logic of modern capitalism that he felt to be gravely dangerous. The world's financial and consumer superpower had shifted its economy radically toward the "scalable" activities of Extremistan--where the same number of labor hours could result in one sale or 1 million--while maintaining Mediocristan's solidly "average" talent base as well as the base's conventional sense that "success" is largely a function of craftsmanship, experience and innate talent. He did not blame books like The Tipping Point for encouraging readers to believe they could game their fates in the face of Extremistan's governing randomness, but he could have.

Gladwell's profile explained none of Taleb's ideas in detail, but its timing was impeccable: in 2002 Wall Street was reeling from the "blow-up" of Enron, the Twin Towers and the accounting industry, and Taleb, who claimed his methods had insulated his fund from such a fate, cut a compelling figure. "We cannot blow up, we can only bleed to death," Taleb told Gladwell. Gladwell likened Fooled by Randomness to Martin Luther's ninety-five theses, solemnly concluding:

This kind of caution does not seem heroic, of course. It seems like the joyless prudence of the accountant and the Sunday-school teacher.... We associate the willingness to risk great failure--and the ability to climb back from catastrophe--with courage. But in this we are wrong. That is the lesson of Nassim Taleb...and also the lesson of our volatile times.

Mirthless as he may appear to Gladwell, Taleb is a millionaire who gets to say he told you so. Why has no one said the same for Gladwell? After all, it's true. Perhaps the reason is partly the unyielding chicken-egg binariness of his patented "To intuit, or to counter-intuit?" method, which proved insufficient to explain the increasingly complex topics he approached after Taleb, most notably the implosion of Enron. In "The Talent Myth," published in July 2002, he declared the firm a casualty of the article's titular fallacy, which was then in vogue among many elite companies. He used as evidence the career of Lou Pai, who found himself kicked upstairs so many times that when he left Enron in 2001, he was CEO of one of its largest subsidiaries: "Because Pai had 'talent,' he was given new opportunities, and when he failed at those new opportunities he was given still more opportunities...because he had 'talent.'"

This certainly was likely to interest anyone who bought Taleb's contention, in Fooled by Randomness, that the most vexing problem of modern finance was its practitioners' tendency to conflate success and talent. According to their logic, failure equals talent, too! But if both were true, surely an industry rife with Lou Pais was not a little corrupt?

Alas, when presented with the chance to implicate any self-aggrandizing Extremistanis in the crime of succumbing to their context, Gladwell never missed an opportunity to miss an opportunity. The lesson of Enron, he wrote in "The Talent Myth," was that smart people might be overrated. Five years later, in "Open Secrets," he offered another view, challenging readers to compare Enron with Watergate. Whereas Watergate had been a puzzle, a scandal with an obvious narrator and cast of perpetrators, Enron was a mystery--a scandal too complex to comprehend. "Enron's downfall has been documented so extensively that it is easy to overlook how peculiar it was," he wrote. This assertion might ring less false were it followed by an elaboration of how it differed from other "mysteries": the Enron crooks were caught and prosecuted. One noteworthy event Gladwell fails to mention is the panicked plea of Enron CEO Ken Lay for a federal bailout on grounds of the "systemic risk" the firm's collapse would pose, a plea rejected by Treasury Secretary Paul O'Neill. All of this appears to muddy Gladwell's earlier assertion that Enron and its management consultants at McKinsey

believe in stars, because they don't believe in systems. In a way, that's understandable, because our lives are so obviously enriched by individual brilliance. Groups don't write great novels, and a committee didn't come up with the theory of relativity.

But stars do believe in systems--at least when the system is down several trillion dollars.

