Sunday, January 25, 2009

Searching for the Comfort of Cycles

Our earliest experience has to do with being fed on a regular basis. After the very first drink, we learn there is a second which is followed by a third and so on. Thus we learn rhythms, albeit two separate notes between being fed and sleeping. A little later we start to identify the time pattern between feeding and sleeping, and the third state of waiting for either to happen. From this three stage development we learn about cycles, and to keep us in good humor, the predictability of these cycles. Now that we are larger, in many ways no less baby-like, we search for the comfort of the predictability of cycles. After all, we know about the cycle of day and night. In order to schedule joint activity with others, we introduced the primitive concepts of a clock which divided time into segments of hours. To effectively regularize our lives we introduced an abstraction of assigning 24 hours to a day. Using this abstraction one could be certain as to the future. There WILL be a six o’clock tomorrow morning, and for most of us that is comforting because it means that we will consume our first meal of the day.

The problem in applying this abstraction is that we don’t know whether the sun will be up over our horizon on any particular morning. We are unsure for two reasons. First, the “rising” of the sun, in reality is the rotation of the earth, a predictable cycle which is not based on our clock system. The second reason is that we may not have great light at dawn (or any other part of the day), as there may be clouds overhead, sometimes dark clouds. These primitive experiences help us appreciate the frustration of today’s investors attempting to predict market movements.

We would all like to have the predictability of being fed on time, in a pre-ordained way like the sun rising. We want to be able to believe that next Tuesday most stocks, or more importantly my stocks, will begin a ten year rise of historic proportions. The problem is that there are serious economic, financial, political, social and scientific black clouds overhead. We are not only losing money, but we are also frustrated about our inability to predict the future. While I can not predict the future, I can examine the nature of selected past cycles with you.

As usual, we can learn from the ancients who had to supply stories to worried people without the aid of Bloomberg and Blackberry devices. While the ancient Greeks looked at the stars and saw various perceived actions, in effect what they were doing was dealing with the mysteries of human behavior. But due to the unfathomed rotation of the earth, they “saw” movements with enough regularity as to make their stories predictable. Similarly, we seek predictability even though we don’t understand the reality of the mechanism that creates the predictability. We really don’t care why the market, and particularly our stocks, are going up as long as they do. (A lesson Bernie Madoff learned early and well.)

Agriculture, with its dependence on weather, has always been a cyclical activity. Farmers and herdsmen want to supply their markets with substantial volume at high market prices. Their desire is to develop a bumper crop, when many others don’t for whatever reason. If successful, these farmers would be living in what is today called Fat City. I will let the various religious and scientific authorities determine whether the seven fat years followed by the seven lean years is mathematically accurate or just a very useful allegory. From a humble analyst’s point of view, the Biblical story deals with a beautiful description of both secular cycles and a tendency to reverse directions when a trend becomes historically excessive. Let me point out that small market caps seem to move in periods similar to the seven good years followed by seven bad years. Again the explanation for this cycle is a lot like the ancients looking at the nighttime sky for human answers; we could be looking at the wrong place.

I believe the small cap cycle is really a function of recognizing that prices are full for large, seemingly mature capitalization stocks, while searching for alternatives before the economic cycle turns down. My evidence is that operating earnings, if any, of small caps do not lead small cap stock prices. The best coincident indicator for small cap stock prices is the frequency and intensity of Initial Public Offerings (IPO), excluding the IPOs of closed end funds. Thus, when we examine the records of venture capital funds we see certain vintage years standing out as big winners.

The different types of cycles, and the various abstractions used to explain the cycles, in truth do not yield a useful understanding of what really drives the cycles. All we want is predictability! In particular we are searching for a predictable turnaround for a depressed and depressing market.

Allow me to look at the nighttime sky and suggest that the conditions are favorable for a turnaround. Since 1920 there have been 17 designated recessions in the U.S, including the present one. Only four of the sixteen recessions have lasted more than the current duration of 13 months. Narrowing the focus to exclude the recessions that began in 1920 and 1929, there were only two modern day recessions which lasted more than the 13 months, and they were both finished in 16 months.

