Introduction
Sales people of all types are taught the doctrine of KISS, Keep It
Simple Stupid. A more urban version of this is the “elevator speech” to be used
meeting a client or prospect in an elevator and designed to be delivered
quickly and simply in the time the elevator
takes to go from the lobby to the floor of the intended client’s interest. Both
of these approaches prize getting an intended result rather than a transmission
of understanding.
William Shakespeare, market analyst
In his masterpiece of summing up trouble, Shakespeare has the three
witches in Macbeth, Act IV, Scene I intone “Double, double toil and trouble;
Fire burn and cauldron bubble.” This may be the first literary introduction to a market bubble. Notice the words
“double, double.” In the investment marketplaces, a requirement for a “bubble”
is a phenomenon of great popularly-driven walls of money flowing into dotcoms,
housing, derivatives, treasuries, and high yields. Note there is nothing wrong
with any of these investments in moderation, but when they enter into the phase
of double, double, or much more there is danger of being in violation of the
concept of prudence by not avoiding large losses. (In handing his ruling against
Harvard College in 1830, Judge Putnam intoned the famous “Prudent Man Rule”
which required a trustee or fiduciary to do those things that other men of
intelligence and prudence did with their own money.”) This ruling created a peer-related legal
concept of prudence. By definition, if there are large holdings in a security
or sector, when they go down there is limited demand for the falling securities
which will lead to even greater declines.
Camp followers or market followers
In many European wars the armies were closely followed by a bunch of
women; some of these were the wives of the soldiers, others pursued a more
professional type of transient relationship. The wives were interested in the
long-term, the second group were more interested in the action of the moment. I
see a parallel to the second group in some of the emerging trends today.
This week the MacArthur Foundation recognized Professor Colin Camerer from
the California Institute of Technology for a genius award. I am a Caltech
Trustee, thus my wife Ruth and I know and prize Professor Camerer for his
leadership of a group of graduate and post-doctoral students who finished their
work at other universities. Their combined study that linked blood flows in the
brain to financial decisions showed that sophisticated risk-taking investors
rather than neophytes were more likely to get caught up in playing bubbles. (Two
well known brains who lost a great amount of their wealth in past bubbles were
Sir Isaac Newton and Winston Churchill.) When I read about Colin’s success I
wrote that the victims were
in effect playing the old market ploy of the 'greater fool theory'. My good
friend and regular Wall Street Journal columnist Jason Zweig had the same conclusion.
The greater fool theory works on the basis of buying and holding an investment
at a price that is disassociated from reasonable value on the basis that there
will be a bigger fool who will pay an even higher price. Essentially these “fools”
are letting the market make their decisions for them on the belief they can
identify the ultimate fool. (Not themselves, of course.) It didn’t work with tulips
or any of the other previous investment bubbles.
Where is this present bubble?
Over this past week and on a recent trip to London I was made aware of
investment managers who on the basis of their back-tested data make the claim
that they can produce better than market results due to their timing and
selection of market sector skills through the use of Exchange Traded Funds
(ETFs). As with other vehicles which can be driven too fast, ETFs are based on
a safer, older model that had a more prosaic basis. Having given up on
selection skills in picking managers or securities, many financial institutions
are opting to closely match the market through low-cost index funds. (Unless
the profits on securities loans or smart intraday trading are particularly
adroit, the fees charged most of the time mean that the index vehicle comes close to matching the reported index
return, but rarely produces the exact return of the index.) The merchandisers
of securities recognized that using an index in a publicly traded security opened
up opportunities for them to generate commissions, spreads, arbitrage
opportunities and margin interest and thus became advocates of ETFs (Bubble,
double bubble). Further, hedge funds found a safer vehicle to short against the
risks in their long positions.
KISS and Elevator Speeches seem to be working. Each week I look at the
net flows into ETFs and mutual funds as produced by my old firm now known as
Lipper, Inc. In these reports the volatility of the dollar flows into and
occasionally out of ETFs are larger than mutual funds even though the total
size of the fast growing ETF business is considerably smaller than the mutual
fund business. This is beginning to feel like the players of the day are
increasingly playing the greater fool theory. I don’t know how long this phase
of the game can last.
The revenge for 2008
Diversification became the buzz word for safety in many financial
institutions. The assumption is that if one is invested in a number of
different asset classes and sectors one can’t lose it all at the same time.
This belief was based on a mathematical model that showed traditionally
different market sectors were not particularly well correlated. However in 2008
almost every stock and bond around the world went down, except for treasuries
and some small markets not usually held by foreigners. The spread of
correlations collapsed. In reaction to
this painful experience many chose to play the market in a risk on/risk off
fashion. For a lot of these players the ideal vehicle was and is today, ETFs.
(double, double bubble).
A study of history may suggest that we are in the midst of a Hegelian
Synthesis where one trend creates an opposite trend and prominence of one over
the other reverses. We may be heading back into a market of security selection
not index trends.
The lessons of George Washington
One of the lessons from this weekend for Ruth and I with some good
friends came from the dedication of a national library for the study of the
first President. In the dedication of the library at Mount Vernon, the well known
author David McCullough said George Washington had no better than a sixth grade
education, but his library and his letters showed that he learned a lot. His
first military battles were defeats but he learned to be a brilliant tactician
using maneuver and surprise that my Marine Corps text books value so highly. He
was a great leader of men getting his troops to stay with his ragtag army when
their enlistments were up and farming season was looming. He stopped a
potential army take-over in its tracks by just addressing the troops. Of all
his manifold skills the greatest of them all was his leadership.
Applying General Washington’s leadership to your portfolio
How do you avoid the group think that is surging through the use of
ETFs and other index-hugging approaches? George Washington was not afraid to
try different things. He found and led other generals who were more trained in
the arts of war than he. He kept his eye on his strategic goals and did not
focus only on tactical moves. He endured the loneliness of command well. In the
context of today’s investing world this means picking securities and managers
who are different and that are focused on the strategic goals of the account to
deliver funding when needed.
Are you strong enough in your investment beliefs to escape indexing a
major portion of your investment responsibilities? Share your views with me
privately or publicly.
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