Now let's skip ahead to "Group Think," an article Gladwell published in December 2002, just a few months after "The Talent Myth," by which time Gladwell had fixed his lens on some new constellations, the stars of the television show Saturday Night Live:

We are inclined to think that genuine innovators are loners, that they do not need the social reinforcement the rest of us crave. But that's not how it works, whether it's television comedy or, for that matter, the more exalted realms of art and politics and ideas. In his book "The Sociology of Philosophies," Randall Collins finds in all of known history only three major thinkers who appeared on the scene by themselves: the first-century Taoist metaphysician Wang Ch'ung, the fourteenth-century Zen mystic Bassui Tokusho, and the fourteenth-century Arabic philosopher Ibn Khaldun. Everyone else who mattered was part of a movement, a school, a band of followers and disciples and mentors and rivals and friends who saw each other all the time and had long arguments over coffee and slept with one another's spouses.

Stars! They're just like us. Which is to say, every time Gladwell begins to close in on a conclusion of real meaning or intellectual impact, he clicks his heels and returns to the mental Melrose Place of quippy clichés. What's more, he apparently has no problem espousing the whole-truthness of two antithetical clichés--the innateness of genius and "The Power of Context" (as Gladwell had christened this truism in The Tipping Point) at almost simultaneous moments in time. Reduced further, depending on Gladwell's narrative needs, genius is either nature or nurture, and he has cheerily eaten his cake, wrapped it up neatly in a take-away box and left us wondering where the crumbs disappeared to.

It may seem obvious to some that these are false dichotomies; neither half is ever true to the exclusion of the other. But that is the rub: there are a great many book buyers determined to hedge their bets in precisely this Gladwellian mode. Depending on the situation, they want to believe in the sovereign power of either nature or nurture--to convince themselves that anyone can be a success but also that should one be so unfortunate as to fail, that failure was predestined by an accident of fate. This is the contradictory "story of success" that runs through Gladwell's articles, The Tipping Point and Outliers. The "power of apparent inevitability," as The Economist termed it, is a narrative that his hungriest readers can use to explain any turn their lives might take, and it was precisely these readers who flooded Gladwell's e-mail inbox with raves about how The Tipping Point had empowered them to take control of their lives and "contexts."

By the time Gladwell produced a sequel to The Tipping Point, Blink, his preference for light vignettes featuring plucky heroes over grimmer fare was proving its own insult. In Blink's afterword, he describes the book as "a journey into the wonders of our unconscious" but one that should not "be confused with the unconscious described by Sigmund Freud, which was a dark and murky place filled with desires and memories and fantasies that were too disturbing for us to think about consciously." Instead, Blink plumbs an unconscious realm that is surprisingly hospitable. Gladwell makes the case that because human existence is entirely too rich and nuanced to be reducible to data or logic (and by extension, to arguments or allegations), reason and reflex blend over time to yield snap decisions that are often better than the best-laid plans.

If nothing else, it was a counterintuitive moment for Gladwell to come out in favor of intuition: by 2005 the citizenry was turning against the warmongering gut instincts of the commander in chief. In Iraq, the number of casualties continued to mount daily despite Defense Secretary Donald Rumsfeld's entreaty for the public to sit back and wait for the war to reach its tipping point. Blink does include a chapter on the war, in which Gladwell reveals that Rumsfeld's disastrous battle plan had been roundly defeated by a retired Marine general named Paul Van Riper in an elaborate simulation game in 2002 (the Pentagon then ran another test, in which it sabotaged Van Riper by installing a disloyal deputy and disarming the bulk of his equipment). But despite his proximity to these proceedings, Rumsfeld is never mentioned by name in Blink. Nor, for that matter, is Bush.

It seems odd that Gladwell would write an entire chapter about the war without ever mentioning two of its main protagonists, almost as if he might believe his readers were paying so little attention that they could forget whose hunches about a failed battle plan had gotten them into this mess. And perhaps he did. In The New Republic, Richard Posner jeered that Blink "is written like a book intended for people who do not read books." But that's not quite right: Blink appears to have been written not for people who don't read books but for people who read only books that spend years on the bestseller lists, books you can talk about with your boss or buy in bulk for the marketing department.