There are lots of things wrong with these predictions, including:

  1. Stock prices and the movement of the economy are tightly correlated. Our bullish friends point out that stock prices have a discounting of the future function, and often the market anticipates the economy by three months or more.

  2. The current global economic malaise seems to be more like the destabilization period which began in 1873, when financial and political power was shifting from agriculture to the industrial sector. (Perhaps the real meaning of the US Civil War).

  3. The absence of an identified cause for the reemergence of consumer faith, that is faith in a better future.

Even though I do not have appropriate answers to my own questions, I want to believe in a turnaround as well as the availability of my next meal. The danger in searching for simple declarative, forceful answers is that we become vulnerable to the new Great Policy, Man or Party. (Now more than ever we need the minority to protect the majority.)

As they said on “Star Wars,” which really dates me, “Let the force be with you.” I say, “Let the cycles be with you.”

Sunday, January 18, 2009

Are There Big Traps in the Credits and Foreign Exchange Markets?

Serving on numerous non-profit boards, investment and finance committees as well as being investment advisor to various wealthy investors and financial institutions provides me with the advantages of having a wide source of information, opinions and talents. By regulatory definition these clients qualify as “sophisticated investors.” As each investment pool is designed to meet the specific needs of an account, there is only a minor degree of overlap in investments. Thus when I hear from different groups the desire to add a specific type of investment product or strategy, these desires become an important trend to consider.

Recently this development occurred when members of diverse groups from both coasts wanted to add investments in credits to their portfolios. They were not focusing primarily on bonds, except those that were in distress. Instead, they were focusing on mortgages, asset-backed loans, bank loans and other credits perceived to be in trouble. My concern is that both the credit and FX markets have similar characteristics which have been troublesome in the past. These are:

  • Over-the-Counter trading without central price reporting and settlement of trades

  • Unfamiliarity to most institutional and individual investors

  • The availability of high margin (up to 99% in some cases)

  • A largely unregulated global market without fixed market hours

  • Apparent hedging through complex derivatives

  • Trading requires specific skills and broad networks

  • Many, but not all, of the players are working for unfamiliar names

Note that often these credits are not in the form of securities and may not be under the aegis of the SEC. In most cases the search for such investments leads to managers who are not used for high quality investments and are often engaged with low fees. None of the managers have relevant track records, but all share the characteristics of wanting high fees and/or profit participation roles.

Certain aspects of this market may offer a prescription for high level, leveraged, and operationally intensive, price and fraud risks.

I have no doubt that there will be some money made in credits in the months and years ahead. (My definition of “money made” is the aggregate withdrawals that can be made after relevant taxes without invading inflation-adjusted principal.)

The search for credit opportunities is almost exclusively institutional in nature. The retail equivalent of this search is Foreign Exchange (FX). FX exists in the global 24-hour market whose heavy, cable-advertised drumbeats may mask some of its toxic nature. While there is a bit of institutional interest in trading FX directly, FX trading in size is usually conducted through bank channels. Many investors have learned to their dismay that price risk, with its relatively small movements, is not the only risk. In the credit and FX markets, counterparty risk should be examined; the other side may not be good for its trade. To many, the Lehman Brothers’ bankruptcy exposed the unfathomed depths of counterparty risk. The critical interrelationships of these markets are underscored by the name which many brokerage firms identify this combined market group: “FICC” standing for Fixed Income, Currency and Commodities. This group is traditionally a major user of its firms’ capital and a generator of profits, and more recently, large losses.

I am not advocating that one totally avoid investing in either credits and/or currencies. What I am suggesting is that instead of being a strategic reserve element to a portfolio, that these investments can prove to be high risk/high reward elements that should cause lowering the potential loss of permanent capital in other parts of the portfolio.

Sunday, January 11, 2009

Did Fixed Income Confusion Create Madoff Victims?

