Behavior Patterns Help and Hurt

Introduction

Investment professionals and seasoned investors prize numbers including repetitive patterns. With these abstractions of reality we can build nice neat statistical formulas that give us a good chance to be correct most of the time. The problem with that belief is the recognition that we won’t be right all of the time and some of the time when we are wrong the results are costly. Probably the best known user of numbers was the physicist Albert Einstein, who was lured away from Caltech to Princeton by more money (again numbers).  According to John Mauldin’s latest letter the Professor had on his desk a sign which read “not everything can be measured and not everything which counts can be measured.” Clearly he was recognizing that the “unknown unknowns,” as Donald Rumsfeld has said, make us understand that we can not have complete confidence about both the understanding of the current situation and our ability to predict the future.

Behavior

Many learned institutions around the world, including Caltech have been studying how various elements in the brain’s circuitry light up repetitively as reactions to (or possibly causes of) specific behavior patterns. Of the work that I have seen, the connections between the specific brain waves and human acts are pretty simple and rely on learned memories of past pleasures or pains; e.g., digesting food when hungry. So far I have not seen how our minds react to indirect stimuli. This is important in that we live in a dynamic world where threats of bubbles and forgone opportunities are present at a much accelerating rate.

Opportunities

My study of history indicates that every single day some people are not only making money, but each day someone begins the climb to real wealth. Often those periods when great fortunes were ignited were described by the headlines of the day as troubled. Many investors, some seasoned and some not, are perturbed by the level of real unemployment or underemployment throughout the age range, but particularly for the youth with or without college education. They are concerned by the political uncertainties in most democracies. The low level of interest rates manipulated by the major central banks is leading many into uncomfortable, and in some cases, unusual investments. In other words, many investors lack confidence and are unhappy. On the other hand, currently most economic and financial conditions as reported are not getting worse. The relatively low level of financial and investment activity is reassuring to some that are current market participants, as there are less chances that global transaction prices go crazy, with the exception of extreme high-end real estate.

Perhaps in the real world that is beyond the financial and political communities, people are coping. They are getting on with their lives and new hard-worked fortunes are beginning. What our academic friends have not yet captured is the ability of humans to cope with conditions that they have no historical preparations. Think in terms of the recoveries of people in London, during and after their bombings, New York City after 9/11, Japan after the Fukushima disaster, and in Boston after the explosions at their Marathon. Humans can eventually figure out how to survive and then prosper by using their developed problem-solving abilities that have no direct historical parallel. I believe we are in such a period now. Coping is working slowly and we are making some progress. We have a framed motto in our home from the US Marine Corps which intones “Adapt, Improvise, and Overcome.” People all over the world are doing just that.  This is not to say that everything is wonderful for all or that in the future we won’t suffer from human-induced bubbles.

Bubbles

Many keen observers of market prices have written about bubbles for hundreds of years. The most famous in the English language was Charles Mackay’s “Extraordinary Popular Delusions and the Madness of Crowds.” Other insightful authors were Charles Kindleberger and Hyman Minsky. Not at the same level but an effective scribe is John Mauldin who is promoting his latest book through his weekly letter, quoting others that have written well on bubbles.

Most of the time financial prices act in a rational fashion often extrapolating near-term trends into the nearby future. Major price swings are largely absent and can be easily explained. In other words most investments are dull, which is the best possible operating conditions for disciplined traders. However, what the media and the amateur investors focus on are bubbles which distort for a period of time the normal price trajectories. I have not seen a good definition of a bubble so let me suggest one:

 

     An exponential price move (multiple doubles) in a relatively compressed period of time, normally 250 or less trading days on the way up and a similar (or more frequently, a smaller number of trading days in decline). 

     Unless one is in control of one’s investment emotions these not infrequent disruptions can destroy a sound careful investment strategy.

What is particularly disturbing about bubbles is that they start out as recognition of some important price trend outside the normal trading markets for most investors. While the mathematical description of bubbles is remarkably consistent, the external factors are different. There is the so-called Kindleberger-Minsky Perspective of five stages. The first is heralded change to the perceived order of things the widespread advent of electricity, radio, nuclear power, Internet and new debt instruments. In the second phase early adapters enjoy a boom. By the time of the third stage almost everyone has joined in the Euphoria. 

I remember the bubble in transistors the forerunner of semiconductors. We were told to think about how big the market would be for transistor radios when they penetrated each village in India and how much better the world would be. This in turn led to the fourth stage or crisis. (Something happened between the bullish case of the 1960s and now when cell phones are helping lower-earning farmers to negotiate better prices for their crops knowing what the markets are paying.) What happened was over-capacity and under-financed marginal companies bombed the prices for transistors. The final stage of the cycle is one of revulsion. I remember one large mutual fund in the 1960s that was heralded for having little to no investments in electronics. It was the equivalent of having a closet full of Nehru jackets or for women having skirts of the wrong length.

I do not know when and from what sector a bubble will appear. Others have identified bubbles in 1929, 1962, 1987, 1998, 2000 and 2008. I might add some others that I have lived through. The main point is that we could be due for one which will be called an upside breakout to recognize how productive the world will be in the future. What has me particularly concerned is that various studies at Caltech and elsewhere have found that many participants in a simulated bubble knew it was risky, but were playing the so-called “bigger fool theory” that were paying too much but believed that they could sell at a bigger price. When the eventual decline is underway the most likely panickers will be the bigger-fools turning on themselves.

Statistical hurdles

In trying to convince investors of the soundness of any manager or investment thesis, back-tested results are brought out. Notice none are shown that put the proposed concept at a disadvantage. While I am skeptical about all back-testing I am particularly cynical of ideas that do not show the purported annual performance since 1990. Better yet would be quarterly performance since 1985. The comparisons should be against live, expense-paying competitors not a publisher’s collection with its own biases.

