Sunday, July 29, 2012

The Investment Danger in Models

I have spent a good bit of time over the last decade conversing with portfolio managers with good to great long-term records. But their current performances are far from stellar. What has happened?  I might stretch to answer with a paraphrase from Shakespeare, “Aren’t they honorable men (women)?”

Last week’s blog focused on the way most of our brains work, relying on short-term memory to make current decisions. Those who have had damage to the frontopolar cortex portion of the brain rely on longer term experiences. This dichotomy has made me wonder how we think throughout life. As a baby we find food and compassion wonderful and wish to obtain more. We learn to quickly translate the specific pleasure to an expected generalized pleasure. Our formal education continues to use the appeal of future benefits as a reward. By the time we formally learn about finance and investing we are hooked on the generalized rewards that can be programmed into our actions. Particularly in schools of so-called higher learning we are introduced to mathematical models. In effect, the models substitute for the reality that is available for inspection.

Time pressure

In college and graduate school as well as most entry level jobs in the financial community, we must immediately start plugging numbers into the models provided to be one of the first to solve the problem in the expected way. Rarely do we take the time to understand the historic development of the model and how the immediate conditions are different from those present at the foundation of the model.


Bankers, borrowers, and other lenders took the published Libor rate as the price for high-quality borrowers.  In terms of the US dollar Libor, they did not focus on the fact that this was a private collection of expectations of sixteen banks set in London. On many days during the crisis of 2007-2008 there may not have been a single loan at the expected rate. Further, the calculation excluded the four highest and the four lowest expectations. If one wanted to manipulate the rate one had to “reach” the middle eight to rig expectations and these middle eight could change every day. During this period there was practically no confidence on the parts of banks that other banks would repay the loans promptly. Thus the conditions that led to the creation of the model were very different than the conditions during this current bank crisis. A prudent person should not have looked to Libor as a reliable rate-setting mechanism. In a moral sense the criminals in this situation were those that used the mechanism without comprehending and revealing its frailty.


The establishment of “The Single Currency” was an attempt by Western (Continental) European governments to replace the US dollar as a reserve currency for intra-European trade. The single currency was meant to be followed by a series of additional political, economic, and legal moves. These provisions would provide backing for the currency. Long before the current problems with the PIIGS, (Portugal, Italy, Ireland, Greece, and Spain) there was a strong clue that the people of Europe did not truly support their intended union. The politicians wanted to stop the bloodshed in the Balkans, calling for NATO to provide the muscle to end the conflict. The only problem was that the various countries would not tax their populations enough in money and manpower to bring a military victory. In the end the US had to provide the additional muscle that was needed. There is an important lesson here. With rare exception, a permanently strong currency rests on both a sound economy and the bayonets that are willing to enforce the government’s will. (Perhaps I have had too much US Marine Corps training.)

I do not know if the recent brave statement by the ECB will temporarily turn the tide. Similar statements “of whatever it takes” have been an invitation to hedge funds and other speculators to move against the currency. Remember, speculators can leverage more en masse than central banks can. Stopping the run on the currency without permanently addressing the deficit will be insufficient to hold the euro up. (I hope our European brethren do find a way to address their deficits as we in the US will need an inspiration.) However at this point, if pressed, one would have to say the euro model is failing.

Indexed ETFs

While it is too early to call Indexed ETFs a failure, I am beginning to see some early warning signs that investors are not paying attention. Recently I was with the senior investment officer of a multi-billion dollar fund with a small but ample staff. I was concerned that he had a considerable number of investment funds in which the group was invested. My concern was even with his staff, did he have enough professional help? He felt he did, in that he did not have to devote much time to his index funds. At the moment he could be correct. However, I see two areas of concern. First the change in the weighting of individual stocks within an index. Within the S&P 500 one can see the rapid escalation of the weight of Apple and the decreasing weight of the older “Blue Chips.” Second, at some point these changes may call into question whether or not the index is an appropriate measure for various institutional needs. If that were to happen quickly, there might be some pressure on ETF liquidity considering the large hedge fund holdings in many ETFs.