There are three principal reasons to own individual fixed income securities or funds. The first is capital preservation. In the balanced accounts that we manage for institutions and wealthy people, capital preservation is our primary concern in our use of fixed income. For these accounts, fixed income is meant to be a strategic reserve against the chance of significant loss from irreparable declines in equities. For more than a year we have executed this strategy by directly owning very short term treasuries, or totally pure US Treasury money market funds. At some point in the future we will have to extend maturities a bit as yields go up.

The second reason to own fixed income is the need to produce income. Neither equities nor high quality bonds are producing enough income today to meet normal endowment and foundation pay-out needs on their own, and certainly not enough income for balanced accounts that are also invested in future-oriented equities. However, the yields on fixed income come closer to the goal than equities do.

The third reason to own fixed income securities in a managed account or fund is to make a bet on the skills of a manager to anticipate interest rate moves, or to rotate through the various sectors or types of fixed income securities. There are managers that have records of making these shifts successfully, however over the long term these skills are probably even rarer than selecting successful rotations by stock portfolio managers.

Each of these three basic reasons is modified by two other considerations. If one believes, as I do, that inflation is a major concern in the long term, then inflation-adjusted paper should be considered in this part of the portfolio or possibly in the equity portion. The second consideration is taxes, which may suggest to some a heavy portion of tax exempt bonds and an understanding of how inflation-adjusted paper increases taxable income without immediate cash generation.

Many investors are challenged by wanting to own fixed income to fulfill all three needs. No single instrument can deliver at the same time on these requirements. Many investors, both individual and institutional, recognize the problem and turn their money over to a manager or fund to accomplish the task. In the end they want capital preservation, largely predictable income, and the ability to take advantage of the rotation of values, both on the long and short side.

While neither Mr. Madoff nor the feeder funds or operations he used ever pitched their investments as fixed income, the supposed record was long enough, and co-investors comfortable enough, to generate fixed-income like confidence. Madoff’s stated performance results in most periods were not as good as what leading equity managers produced, however (at least on paper), Madoff’s results were such that some investors could view his product as a fixed income alternative. Even if true, the performance was supposedly based on the skill of the manager, which should have been a warning that there was a lot more specific risk.

I believe many of these investors should have been investing in dull, boring fixed income, with some portion invested for capital preservation, a smaller portion in the generation of income and a very small bet on manager skills.

Sunday, January 4, 2009

Similarities in Picking the SUPER BOWL Winner and Fund Selection

For many of us, this is the season of selecting which team will win the forthcoming Super Bowl. This year is a bit different for me because of this blog.

One reader recently asked me about fund selection, and the analyst in me forced me to list selection criteria topics that could apply to each selection task. I stopped when I had listed 25 items. To reduce mental strain on your reading, and writing efforts on me, I will only briefly discuss 14 of the items. For other analysts and exacting types who would like to read the entire list, please send me an email,, and I will send you the list.

Before I begin, I should disclose that for the last 15 years I have worked with the NFL Players Association on their various retirement plans. I have been watching and thinking about the Super Bowl for many years before my professional responsibilities began.

SELECTION BRIEFS - For each selection point below, my Super Bowl comments are first, in bold.
The related fund selection comments are second in italics,
and my comments last, in plain type.

1. Compare the simple Won and Lost record compared with all other teams.

Compare Fund Performance Rank against all other funds.

Both sound bites are useful if the competition is in the past.

2. Analyze the success or failure in “Red Zones,” within 20 yards of the goal line.

Analyze the general price level of securities high vs. low.

Most of the time the game is played in mid-field or within normal price levels, but the big dollars are earned in extreme places both for the offense and the defense.

3. Examine the heroes, usually the quarterback and one or two backs or line backs.

Examine the Portfolio Managers or lead managers.

Unfortunately, little or no recognition is given to the offense or defensive lines (or analysts and traders). In many cases they make the guy up front look good while they do the hard work.

4. Understand that the Offensive Line protects the backs, creates the holes in the opposing lines and confuses the opposition.

Analysts, both within and outside a fund organization, see what others don’t or see it faster.

5. A Defensive Line breaks up the offense’s plays and protects their goal lines.

The contrarians look for weaknesses in momentum and uncover the big users of Cash.