Gladwell has documented his love-hate relationship with such books: he has gone on the record about his disdain for the diet-book industry, but he has also described his admiration for Rick Warren's The Purpose-Driven Life. And if Taleb is Gladwell's hero, his villain is, as Taleb's was, the mendacious and self-aggrandizing CEO. In 2001 Gladwell ridiculed Michael Eisner, Sumner Redstone and Jack Welch for ripping off Lee Iacocca's formula for the corporate memoir wherein modest, homespun beginnings and "gruff, no-nonsense" mentors lay the foundations for a self-made man to make his way to the corner office. Outliers is Gladwell's corrective to this genre. In it, we learn that Bill Gates, Steve Jobs and sundry other titans of Silicon Valley were all born into affluent households in the mid-1950s and otherwise benefited from a variety of cultural and circumstantial factors that yielded some of the world's most successful people.

And so once again we find Gladwell muckraking in the trenches of banal cliché and thereby reinforcing said cliché--and, more insidiously, banality itself. In Outliers, as in Blink, he appears to assume that the unexamined life is the only sort his readers could be living, though lessons with titles like "Demographic Luck" and "The Importance of Being Jewish" suggest that he may have downgraded his expectation of who his readers are from the less savvy to the truly oblivious. Outliers contains a few new terms and morsels of trivia: the 10,000-Hour Rule describes the number of practice hours one must put in to attain true genius; we also learn that fourteen of the seventy-five individuals on Gladwell's list of the "richest people in human history" were Americans born between 1831 and 1840. (Cleopatra is No. 21.) But for the most part, the book's first section, "Opportunity," contains nothing that will enlighten anyone who has given even a small fraction of 10,000 hours of thought to the word's meaning.

But it is when Gladwell ventures from the home of the brave to foreign cultures--primarily the Asian ones we've voted most likely to succeed--that Outliers begins to rely on clichés that are not only inane but, in some cases, comically offensive. In a section on the crash of a Korean Air passenger jet, Gladwell blames cultural deference for enabling numerous preventable in-flight disasters on the carrier--and credits the airline's ability to overcome its rigid "cultural legacy" for steering Korean Air back toward safety. We also travel to China's rice paddies, where the Chinese long ago learned--at least in the south, the region where rice is farmed--teamwork, self-discipline and the appreciation of complex but "meaningful" work that has enabled them to dominate global manufacturing. And in the most convoluted section of Outliers, Gladwell repurposes an argument from a book called The Number Sense that posits that Asians are good at math because in Chinese, the numerals one through nine are single-syllable, so brief to think or speak that Chinese children can fit a great many of them in their heads in any given time span, which gives them a self-perpetuating cognitive edge from the age they learn to count. From here, Gladwell explains that these tiny numerals are ordered in a system simpler than ours (the number eleven, for example, is expressed as ten-one) and that this ease and logic, combined with the discipline they've learned diligently tending their rice paddies, is what makes not just Chinese students of mathematics but also Japanese and Korean students superior to their Western counterparts.

For now let's ignore Gladwell's agronomical observations as well as the fact that the Number Sense argument can't apply to Japanese or Korean, in which several of the numbers from one through nine are polysyllabic. Let's instead turn a Gladwellian eye to a sixteenth-century Italian missionary named Matteo Ricci. One of the first Westerners to travel to China, in 1583, Ricci found a nation that was not, it might surprise you to learn, very good at math. His twenty-seven-year stay in China is described in detail in The Memory Palace of Matteo Ricci (1984), a book by historian Jonathan Spence. Under previous dynasties the Chinese had made significant advances in mathematics, but during the European Renaissance China's Ming emperors--whose primary goal was to reassert Chinese cultural supremacy after a hundred years of humiliating Mongol rule--prioritized literature and art over scientific discovery, a bias they reinforced through a rigorous examination system that governed advancement in civil service. The turning or tipping point or whatever came when Ricci learned Chinese. While all the conventional, data-supported wisdom tells u

A mind is a terrible thing to change.

You decide gold is a good bet to hedge against inflation, and suddenly the news seems to be teeming with signs of a falling dollar and rising prices down the road. Or you believe stocks are going to outperform other assets, and all you can hear are warnings of the bloodbath to come in the bond and commodity markets.