Investment applications

Far too many investors and some managers are using Index funds, ETFs and closet indexers to meet the investment needs of their institutional and individual clients. These are closed minded systems that only change their holdings when required to by outside forces that have nothing to do with sound investment judgment. One of my real concerns is  that in the rapid acceleration phase of a bubble; e.g., the run-up of Apple’s price to $705 in NASDAQ and other portfolios created all kinds of risks. This was just the parabolic performance impact of one stock; imagine the long term impact of a bubble on the whole index. This may well explain why the NASDAQ Index is still well below its peak during the Internet bubble of the 1990s even though many of the companies within the index have prospered.

Professor Einstein had it right when he focused on what we can measure and what we can’t.

What are you not measuring that you should?           

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Current Worries Obscure Long-Term Portfolio Thinking

There is too little enthusiasm about investments these days despite the fact that we have just slightly breached the old highs on the popular US stock market indexes. This weekend I seem to be besieged by too many worries to enjoy either my market price gains or a wonderful concert by the New Jersey Symphony Orchestra playing three Tchaikovsky pieces very well, plus a spirited encore. (As my wife Ruth is Co-Chair of the NJSO, it should have been exhilarating for me.) Somewhat like Tchaikovsky’s tragic to triumphant Fifth Symphony, my investment worries obscure the good results we and our clients have achieved, and what should be an attractive long-term future.

Worries

I find it difficult to rank worries as any one of them could be the proverbial canary in the mine shaft. Thus, I am just listing them in the order that they hit me.

1.    The demand for US $100 dollar bills is up, particularly in Europe. I take this to be showing a concern about the value of various European currencies rather than a money transfer tactic of the global underworld.

2.    Most of the financial press is devoted to the problems of Cyprus and some of the other peripheral economies rather than paying attention to the remaining parts of the world. China now has reserves of $3.44 Trillion which is about the same size of the entire economy of Germany. Interesting the last time China published its gold holdings was 2009.

3.    Due to the fact that governments are trying to dictate to their economies through the banking systems, financial transactions including loans are moving out of the depository banks and into “other’ financial institutions, often called the shadow banking sphere. In China for instance the growth in commercial and personal credit is greater than in the regulated banks. In the US a portfolio of bank stocks has been recovering, but is still behind the other financials’ stock price performance.

4.    The current chatter of the talking heads in the financial press is focused almost exclusively on the pace of the expanding economy. People seem to have forgotten that in every decade there is at least one economic recession and often two. Where this plays a role is in the “happy talk” emanating out of Washington about reaching a balanced budget over the next ten years. According to John Mauldin, there is not any suggestion that the period will include one or more recessions which could balloon government social spending.

5.    A recent census report adding all the levels of US government spending per household concluded that the average is approximately $50,000 and the median household income is about $49,000. No wonder that there is not enough consumer saving to pay for the physical infrastructure needs and intellectual infrastructure needs to create the knowledge and work habits to fuel this economy.

6.    The price, volume, and shorting actions in Exchange Traded Funds (ETFs) suggest to me that an important part of the trading in these vehicles is being conducted by short-term traders similar to hedge funds. If more individual investors were using them I would be worried by a recent study by Mark Hulbert as published online in Barron’s on Thursday. Mark compared the performance of a number of ETFs to actively managed funds within the same organization. He found that, on average, the active managers out-performed their less expensive stable mates. This may be particularly important in the next major market decline where the active managers can either raise some cash and/or get out of some of the larger volume stocks that are leading the market down. (Of course when there is a rally, as they say “cash is trash” and can hurt performance.)

7.    This weekend some of us will be watching the Asian markets and later the opening of the European markets to see what the price of gold will be doing after a major fall at the end of last week. As a well-known and respected non-gold bug said to me this weekend, “The reason to own gold, in some form, has to do with fundamental concerns about the continuing value of paper money; it is just as present today as it was last week month or year.”  The purpose of gold is as an insurance policy within a portfolio of other assets. For generations European private bankers have urged their wealthy clients to own 5-10% of their portfolios in some form of gold. Just as I don’t like to drive on the road with drivers that do not have appropriate auto insurance, I hope that a few do not use the drop in the price of gold as an excuse not to pay their “value of money insurance policy.”

Analyzing your long-term investments

As indicated, the list of worries above is obscuring what you and my fellow long-term investors should be focusing. I am an advocate of dividing one’s portfolio into different time horizon and special pocket investments. At the moment I want to focus on the longer-term time horizon bucket. This is the bucket to fund multi-generational needs for both families and charitable institutions. 

One useful exercise is to look at the current market weighting of each of your investments and assign them into these somewhat distinct categories:

Category one: The portion of your portfolio which is the result of the accident of gains. One never expected this to be such a big winner, even if it was the family company. Now one has a very large unrealized capital appreciation = tax and/or disposal issue.

Category two: Holdings that are selling at very deep discounts compared with other market indicators. The future price potential is large and if successful in later years could be moved up into category one.

Category three: Some investments that are selling substantially below what a knowledgeable buyer would pay for the company, particularly if a new management could be installed. Dell?

Category four: There are some very high quality companies whose shares most of the time reflects their quality, but not all the time. This weekend I read the very long proxy and annual report of Goldman Sachs, a stock that is owned in my private financial services fund. For some this may be a controversial firm, but I find in general in most of their varied businesses they do conduct their activities in a high quality fashion according to the ethics of the business. I own other high-quality names but I was using Goldman just as an example.

When you get all through assigning weights to these and/or other categories see whether they are in an appropriate mix for your long-term needs. I would be pleased to discuss this exercise with you if it helps to bring some additional clarity to your investing.

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.