In items 4 & 5, we see the importance of the supporting roles contributing to the success of the team and the fund.

6. In terms of compensation, both groups use financial incentives to motivate their teams. In professional football, the players have well-defined contracts.

In the investment world, most serve as “at will” employees, but often the bulk of their compensation is paid as a bonus.

Too often the bonus emphasizes current year performance and very little, if any, based on team-building and leadership.

7. A vital factor is the football team’s Front Office, who provides the financial and real estate resources to build the franchise.

In fund organizations, the business management often has similar responsibilities, including reporting to shareholders (both inside and outside), as well Holding Companies, particularly those of banks, insurance companies, and brokers.

Fund stakeholders usually have different (longer) satisfaction time thresholds.

8. Penalty-prone teams may try too hard, generating loss of yardage on the field, and fines off the field.

Similarly, a fund could wander or purposefully enter the “information gray zone.”

This straying action could negatively impact a fund’s performance.

9. Fan Support can be very encouraging at both open practices and game time, and may give some teams a big home field advantage.

Retail investors who buy with a broker’s assistance and 401(k) investors tend to be more patient than some institutional investors or pure no load investors who only focus on near-term performance or momentum.

The NFL team front office and a fund’s business management both understand the long term cost of losing their base.

10. The “Hail Mary Pass” is an extremely long pass thrown at the end of a game to attempt to reverse a losing score.

Similarly, a fund may have an out-sized position, often in a relatively, thinly traded stock during the last quarter of the year.

Both approaches have produced winners, but not as often as tried. Desperation does not produce comfort for investors nor fans.

11. A running game focuses on backs going through or around the defensive line, mostly resulting in short yardage that occasionally leads to big yardage and a score.

A fund, trading for small advantage in short periods often produces more highly taxed gains.

The tax orientation of the manager is often a good clue to who should own the fund.

12. The fact that any team in the league can win on any given day is particularly true in the last three games, especially after the teams that do not make the playoffs are eliminated.

A fund’s “season” is its performance, annual period. It is unlikely that a bottom performing fund can become a top performer late in the period, but it can happen. The winners are likely among the current performance leaders, or among those showing momentum. This is particularly true in a tightly defined peer group.

Do not despair for this year’s laggards. Often a particular period is being used to develop a winner over a longer time period, particularly when, or if, market conditions change.

13. What about a “Winners Curse?” To the best of my memory there has never been a winner of four consecutive Super Bowls.

The same can be said for funds. Except in the case of a long market, rarely do winners repeat three years in a row and even twice is difficult.

The winners become celebrities and at least become more expensive, if not more difficult to manage. The winners attract fair weather friends and fans who are more demanding than those who were steady company in the dark days.

14. Dynasties are extremely difficult to sustain. Start with the Winners Curse and the absolute fact that each year humans get older and more prone to the trials of the flesh.

Among these mortal groups are team scouts, who may miss insights or talent opportunities.

In the investment world there is no business-wide compensation cap, and only 100% of equity that conceivably could be redistributed and most of the time much, much less.

So after all this analysis what are my choices for ’09? You will understand that I can not make a public prediction as to the winner of the Super Bowl as all the participants are clients. However, going through the thought drill of the above items, I do not see that any single team has an overwhelming advantage. My guess is that the two finalists will be a surprise to most of us, and particularly one of them. The key question is whether the game will be close, which is a function of luck and the Zebras (the officials). So I root, as I do each game, for the Zebras. May they call a good game!

In terms of fund selection, I will go just a little further out on a limb for the non-paying crowd. First, I do not expect a repeat of this year’s winners. I expect the winners in 2009 to be more diverse than this year’s Dedicated Short Biased funds. The winners will be based on their individual security selection skills, which can be found in equities, fixed income and international securities. A top down approach will not be effective enough.

A number of winning portfolio managers will come back from long-forgotten victories, while other winners may be inexperienced investors who did not see the same risks that their colleagues feared in 2009.

Let the Games begin...