In short, your own mind acts like a compulsive yes-man who echoes whatever you want to believe. Psychologists call this mental gremlin the "confirmation bias." A recent analysis of psychological studies with nearly 8,000 participants concluded that people are twice as likely to seek information that confirms what they already believe as they are to consider evidence that would challenge those beliefs.

Why is a mind-made-up so hard to penetrate?

"We're all mentally lazy," says psychologist Scott Lilienfeld of Emory University in Atlanta. "It's simply easier to focus our attention on data that supports our hypothesis, rather than to seek out evidence that might disprove it."

It also is easier for people to rationalize than to be rational. "We're very good at cooking up post-hoc explanations of why our predictions didn't work," Prof. Lilienfeld says. "We reinterpret our failures as near-misses: 'This stock would have gone up if only X had happened,' or '99 times out of 100 I would have been right if not for this freak event.'"

The more you learn, the more certain you become that you are right. While gathering more data makes people more confident, it doesn't make their predictions much more accurate. Each new fact makes you more inclined to find another fact that resembles it, reducing the diversity and value of your information.

Confirmation bias contaminates the thinking of professional investors, too. "We've made tons of errors like this," says Staley Cates, president of Southeastern Asset Management, the Memphis, Tenn., value-investing firm that runs the Longleaf funds. "A lot of psychological traps can be combated with humility, but on this one, that doesn't help." Longleaf, Mr. Cates says, clung too long to a big position in General Motors, letting product improvements and cost savings "blind us to the fact that GM might not make it" without government help.

So how can you counteract confirmation bias?

Gary Klein, a psychologist at Applied Research Associates, of Albuquerque, N.M., recommends imagining that you have looked into a crystal ball and have seen that your investment has gone bust. Next, come up with the most compelling explanations you can find for the failure. This exercise, which Christopher Davis of the Davis funds has integrated into the research process at his value-investing firm, can help you realize that your beliefs mightn't be as solid as you thought.

Try estimating the odds that your analysis is wrong. Let us say that you reckon there is a 20% chance of an adverse outcome; that is like saying you will be proven wrong one in every five times. This way, if the investment does go awry, you will be less likely to dig in your analytical heels and desperately try to prove that you are still right. This procedure, says Michael Mauboussin, chief investment strategist at Legg Mason Capital Management, provides "psychological cover for admitting that you're wrong."

Show your investment to another person you respect whose ego isn't already invested in the decision. Ask: If you didn't own this, would you buy it now? If you did own it, would you sell it now?

Run an imaginary portfolio alongside your real one. There, you can buy or sell at will, with no risk to your wealth. On that blank slate, would you own more—or less—of this investment? Mr. Cates says at Southeastern Asset Management requires each of its analysts and portfolio managers to run a paper portfolio and to justify any differences between their paper holdings and the firm's real-world bets. "It helps us know what people really think," Mr. Cates says.

Before you buy in the first place, write down a statement of what would compel you to change your view of the investment. If any of those events come to pass, the written record will make it harder for you to pretend nothing has changed or that you don't have to do anything in response.

Messrs. Cates, Davis and Mauboussin help run funds that posted steep losses last year clinging to stocks in the face of evidence that they might be wrong. They all say that fighting confirmation bias is a never-ending battle. But if you can't conquer this gremlin of your own mind, you don't stand a chance of outwitting the market.

'Greatest Trade': How You Can Make $20 Billion

By GREGORY ZUCKERMAN

Even as the financial system collapsed last year, and millions of investors lost billions of dollars, one unlikely investor was racking up historic profits: John Paulson, a hedge-fund manager in New York.

His firm made $20 billion between 2007 and early 2009 by betting against the housing market and big financial companies. Mr. Paulson's personal cut would amount to nearly $4 billion, or more than $10 million a day. That was more than the 2007 earnings of J.K. Rowling, Oprah Winfrey and Tiger Woods combined.

