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.

Libor

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.

Euro

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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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 29^th

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 28^th of June

The following thoughts stated briefly were going to be the basis of this week’s blog before the 29^th 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 29^th, please contact me.

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

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Storms on Both Sides of the Atlantic

Normally I think about my blog communications to you throughout the preceding week, then I spend Sunday working on my first draft in order to get a completed version before the end of the evening. As I sit here on Saturday night before the impact of Hurricane Irene is forecast to hit us Sunday, I am concerned that some fallen trees might knock us off the electrical grid. Thus, I am pulling together my scraps of paper and other thoughts about 24 hours earlier than normal. The result is a collection of questions and observations on various bits of news and commentary I have reviewed this week.

Europe: What will it be?

There are two concerns which are keeping investors away from the stock market. The first concern is whether the US will tip into recession (more on this in a minute), and the second is Europe. At its core, the issue in terms of Europe is whether Germany will provide the capital to bail out the Mediterranean and Irish governments, and more specifically, their banks and the banks’ counter-parties in the more solvent countries. The European bureaucrats have maneuvered their creation, the European Central Bank (ECB), into buying sovereign debt issues of some of the peripheral countries in the secondary market. On September 7th, a senior German court will rule as to whether this was in violation of the law (and spirit) of the agreement to create the ECB. Logic from afar suggests that it was in violation, and now questions whether Europe as we know it will continue to exist. Any form of disequilibrium created by these events and discussions will have some unpleasant impacts on US securities, particularly commercial banks.

What does 1% (actually 0.99%) mean to the US?

The latest reading on the growth of the US Gross Domestic Product (GDP) for the second quarter, was a gain of 0.99%, generously translated to be 1%. Subsequent quarters were expected to be higher, with the final quarter generating a 3% growth rate. (Many believe a 3% growth rate or better is required to make a meaningful dent in US unemployment and under-employment statistics.) As disheartening as the 1% figure is to the economy, it suggests other concerns to me. While the financial community will gladly do battle over 1% (or as we most likely will refer to it, as 100 basis points) in this period of declining volume and excess capacity, there is a deeper concern on the part of number crunchers like me. What is rarely discussed (but is included in the full breakdown of the national accounts) is a line item called Errors and Omissions. Considering how often there are significant corrections or adjustments to federal government numbers, I wonder whether there was any growth in the US in the second quarter! My concern was heightened when I read the following excerpt from a fellow member of our blog community who is a corporate environmental counsel and a former FDA counsel. He summarized his interactions with the government:

“The overhead of any program and waste consumes a substantial fraction of the funds allocated. They are spent on feeding the 'perpetual bureaucracy' or temporary managers as administrative costs or the money is simply wasted and does not go to any economically productive use.”

Bear in mind that the government is spending roughly one of every five dollars counted in our economic progress.

Are We Creating a Self-Induced Recession?

Much has been written about the “wealth effect” which states that when people believe that their wealth is growing they will spend more. This was one of the excuses for QE2. It didn’t work in a meaningful way. But are we seeing the reverse, when the uncertainties created by the politicians on both sides of the Atlantic are causing investors to stay away from the market? There are always circumstances when investors desire to sell their securities. In the absence of securities buyers, the forced sales will generate lower prices; that in turn makes bystanders feel poorer, and therefore they reduce their spending for various goods and services.

The “Halo Effect”

Jason Zweig, in his weekend column in the WSJ, places halos on Steve Jobs and Warren Buffett, and then does a good job of reporting on the mistakes each has done without diminishing their overall record. Also, the Financial Times Saturday edition, in reporting on Mr. Buffett’s latest purchase of Bank of America preferred stock with warrants, notes a number of quotes whereby he acknowledges less than perfect foresight into financial services companies. (Disclosure: Berkshire Hathaway is a position in my private financial service fund as well as my personal account.) The halo effect is a constant worry to me in selecting mutual funds to invest for my institutional and high net worth clients. We all find it easier to invest with a successful investor than one who is currently not doing well. We gloss over the past mistakes of our heroes and focus on the mistakes of the current laggard. Mr. Buffet reminds us of his fallibility by maintaining his corporate name on a very bad operating investment he made.

As we are moving into particularly troubled financial, economic and political waters, we should be aware of the risks attached to the halo effect.

Am I Premature?

In a recent investment committee meeting with a number of well-known investment professionals, I was asked whether I was premature when I took contrary positions to the perceived knowledge. My respect for the questioner was such that I had to examine my past thinking on investments in order to answer thoughtfully. As often is the case with this individual, he was right. I tend to look at investments as an entrepreneur rather than as a trader. I look for structural imbalances and opportunities. Most of the time I would prefer to be early than late. Even though it was a favorite song of my late daughter's, when I was expressing frustration about change, I couldn’t relax to go along with her view of “Que Sera, Sera,” but she was a calmer person than me.

Reactions to any of these observations?

Note: We will be in London in late September visiting with investors and managers. Are there additional people we should see if appointments can be arranged?
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