Looking beyond the models

The current models in many shops today call primarily for US cyclical and recovery stocks.  As you might suspect, I will be looking for something different. In my quest for long-term investment additions to the accounts of my clients and family, I seek inputs from a variety of sources. If you have any insights to deliver to me privately, please do so.  I would also be happy to talk if you would like to join our growth adventure.
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Sunday, July 22, 2012

Brains are Wired to Produce Long-Term Losses

“Don't blame me for the way my mind is wired, nor how I made wrong choices over my investment life.” This statement is a cop-out,  equivalent to the old Flip Wilson line "the devil made me do it."

One of the reasons to read Jason Zweig's column in the Wall Street Journal every Saturday is that he is one of the few columnists who regularly reads, understands, and reports on academic papers found in the learned journals.

Brain wiring produces long-term losses

In Jason's column this week, he reports on a study published by the Journal of Neuroscience. The authors of the paper were professors/researchers from Caltech, NYU, and the University of Iowa. (Disclosure: I am a trustee of Caltech and have supported some of its work in examining how brain functions drive investment decisions. Furthermore, I seek to keep current with NYU and the University of Iowa, as a grandniece is entering NYU and Ruth and I know a number of successful graduates from UI.)  These studies indicate that most people rely on short-term memory to shape their actions. Therefore immediate past successes count more than longer-term experiences. (My technical analyst friends have known this for years under the rubric of momentum investing.)  This pattern conforms to Newton's First Law of Motion whereby a body in motion stays in motion, or as commodity players often believe, "the trend is your friend." The portion of the brain that is wired to produce these results is called  the "frontopolar cortex." People with a damaged frontopolar cortex do not rely on short-term memory, but are more influenced by a combination of long-term trends.

Performance significance

While there are not many short-term traders that have been able to put together a career history of above-average investment results, there are more successful long-term investors. The secret to their results stems from the ability to buy sound companies when they are unpopular. I have known a few of the managers that exhibit these attributes, including Warren Buffett, Charlie Munger, John Neff, and Sir John Templeton. 

In terms of today's global markets, I would suggest that a heavy commitment to growth-focused mutual funds or equities would be a good place to start.

The same rules apply in the political world

The current crop of political leaders are also reacting to short-term focused issues in preference to addressing the longer-term problems. Their global focus is on the momentum in the latest polls, or what American political leaders call the "Big Mo." These are politicians not statesman. Perhaps even worse is the tendency of central bankers to follow the politicians rather than to focus on the structural threats to their nations.

Forthcoming blogs

Ruth and I are in California for the Caltech board meeting after listening to good music at the Aspen Music Festival. I suspect next week's blog or the ones thereafter will focus on investing in technology and the importance of what is happening in China. If you have any views on these topics, please share.
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Sunday, July 15, 2012

Risk Controls Hurt Investment Profits

Investors are giving up too much on the upside

The financial world is being buffeted by credit risks. To protect investors from large unexpected credit failures, various risk control approaches are being used. A look at financial history suggests that hiding a problem only makes it worse when it is revealed. In the meantime, by hedging the risks, money is taken away from more productive investing at today’s low prices. Those that are doing the hiding, hedging and manipulating of the markets are concerned about career risk for themselves or their leaders.  I believe we should deal with the present unpleasant problems,  re-set our levels, and unencumber the potential upside.   

Questions for Jamie Dimon

I was one of the analysts and portfolio managers that attended the early morning analyst meeting masterfully presided over by JPMorgan Chase* CEO Jamie Dimon. Both in his presentation and the two accompanying presentations, attention as well as most of the analysts’ questions were focused on the CIO (Chief Investment Office) and the “London Whale” losses. Many who know me either directly or through reading this blog may recognize that when all or almost all attention is focused narrowly on one topic, I try to explore other areas that I believe can be more fruitful. Thus I asked two somewhat related questions about derivative exposure. The first was, “With some $86 billion in derivative assets and $76 billion in liabilities, how much was netted with the same counterparty?" The second question was how much of the June 30 statement included the CIO debacle?  The answer to my first question was that the subject was covered in a previous presentation to analysts as to the complexities of its management of derivatives. My second question was answered with the statement “very little.” The answers delivered were not satisfying.