How did he do it? Believing that a housing-market collapse was coming, Mr. Paulson spent over $1 billion in 2006 to buy insurance on what he then saw as risky mortgage investments. When the housing market cracked and the mortgages tumbled, the value of Mr. Paulson's insurance soared. One of his funds rose more than 500% that year. Then in 2008, he shorted financial shares, or wagered that they would fall in price, profiting again when these companies collapsed.

And are there any investing skills that average investors can learn from his success? Yes. There are no guarantees, of course, but the success of Mr. Paulson and a few other underdog investors lends encouragement to individuals trying to compete with Wall Street's pros.

Here are eight investing lessons of Mr. Paulson's $20 billion gamble, the greatest trade in financial history:

1 Don't Rely on the Experts

Wesley Bedrosian

Many investors lost big in 2007 and 2008 as housing crumbled and the stock market tumbled. But no one lost more than commercial and investment banks caught with toxic mortgage-related securities. These bankers were the very same ones who created these investments, and Wall Street's top analysts had vouched for their safety, even as Mr. Paulson and others bet against the investments.

Lesson: When Wall Street is wheeling out its latest can't-miss product, be skeptical.

2 Bubble Trouble

Some academics argue that financial markets have become more efficient. But a rash of financial bubbles in recent years -- including housing, energy, technology and Asian currencies -- suggests that markets are becoming harder to navigate, and are more prone to overshooting. Today, investors of all sizes read the same articles, watch the same business-television programs and chase the same hot tips. They invariably head for the exits at the same time.

Lesson: Have an exit strategy -- and cash to cushion any tumble.

3 Focus on Debt Markets

Most investors track the ups and downs of the stock market but have only a vague sense of moves in debt markets. That's a mistake. Early signs of trouble were seen in sophisticated markets that don't get much limelight, like the subprime-mortgage bond market. These problems eventually felled the housing and stock markets, and the overall economy, a set of falling dominos that Mr. Paulson and his team correctly anticipated.

Lesson: Debt markets can do a better job predicting problems than stock markets.

4 Master New Investments

Mr. Paulson scored huge profits by buying credit-default swaps, a derivative investment that serves as insurance on debt. When risky mortgage bonds tumbled in value, Mr. Paulson's insurance soared. But many experts were flummoxed by CDS contracts or shied away from educating themselves about these relatively new investments.

Mr. Paulson and his team had no experience with CDS contracts. But they put the time into learning about them.

Lesson: Educate yourself about the range of exchange-traded funds being introduced, some of which can play a valuable role in a portfolio.

5 Insurance Pays

A number of investors worried about a bursting of the housing market, but few did much about it, even though insurance, such as CDS contracts, at the time were selling at dirt-cheap prices. Out-of-the-money put contracts -- options that pay off only if the market tumbles -- also were trading at reasonable levels. As cheap as this insurance was, many pros ignored it.

Lesson: Don't underestimate the value of a safety net, such as put options.

6 Experience Counts

Some of the biggest winners in the meltdown were middle-aged investors dismissed by some as past their prime. But they had experienced past market downturns, while some of the bankers and analysts caught flat-footed knew only good times.

Lesson: A historical perspective can be a valuable tool.

7 Don't Fall in Love

With an Investment

In early 2009, Mr. Paulson became more bullish about the banks and financial companies that he had wagered against in 2008, after determining that these companies had improved their balance sheets. The moves resulted in profits this year.

Lesson: Even the greatest trade doesn't last forever.

8 Luck Helps

In early 2006, Mr. Paulson determined that housing was in trouble and set out to profit from the impending fall. But some housing experts already had determined that real estate was overpriced; others had wagered against housing but could no longer stomach their losses. Just months after Mr. Paulson placed his historic trade, U.S. housing prices began to fall.

Lesson: Don't risk too much in any one trade, even one that seems like a sure thing.

Apple Wouldn't Risk Its Cool Over an Ad Gimmick, Would It?

"SOME of the best-loved technology on the planet" is how Apple describes its products when recruiting new employees. It's a fair description.

But the love that consumers send Apple's way could flag if the company puts into place new advertising technology it has developed. In an application filed last year and made public last month by the United States Patent and Trademark Office, Apple is seeking a patent for technology that displays advertising on almost anything that has a screen of some kind: computers, phones, televisions, media players, game devices and other consumer electronics.

