Sunday, July 6, 2014

Top Down is Popular, Easy and Wrong


We are all victims of time management. In school, our classes are usually under an hour; we select articles to read based on headlines; our media diet is largely based on twenty second sound bites; our instructions to and from co-workers are brief. In almost all cases these inputs start with an overarching declarative statement followed by the identification that there are supporting details, but these are rarely discussed. The initial overall statement is designed to be accepted without any serious debate. Whatever details that are mentioned are all expected to be in support of the grand top down statement. Over a lifetime of inquiry in just about every activity, I have learned the best defense against the power of the grand statement is the phrase “God is in the details.”

The “Franklin Close”

The American Revolution, unlike most revolutions, was not about the transfer of property to aggrieved masses, but about tax and trade regulations. (The Boston Tea Party was a symptom of a detailed complaint.) One of the wisest, politically most successful, and a good investor/merchant was Benjamin Franklin. Dr. Franklin’s technique in bringing together the strong personalities of fellow members of the Continental Congress was to arrange a list of the positive arguments on one side of the page and the negatives on the other side. His skill was shown in that the number of supporting details was often uneven. Thus the side with the most arguments usually won. For years this technique was called the “Franklin Close.”  In his presentation he appeared to have martialed all the important details and thus his preferred solution had the benefit of seeming to be a well balanced point of view. In the give and take of the debate, the wording of the overall proposition was modified and the final version received general support.

In today’s world the top down statement is expressed as an immutable law for which there can be only full acceptance. Further, because of time constraints and general impatience there is no room for a thorough discussion of details. Typical of these top down pronouncements which lead inexhaustibly to a specific investment conclusion are:  “If interest rates go up, the mid-term election will dictate the next US president.” “A rise in the price of oil is bad,” etc.

Why I am wary about Top Down analysis

As a professional analyst I am trained to take either side of these top down pronouncements. Often, I find that the proponents do not have the command of all the relevant facts and certainly do not understand the other side. For example, I could proclaim that the US economy is getting better for our local town because  I saw a placard in front of a bank reading “We are making loans.” While the overall view may be correct, extrapolating from a single or a small number of signs does not constitute proof positive. Occasionally there are technical factors which drive a particular input that can be misleading. For example, in last week’s post I noted with surprise the sharp rise in the average interest rates paid by banks from 0.37% to 0.43%, a significant change from one week to the next. I mentioned that it could be caused by some technical factor. This week the rate dropped back to 0.40%. I was hoping that the sharp increase in the week before was a sign that banks needed deposits because of a surge in loans. While this may be true, I suspect that at least half of the sharp run up in rates may have been caused by some banks who for regulatory purposes wanted to show more deposits that would reduce their ratio of loans to deposits.

Successful investors are concerned about specifics

When I spend time with successful investors, particularly with competitive portfolio managers, they quickly dispose of geopolitical, economic, and interest rate discussions. What they want to talk about are individual investments and the details behind them in a balanced discussion. Often they use a modified “Franklin Close” to cap their views. The other evening we were having dinner with a well-known manager. He was concerned about a particular trade in Japan. I found it interesting that there was no chatter about the general economic outlook for Japan. When I really go into detail with a manager I discuss the significant losses that he or she had. It is almost like the proverbial fishermen when they chat about  “the one that got away.” These are not top down exchanges.

The biggest problem with those pundits and others with their top down pronouncements is no one has a particularly good record of being right on the specific view or its impact on the price of specific securities. Perhaps we can secure better results if we require history teachers to stay with facts and most importantly figures and avoid thematic lessons. Maybe economists should only teach microeconomics, not macroeconomics; and there should be no financial/investment briefs in the media without someone representing the other side of the page. These modest proposals will not happen, thus my advice is to save your attention capital for detail discussions that are balanced.

Facts that could cause future trends

The following comments could foreshadow important future trends:

1.  Company-sponsored sports events such as softball with other firms are declining. Though in the past this activity has led to inappropriate hiring practices, such events were considered team-building for employees.  This decline symbolizes a significant change in business philosophy, and this is having impact on overall employment totals, length of employment, and long-term valuation.

Lifetime employment is being curtailed as being too expensive in its current and retirement phases. Some may question the productivity advantages of more senior employees, I don't in intellectually   challenging occupations such as the investment advisory segment for intelligent clients. There was a time when to be considered well-managed an organization had to have a deep bench and one or more good replacements for each critical role. This is not the case today in many instances. As I have been involved both as a buyer and seller, I know that part of total acquisition cost is often restarting the firm, thus impacting the value of the deal. A lower terminal valuation should lead to a lower current price earnings ratio. Therefore one could say that striking out in industrial softball is a bad play for both the economy and the markets.

2.  US World Cup Team member Omar Gonzalez‘s comment: “We will never give up, it is ingrained in US spirit.” (A possible return to a wider belief in US exceptionally?)

3.  Martin Wolff in the Financial Times noting that the US recognizes the correctness of the BIS cautionary statements, (mentioned in my last week’s post) but does not accept its austerity solution.  In the US we continue to want to “have our eat cake and eat it too,” even if it makes us eventually sick.

4.  PIMCO Total Return Fund is having net redemptions, but its ETF version has net sales. This shows that investors, perhaps guided by advisors or gatekeepers are reacting to the poor performance of the last couple of years, whereas hedge funds and other more speculative investors are looking forward to markets where this portfolio will do absolutely and relatively better. This dichotomy shows the very real difference between mutual fund and ETF investors inhabiting the same portfolio.

What are you seeing that might influence your investments, particularly anything that will cause you to transact?
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