What was the JPM CIO designed to do?
Purportedly the office, among other tasks, was meant to hedge some of the loans made by the bank. These loans of various maturities were with governments, central banks, commercial customers, and other banks. A bank can only stay in business by accepting some of the risks of making loans. JP Morgan does some of the best credit work of any large bank, thus it had to have some inkling as to the type of credit losses it was exposed to through its loan portfolio. Considering what has been going on in Europe for the last year, one would assume that JPM had some worries as to its loans to various European financial institutions. (Reportedly the large loss was in a derivative that tracked the credit of large US commercial entities. However this does not totally eliminate a concern about some large European Banks.) I do not know whether there were additional concerns about prompt payment from certain derivative counterparties, particularly if the originating derivative transaction was not executed through an exchange with a strong clearing house behind it.
*For many years I have owned shares in JP Morgan, but they are not currently owned in the private financial services fund that I manage.

JPM and Libor

Somewhat more understandable was Jamie’s ducking questions as to the ongoing Libor investigations. (Wouldn’t it have been interesting to hear his views from his place on the board of the New York Fed?) Some may not see the connection to the two probes, but I believe that they are getting to the crux of the overriding problem facing investors and financial consumers.

Too much fudge can make one sick 

As kids we all liked sweet things, I was particularly enthralled with brown sugar fudge. After a while it became clear to me that eating too much fudge made me sick.  As an adult, I find the “fudging” of data makes me equally unwell.
Since probably sometime in 2007 there was an attempt by some to manipulate the Libor rate. One of the repeated mistakes of the financial community is to use a particular metric designed for a specific purpose for other uses. (My favorite misapplication is the use of price/earnings ratios to identify cheap or expensive, growth or value stocks.) The original purpose for the daily setting of a US dollar Libor rate, was to estimate the rate that banks would pay for US dollar loans from other banks  on days when there were no known transactions. The methodology used was for sixteen specified banks with operations in London to indicate what it would pay for money. Reuters, now Thomson Reuters**, would collect the data, then drop the four highest and the four lowest samples and take the inter-quartile mean of the eight central results and report that calculation to the British Banking Association which authorized its publication as an estimate. 

The rate was never designed to be an interest rate arbiter for non-banking loans. When floating rate paper was being developed first at the wholesale level and then on the retail level, some “bright person” at a law firm or an investment bank grabbed Libor as a well-known daily fluctuating interest rate that the London market controlled rather than a US Treasury rate. Starting in 2008 some in the marketplace were getting concerned that the interest rate estimates were being influenced by traders for the benefit of their trading positions. At any rate the British government used its knowledge of the individual bank submissions as a possible indicator that a bank with a high rate needed to use the high rate to attract capital, for it was perceived to be having problems. It is alleged that the Bank of England, the central bank, did not want to have to rescue another failing bank, suggested to at least one bank that it need not always be the highest bidder for money. No one is publicly discussing that banks that submitted lower rates did not expect to get additional loans or equity through the marketplace and thus following a US Marine Corps tradition, “kept off the skyline.”  The rumors of these concerns probably entered the hedging practices in JP Morgan’s CIO as well as others who were in the business of making loans to banks. (Confirming this assumption would have helped in understanding what the CIO was doing in its proper hedging activities.)
** In 1998 Reuters bought the operating assets of my old firm, Lipper Analytical Services for cash. While currently a user of the firm’s data and an occasional columnist for Reuters, I have no contractual relationship with the company. Both the fund I supervise and personally I own shares in Thomson Reuters.

