Sunday, October 4, 2015

“Fox” Forecasting vs.
Data Dependent Hedgehog


The great and late Yogi Berra, said "You can observe a lot by just by watching." I will attempt to see the future by observing the results of the recently concluded third quarter of 2015. My attempt will be as a “fox” forecaster rather than a “hedgehog,” as described in a new book, The Art & Science of Prediction by Philip Tetlock and Dan Gardner. They divide predictors into two animal groups the hedgehogs who focus only on a very few variables in order to hedge future results and the foxes who recognize that the future is too complex for simple forecasts. I am with the second group.

Hedgehog Capsules

The third quarter saw almost every asset class decline in price except US
Treasuries. The two largest economies in the world showed signs of slowdowns, albeit China from a much higher growth rate than the US. The manipulations of the leading central banks continued. Those that were data dependent extrapolators did some selling and less buying for their long-term obligations.

Foxes Look for Changes

As dependable as the laws of gravity, I look at various declines as setting up a change in direction. As a young analyst I got frustrated at market bottoms because they very rarely got to be real cheap or almost steal price levels for long. What I neglected to put into my mathematical projections is that other potential buyers were also waiting for a good entry or re-entry price. These buyers were less patient than I was because they had fiduciary responsibilities and had a lot more money that needed to be deployed. They bought the cheap stock at good prices and didn't wait for my bargain basement prices. This experience taught me to begin buying when prices get into the fair level in view of their long-term future value. This is not to say that I am unworried about a major rip in the market structure that could delay the turnaround for a long time, and there is a potential one today that will be identified later.

How Should Analysts Work?

All too often what passes for analysis is a description, often detailed, of what already exists. Analysts should focus their attention on the future risks and opportunities. In other words, they should recognize that they are part of the tribe of foxes as predictors. To be successful more attention should be paid to the forks in the road as turning points and far less on trends and the determination of central values.

My Analytical Applications

I start with the absolute certainty that no narrowly defined trend will continue in its present configuration. Thus, I look at extreme performances as the most likely trend reversals at some point along their route. Guessing that there are strong odds on a trend reversal is relatively easy. The timing of the turning points is more difficult. It may be sufficient to recognize early that a turn has already happened or is in process. One of the great advantages of being a chart reader is the emotional ability to accept the turn without fully understanding the causes for the turn. Often the people and the conditions that cause the change in direction will be learned later, long after the easy early money has been made.

Currently I am focusing on the worst performing sectors of various markets. I recognize that not all of the poor performers will turn to be good performers and not at the same time. Some of the bad performance is due to poorly executed or too expensive strategies. Nevertheless, when there is massive under-performance by activities that were formerly viewed to be well managed, the instincts of the fox in me want to explore further. After assuring myself that what I am seeing is cyclical behavior, as a good US Marine Corps officer I start to prepare my plan of attack.

First I am focusing on investments that have declined around 20% compared with general declines of 5 to 10% through the end of the third quarter. In a gross over-simplification most of these formerly very successful investments have for many years reacted to falling commodity prices. In most cases (in an age old pattern of increasing supply too far in advance of demand) the clearing of the demand level was achieved by lower prices. Quite possibly prices would
have eventually declined without the slowdown of growth in China and the widespread application of lower cost extraction techniques for oil and particularly gas. Combining these factors with the two largest economies becoming less manufacturing and more services-oriented, the general price levels’ secular rise fell off their trend line to reported slower augmentation.

Having been exposed to past industrial cycles, I expect the excess supply will be eventually absorbed or removed from near-term production. Further, while population growth is slowing in many countries, the existing populations are increasingly exposed to more expensive lifestyles. Thus, I expect we will see reported inflation rise. As a matter of fact, I believe the cost of living for the readers of this blog and many of those who they are responsible for are already
experiencing upward effective price changes, above the vaunted 2% level.

How Do My Portfolios Represent These Concepts?

I have a number of portfolios for different purposes and timespans. (At your leisure I would be pleased to discuss the application of the Timespan L PortfoliosTM to your specific needs.) Most of my timespan oriented investments are long-term and some very long-term. The guiding principles of my choices are to avoid substantial long-term losses with major positions and at the same time produce a more than acceptable return. This translates into some Canadian and Australian investments. I wish to stay within my circle of
competence as is often suggested by Charlie Munger and Warren Buffett. Thus, I invest in each of these commodity based currencies in mutual fund management companies and closed-end funds. I also have a position in the largest commodity fund management and selling organization. Further, in believing in the continuing treachery of central banks to savers, we have a significant portion invested in global fund management organizations as they are avenues for people all over the world to partially escape the debasement of their currencies. For those that must have some of their money in fixed income, we have used TIPS (Treasury Inflation Protected Securities) and for clients who can accept some volatility, income loan participation funds.

Changes in the law may improve the quality of these loans if the banks must keep a small portion of the loans on their balance sheet.

What Should You Do?

My recommendation would be to begin a buy program of investing in the prospect of a long-term increase in inflation either through a commodity, direct or related investments, and in the worst performing US government issues of the last year, TIPS. I would slowly average into these positions by adding to them 1% a month or a quarter. When they move up in price by at least 9%, you may want to consider taking a full normal position.

However, There is a Big Disruption Risk

When there is a large scale disruption in the marketplace all securities and investment plans are impacted, as a rapidly falling level of trading capital needs to be quickly redistributed from strong holdings to meet pressing repayment demands.

The history of monetary demand management by the Federal Reserve is that market bubbles are reduced by opening new arenas for speculation. When we were facing the collapse of wide-scale speculations in "Dot-Coms" the Fed and the Federal Government made highly leveraged, poor credit quality attractive to new home owners and institutional investors. The result was the "sub-prime" collapse. As this was getting painfully unwound a new and bigger bubble was created in using US Treasuries on leverage for collateral purposes in “carry trades.” Because the credit quality of the Treasuries were unquestioned by all except Standard & Poor's, one could borrow heavily against them. The borrowed capital was then used to buy higher rate paper, often emerging market debt. These countries were borrowing US dollars at lower interest rates than what was available in their more knowledgeable local markets. Many of these borrowers were reliant on commodity prices remaining firm which currently is not the case.

At the very same time with the advance of high computational and communication speed, high frequency traders were attracted to the market. These inter-market dealers with their use of algorithms already represent, I am told, over half of the trades in the market. Many believe that they are abusing the market dynamic in Treasuries as they have in other markets. A number of sound, well known hedge funds have complained about these activities in terms of stock prices not representing real demand levels. My guess is that
something will be done about these specific abuses. My further guess is that the regulatory authorities will be reluctant to further constrict the Treasury market when the US government has to continually borrow money. Eventually the regulators will be forced to curtail these activities, but that is only likely to happen after a major disruption.

With Possible Disruption Ahead

Invest cautiously. When and if the disruption does occur, treat it as a periodic change in market structure unrelated to the underlying economy and as a buying opportunity.

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A. Michael Lipper, C.F.A.,
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