Filing a patent application, of course, doesn't necessarily mean that the company plans to use the technology. But the application shows, at the least, that Apple has invested in research to develop what it calls an "enforcement routine" that makes people watch ads they may not want to watch.

Its distinctive feature is a design that doesn't simply invite a user to pay attention to an ad - it also compels attention. The technology can freeze the device until the user clicks a button or answers a test question to demonstrate that he or she has dutifully noticed the commercial message. Because this technology would be embedded in the innermost core of the device, the ads could appear on the screen at any time, no matter what one is doing.

The system also has a version for music players, inserting commercials that come with an audible prompt to press a particular button to verify the listener's attentiveness.

The inventors say the advertising would enable computers and other consumer electronics products to be offered to customers free or at a reduced price. In exchange, recipients would agree to view the ads. If, down the road, users found the advertisements and the attentiveness tests unendurable, they could pay to make the device "ad free" on a temporary or permanent basis.

Would anyone have guessed that Apple, so widely revered, would seek patent protection of a gimmick not unlike one used to sell vacation timeshares? (Agree to attend the sales seminar and get a free weekend getaway!) Or could anyone have predicted that the Apple of 2009, a company with premium products, would file a patent application that could make it a latter-day descendant of Free PC and ZapMe, companies that in 1999 gave away PCs engineered to always display on-screen ads?

What the application calls the "enforcement routine" entails administering periodic tests, like displaying on top of an ad a pop-up box with a response button that must be pressed within five seconds before disappearing to confirm that the user is paying attention.

These tests "can be made progressively more aggressive if the user has failed a previous test," the application says. One option makes the response box smaller and smaller, requiring more concentration to find and banish. Or the system can require that the user press varying keyboard combinations, the current date, or the name of the advertiser upon command, again demonstrating "the presence of an attentive user."

Everything about this technology seems so antithetical to the guiding principles of Apple that one would naturally wonder whether Steven P. Jobs even knows whether his company filed a patent application for such a thing. Apple has 34,300 employees, and Mr. Jobs, though named by Fortune magazine this month as "C.E.O. of the decade," can't be expected to keep track of everything that every Apple employee does.

Yet Mr. Jobs is directly connected to this particular patent application: his name is the first listed of the five inventors. This is a rarity, occurring only four times among the 30 applications on which he is co-inventor that have been published by the patent office since March 2008.

How Mr. Jobs reconciles this advertising technology with Apple's culture is not known. An Apple spokeswoman declined to answer questions about the patent application.

Microsoft is also working on placing advertisements where they have not been before.

 In its case, the plans are definite: next year, Microsoft will offer Office Starter 2010, a free version of Office pre-installed on some PCs. It will include a small Microsoft display ad in the lower-right corner of the screen, and offer only barebones versions of Word and Excel, with fewer functions than the regular paid ones.

 It will not be the first time that Microsoft has experimented with ads on the software that runs on PCs - it began quietly in June 2007 with a version of Microsoft Works.

 IN Office Starter 2010, Microsoft is not seeking revenue from advertising and is going to use the ads only to promote the full-featured, commercial versions of Office. The company plans to take customers "along a journey to educate them about the product," said Bryson Gordon, a director on Microsoft's Office team.

By allowing customers to ignore the ads that will sit passively in the corner of the screen, Microsoft will use a gentle approach to the up-sell.

The approach presented in Apple's patent application is not gentle at all. Beyond that, it's myopic. Were it to use the new technology, it's hard to imagine how free, ad-supported versions of its products wouldn't have a negative impact on the company's brand.

 The technology may be clever and original enough to earn Apple a patent. But the resulting products are likely to be more irritating than beloved.

The rocketing cost of insuring against the bankruptcy of the Japanese state is telling us that the model has smashed into the buffers. Credit default swaps (CDS) on five-year Japanese debt have risen from 35 to 63 basis points since early September. Japan has suddenly decoupled from Germany (21), France (22), the US (22), and even Britain (47).