The Third Aberration To Sound Investing

In addition to the CIO errors and Libor manipulation, the very same concern for the safety and soundness of banks in major countries of the world has led to various central banks rescuing specific banks and banks in general by flooding their economies with cash as well as driving down interest rates. These low interest rates do not recognize the credit risks in the marketplace which has two impacts:  the first is to dry up the lenders’ willingness to lend to the borrowers, which slows the economy. The second and more insidious is that individual and institutional investors that we serve cannot meet their ongoing income needs in high quality investments. Thus they seek other investments with enlarged credit risks so that they can pay for people’s retirements, pay reasonable wages to those devoted to the non-profit areas and provide capital for future expansion of facilities and employment. 

What do you think?
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Sunday, July 8, 2012

Investment Traps: More Evidence


Last week’s blog suggested that the surge of Friday, June 29th could have been a trap for unwary investors. There were three different baits in the trap. They were the relief caused by the US Supreme Court’s decisions on Obamacare, the surprise and pleasure that the latest European summit led to some agreements on loans to troubled banks, and favorable market enthusiasm and market volume. Today we examine each to see whether they are baits or poisoned fruit.

The Supreme Court did not provide needed answers

This is a blog for investors that have substantial, for them, investment portfolios; not for lawyers nor politicians, even though they have been known to have large portfolios from their private sector investing. The implications going forward are that there will be a tax that some wish to call a penalty. (Aren’t all taxes penalties?) The Court’s focus should be interpreting the US Constitution and the conflicts between state and federal law, not to make overt economic judgments. Nevertheless, the decision that taxes or penalizes people for not buying medical insurance has large and unknown economic impacts.

More to the point, I have little confidence in the supposed results of Obamacare. The annual costs to society will be large and disruptive, creating uncertainty in the reactions of individuals, businesses and the medical world. Thus far I see nothing that will lower the society’s cost or more importantly, improve the quality and quantity of healthcare. From an investment viewpoint the Court’s decision leaves open the impact of its actions and thus makes it easy to continue the indecision on the part of employers to hire employees. Over time I suspect that it will lead to more work being put out to small contractors that have exclusions in the present regulations. Bottom line, I see no reason that the markets should rise on the basis of the decision. 

Summit agreement is illusory

By the end of the day Monday, we will learn from the meeting of finance ministers in Brussels how they are going to create a single European bank supervisor. This is not a trick question but a trick that Germany played on the supposed agreement to allow the European Central Bank fund to grant loans directly to banks. This single supervisor would supervise the safety and soundness of all banks in the seventeen countries that use the lamented Euro and by implication all banks in the other countries within the European Community, e.g., the UK. With both the Finnish and the Dutch governments looking for specific collateral and other terms, there does not appear to be much confidence in the existing financial statements of at least some banks. In voting their support for these loans, the German legislators insisted on one of their pet projects: a European (and from their viewpoint, global) transactions tax. London is having enough trouble holding on to its prominence as a financial center with the growing LIBOR scandal that would prevent it from buckling under any continental scheme in the foreseeable future.  The highly respected but controversial economist from Citigroup, Willem Buiter, is quoted as saying “the EU summit measures still fall far short of what is ultimately needed to ensure survival of the Euro area.”

Read with skepticism and believe it won’t happen

I wonder whether we will see the burial of the “Too Big to Fail” concept and recognize the inevitable; that while painful in the long run, it is cheaper and more efficient to let various banks go under. Their smaller replacements will be sounder. I am probably too premature, but the odds are improving every day that this historic approach is still the best one.  I recognize that letting banks fail could in turn lead to some governments defaulting, perhaps as in the past after extraordinary attempts to inflate their way out. After inflation eventually comes deflation; either quickly or agonizingly slowly as in Japan. The lesson from distressed investing is that the quicker the filing for bankruptcy, the smaller the losses sustained by the creditors.

Probably all or nearly all of the summit participants will fight against the fundamental recognition of the structural problem. Thus the ministers in Brussels may find a way to paper over these issues on Monday, but confidence is once again low. (Even if gold drops to a bottom of $1200 an ounce before a subsequent rise as some predict, the trading loss will probably be less than holding so called high-quality paper, the principal reserve element in lots of portfolios.) 

Market mechanisms no longer favorable

On the 29th the reported volume on the New York Stock Exchange was 4.1 billion shares. This week the average daily volume was 2.7 billion shares, or a retrenchment of more than one-third. After Friday’s release of US jobs numbers, the lack of enthusiasm was palpable; pundits were stating that we have entered a stall speed. Experienced pilots and other flyers know that crash landings are probable in a stall unless there is rapid acceleration. 

We are seeing an increasing number of money market funds as well as hedge funds leaving the business. I am also seeing a small number of active equity funds being replaced by their shareholders or management companies with Index funds or ETFs.

To some degree all of this bearishness is a good sign. Bull markets begin when almost all are discouraged. Based on the past however, we need to see capitulation which we have not yet seen. We might if interest rates were higher.

Please share with me your views as to the opinions expressed.
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Sunday, July 1, 2012

Friday’s Market: An Investment Trap?

The Dow Jones Industrial Average rose 277 points on Friday, June 29, for a single day gain of 2.2%. The Standard & Poors 500 rose even more to 2.49%. Our own financial services private fund jumped 3.15% on a gross basis. That gain represented approximately three quarters of the estimated gain for June which in turn is about one-half of the six month’s gain. Clearly, I don’t want to give back Friday’s gains, but I am concerned that Friday’s market action could be setting a major trap for all of us.

A trap works if it looks to be relatively attractive compared to other actions. In this case there was the confluence of three incentives:  (1) favorable news as to the Euro crisis, (2) the Supreme Court ruling on Obamacare, and (3) the market mechanics. As we examine the three items, we need to recognize whether they are poison fruit.

The Euro trap

The agreement made early Friday morning to permit the central market to make funds directly available to the Spanish and possibly the Italian Banks requires the creation of a single banking supervisor for the 17 member countries that use the Euro. The supervisor is meant to be in place by the end of the calendar year and thought to be imbedded within the European Central Bank (ECB) with funding to start in 2013. If this were to happen on schedule, it might be considered the eighth Wonder of the World. First to get these particular seventeen countries to agree quickly will be very difficult. Already both Ireland and Greece are looking for similar bank support that does not raise the nominal debt of the country.  Until the money flows from the center to the banks, there is a good chance that depositors will shift their assets to stronger banks and/or currencies. These actions may cause substantial changes in market shares of specific banks. I wonder how the scheme to have a single bank supervisor is going to attract the other members of the European Community that do not use the Euro currency? In particular I question what would cause the UK to give up its banks’ sovereignty?  Without the UK, and the Scandinavian countries inside the tent, I do not see how the other banks will agree. One of the provisos that the German legislature required in their rapid agreement was a transaction tax. If this tax is put into place for all of Europe, Europeans will have ceded a good bit of the institutional market to the Americans and Asians, a very improbable event. Bottom line, I am not swallowing that the agreement on the Euro is really going to help any time soon.

The supreme trap

Along with practically everyone else I was surprised how the US Supreme Court ruled on the Affordable Care Act. Having read parts of the decision and much of the commentary produced by legal scholars and political pundits, my conclusion from a practical viewpoint is the decision just opened up many more questions than it attempted to answer. For approximately thirty years I have been inordinately concerned as to the rise of healthcare costs within the US. Initially my concern for the rising costs led me to complain to my firm’s trade association, the Securities Industry Association (SIA) as to the annual increase in health insurance premiums that the medium and small sized brokerage firms like my own were paying. In answer to my gripes, as is often the case, they invited the complainer to sit on the board of the captive insurance company. While on that board I did find some inefficiencies and failure to optimize the float for the benefit of the members. No matter what the other members of the board and I did we could not prevent annual premium increases of double digit percentages.