Regime-change in Tokyo and the arrival of Yukio Hatoyama's neophyte Democrats – raising $550bn (£333bn) to help fund their blitz on welfare and the "new social policy" – have concentrated the minds of investors at long last. "Markets are worried that Japan is going to hit a brick wall: the sums are gargantuan," said Albert Edwards, a Japan-veteran at Société Générale.

Simon Johnson, former chief economist of the International Monetary Fund (IMF), told the US Congress last week that the debt path was out of control and raised "a real risk that Japan could end up in a major default".

The IMF expects Japan's gross public debt to reach 218pc of gross domestic product (GDP) this year, 227pc next year, and 246pc by 2014. This has been manageable so far only because Japanese savers have been willing – or coerced – into lending for almost nothing. The yield on 10-year government bonds has been around 1.30pc this year, though they jumped to 1.42pc last week.

"Can these benign conditions be expected to continue in the face of even-larger increases in public debt? Going forward, the markets capacity to absorb debt is likely to diminish as population ageing reduces saving," said the IMF.

The savings rate has crashed from 15pc in 1990 to near 2pc today, half America's rate. Japan's $1.5 trillion state pension fund (the world's biggest) has become a net seller of government bonds this year, as it must to meet pay-out obligations. The demographic crunch has hit. The workforce been contracting since 2005.

Japan Post Bank is balking at further additions to its $1.7 trillion holdings of state debt. The pillars of the government debt market are crumbling. Little wonder that the Ministry of Finance has begun advertising bonds in Tokyo taxis, featuring Koyuki from The Last Samurai. If Japan's bond rates rise to global levels of 3pc to 4pc, interest costs will shatter state finances.

No one knows exactly when a country tips into a debt compound trap. But Japan must be close, even allowing for the fact that liabilities of the state Loan Programme (FILP) have fallen by 40pc of GDP since 2000.

"The debt situation is irrecoverable," said Carl Weinberg from High Frequency Economics. "I don't see any orderly way out of this. They will not be able to fund their deficit. There will be a fiscal shutdown, a pension haircut, and bank failures that will rock the world. It is criminally negligent that rating agencies are not blowing the whistle on this."

Mr Hatoyama inherited a country that was already hurtling into sovereign "Chapter 11". The Great Recession has eaten up 27pc in tax revenues. Industrial output is down 19pc, even after the summer rebound; exports are down 31pc; the economy is 10pc smaller today in "nominal" terms than a year ago – and nominal is what matters for debt.

Tokyo's price index fell 2.4pc in October, the deepest deflation in modern Japanese history. Real interest rates have risen 300 basis points in a year. It reads like a page from Irving Fisher's 1933 paper, Debt Deflation Causes of Great Depressions.

The Bank of Japan seems oddly insouciant. It will end its (feeble) quantitative easing in December by suspending purchases of corporate debt, much to the fury of the Finance Ministry.

"This is incredibly dangerous," said Russell Jones from the RBC Capital Markets. "The rate of deflation is shocking. The debt dynamics are horrible and there is the risk of a downward spiral."

Tokyo has let the yen appreciate violently – 90 to the dollar, 13 to the Chinese yuan – giving another twist to the deflation knife. Top exporters are below break-even cost, says RBS. The government could stop this, as it did in a wave of manic dollar purchases from 2003-2004. It could print money à l'outrance to stave off deflation. Yet it sits frozen, like a rabbit in the headlamps.

Japan's terrible errors are by now well known. It failed to jettison its mercantilist export model in time. It resisted the feminist revolution, leading to a baby strike by young women. It acquiesced in a mad investment bubble (like China now) in the 1980s, stealing growth from the future.

It wasted its immense fiscal firepower, scattering money for 20 years on half-baked spending projects to keep the economy afloat. QE was too little, too late, and this is the lesson for the West. We must cut borrowing drastically over the next decade, and offset this with ultra-easy monetary policy. Does Downing Street understand this? Does the White House? Does the European Central Bank? Clearly not.