After that experience I felt that the hospitals were inefficient and therefore costing the patients and their insurance companies too much and once again the curse of being a complainer struck and I was invited on the investment committee of the local community-owned hospital. Once again costs continued to escalate. This in turn led to a series of mergers with other community-owned hospitals and now I find myself on the Financial Oversight Committee of a complex of three hospitals. Still the costs keep growing. Finally, my wife and I have informally become the healthcare reinsurer to cover expenses that are not picked up by others for a large and growing family.  Thus the rise in healthcare costs really does matter to me. The way I read the decision and the various expected “fixes,” follow-on legislation and regulation, all will add to our costs. Further, I see very little that will improve the quality of healthcare or increase the number of doctors and highly trained nurses and technicians. As you may suspect, I am gagging on the benefits of the Supreme Court delivered fruit.

Fruits of the marketplace

At the end of the trading day, the New York Stock Exchange produces a list of large trade imbalances that wish to have an execution at or near the close. On Friday there was a materially larger than normal list of stocks with an imbalance. I am guessing that the imbalance was many more shares were wanting to be purchased than sold. I am guessing that at least the final twenty point surge in the DJIA was caused by the desperate need for these trades to be executed. Based on my experience as a former member of the NYSE, I believe that some of these trades (as well as some of the above average volume) were initiated by market professionals to add to their first half published holdings, reduced cash positions, and covering exposed short positions. (In the weeks prior to the quarter-end the number of average volume trading days needed to cover shorts rose.) I view each of these trading factors as transitory and cannot be expected to play a similar role in the days and weeks ahead. 

Throw out the implications of June 29th

As regular readers of this blog know, one of two of my most important learning institutions was learning to handicap (analyze) at the race track. One of the lessons in examining past performance was questioning which results were normal and therefore had a higher likelihood of repeating and which were abnormal. In terms of the latter, I learned to disregard atypical events as I had less confidence of a repetition. Using this hard earned logic I am suggesting to throw out the implications of last Friday. 

Having suggested ignoring Friday results, Sunday night and early Monday morning I will be looking at Bloomberg Television. The Sunday night focus will be on Asian markets. Europe is both an important source of trade and bank capital for the Asians. If their markets continue the New York rise, I could be wrong as to the significance of Friday. This trend could be reaffirmed by opening trades in the major stock markets in Europe.

If there are dramatic changes suggested by these trading sessions, I will send out a follow up bulletin. For those of you that depend upon social media, please let me know how I can reach you with a brief message.

As of the 28th of June

The following thoughts stated briefly were going to be the basis of this week’s blog before the 29th surge.

1.  Marathon Asset Management, a London based global asset manager, has a well-written monthly letter focused on the current battle between the optimists and the pessimists. As a long-term investor with a long portfolio, Marathon is clearly in the optimist category.  However the letter introduced the concept that  “a pessimist is an optimist with better information.”  The logic implies lots of reasons to be optimistic, but grants the pessimists the recognition that those good times are further ahead. I would suggest the recently announced trend of a slower rise in consumer spending than consumer income plays into the timing question. In the US, spending patterns may be suggesting that consumers are self-imposing their own austerity program which is bad for consumption, but good for savings long-term.  The result is better for the markets that long-term investors care about. The current downgrading of corporate sales and earnings guidance is reinforcing this trend.

2.  Moody’s* in its Weekly Market Outlook  produced an interesting analysis on the predictive power of the yield spreads between high yield bonds and equivalent maturity US Treasuries. Currently the spread is 100 basis points  higher than normal. This is a bit strange in view of the expected default rate which is below normal at about 3.5. The current spread suggests a default rate of 10%. This is an important bit of analysis for two reasons. First traditionally the bond market is ahead of the stock market at sensing economic and financial problems. Second, there can be another explanation along the lines of the old adage, “if the bridge won’t go up, lower the water.” Maybe the enlarged spread is indicating that in this interest-repressed world, treasury yields are not representative of the appropriate yield to give holders a real return after inflation. I am slightly more concerned about the second interpretation than the first.
* Moody’s common stock is owned in our private financial services fund.

For any of our blog readers who would like to discuss the two longer term items of my focus on the implications of June 29th, please contact me.

For those in the US, I wish you a happy and healthy July 4th Independence Day. To our other readers I will be checking your markets on the 4th and hope that they are kind to all of us.

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