Are History & Economics Books Closed? - Weekly Blog # 953

 

 

 

Mike Lipper’s Monday Morning Musings

 

Are History & Economics Books Closed?

 

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018

  

 

 

The Reward for Analysis is Prediction

The payoff for analysis is plausible prediction, whether correct, wrong, or part of each. As this is an investment guess as to the future, it will at worst beget an emotional reaction, or possibly thoughtful disdain. On the other hand, it might suggest a future looking distinctly different than extrapolating the present, including the desires of those presently in power.

 

This may be an appropriate time to look forward to something different than the present and begin investing on the chance something different happens. The reason this is an appropriate time to express these thoughts is that those in power are only focused on the immediate and have closed the political and economic history books.

 

The following items point to a different kind of future:

Political Disruptions

• There is hardly any national government that is universally popular, which is different than being tolerated by a diverse population. At the moment the majority is not unified and lacks dynamic leadership.
• The current renter of the White House is waging a war which he believes he can end and in so doing can generate a political victory for him and his party. He should study the greatest UK leader of modern times, Winston Churchill, who lost power immediately after WWII to the Labor Party.
• While office holders are getting older, voters are getting younger and richer.
• While some media are controlled, increasingly more are not. Anyone, anywhere, may be able to reach individuals and groups.
• Both ancient Greece and Rome lost total control to an enlarged population. China had similar problems.

 

Financial/Economic Changes

1. The impact of air conditioning is coming to Europe, Asia, Africa, the Middle East, and Latin America. (In the US, the one thing the founding fathers did not foresee was the federal government existing in the humid swamp of Washington DC.)
2. The population of the US is likely to shrink without immigration, causing the national debt, social security, and Medicare to fall under pressure.
3. The rotation of the relative ranking of investment performance is likely to change. Over the last ten years only domestic and international science and tech funds have beaten the average large-cap growth fund average. This is from a universe of over 100 mutual fund category averages. (It is my bet that this will not be the case over the next ten years. None of the initial stocks in the first DJIA are in the current index.) The common denominator of successful funds is essentially the inclusion of computer-oriented products or services with substantial sales in the US. It is this concentration in a dynamic global world that will eventually lead to a rotation to other segments of the market.
4. Evolution has been part of life on our planet since the beginning of time. I believe only change agents have a chance of surviving longer. My accounts have two good examples of successful change agents, along with some mistakes. (These are not recommendations that should be made with complete knowledge of an investor’s needs, wants, and understanding.) Each of these companies began life pursuing other businesses and made significant purchases. Berkshire Hathaway started as   a money-losing textile mill. After Warren Buffett’s hedge fund bought it, Charley Munger taught him how to buy good companies at reasonable prices, which resulted in them building a great holding company. Recently, Warren appointed Greg Able as CEO of the firm. He is in the process of slowly turning Berkshire into more of an operating company by doing the following things:

• Appointed a Senior Executive over groups of single companies.
• Purchased Alphabet stock for cash, making it one of the firm’s 5 largest holdings.
• Purchased a home and community construction company and combined it with an existing builder of factory-built homes and a mortgage provider. (The country needs a major increase in the building of homes, and they will be part of the solution.)

Berkshire has not said anything yet about paying a dividend, although I think they will do so in a number of years. My thinking is based on Mr. Buffett’s statement that he and Charley were not running the company for the shareholders, but for their heirs. (It is already happening. I believe that a good bit of the stock owned by individuals for 50 years or more has been inherited on a step-up basis. These new owners of the stock will have different attitudes toward the company as they consider their own retirement needs. In order to keep this growing number of shareholders happy, it makes sense to pay a reasonable dividend.

 

The second stock already pays a mid-level dividend. The Thomson family controls roughly 70% of all shares of Thomson Reuters through their private holding company. They have made a number of dissimilar investments over time, including a commanding position in the North Sea oil field. Their principal business today is distributing critical data to law firms, accounting firms, corporations, and governments in the US, Canada, the UK, and Latin America. Thomson is the largest provider of this type of data, and they have taken their time converting their products to utilize “AI”. Their customary careful management has recently introduced “AI” driven products which have been well received, making good progress with both old and new customers. (Disclosure: For a few years Thomson owned the data of my firm, Lipper Analytical Services, but they recently sold it to the London Stock Exchange Group.) Thomson Reuters is similar to Moody’s, S&P Global, and other commercial data providers that we own.

 

Working Conclusion:

Change is inevitable and risky, but necessary, and worth the risk most of the time. 

 

Please share your thoughts

 

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Recognizing a Professional: Ratings vs Ranking - Weekly Blog # 811

 

Mike Lipper’s Monday Morning Musings

 

Recognizing a Professional: Ratings vs Ranking

 

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018

 

 

While we can’t know exactly whether someone is schooled in a subject or just pretending, we can presume a lot from their choice of words. In the world of investment statics there are several tribes of analysts that attempt to predict whether a fixed income instrument will go into bankruptcy. They summarize their learned judgements with letter grades, called ratings. These ratings do not give an opinion as to whether they are good investments, just whether they anticipate them entering bankruptcy. The history of the professional credit raters is pretty good, as bankruptcies are relatively few in number. While they give an opinion as to whether the instrument will enter bankruptcy, they do not indicate how much of the issued principle will be lost.

 

One unfortunate trait of inexperienced people is the use of a term from one subject in another. While the term may have some similarities, it is not identical and may not even have the same utility as the original. This is why I used performance ranks and not ratings when developing the practice of mutual fund analysis, using the performance array of mutual funds we tracked each week. This is where my analytical training kicked in.

 

I pity those who passed through the analytical profession and did not learn as I did at the racetrack. My experience instilled in me a strong aversion to losing money. Analysis at the track is similar to the popular method of selecting investments based on past performance. This approach relies on the belief in the repeatability of events and has led to the development of quantitative systems, both in the investment market and at the track. “Quantitative” investing has periodically been very popular in the investment market, buttressed by “ratings” which are meant to be predictive.

 

 I gained an advantage from my many discussions in the grandstands following each race, where some player complained about the failure of “the system” he/she was following. Because I did not like losing money, I paid attention to the complaints of the failed “systems”. What I discovered was these systems actually worked better than half the time for a period of time, but rarely more than 60-70% of the time.

 

Later in life I heard similar complaints from more senior analysts as the corporations they followed failed to deliver the expected performance. The standard complaint was that someone was lying. It took me a while to connect the similarity of their complaints with those I heard over the weekend at the track.

 

This realization led me to think about the process of predicting the future. Since no systematic thinking produced winners all the time, there must be mistakes in the math. As securities analysis is taught as an adjunct to math, or the certainty of law, the losses had to be a function of mechanical mathematic failure. It eventually occurred to me that it was not the process that failed, but the universe of variables being different than those utilized.

 

At the track, the things that could change were the jockey, the trainer, the exercise rider, what the horses were fed, what drugs were administered, or the competition. Each of these possible changes, and others, could and often did impact results. This is why I believe we should pay more attention to changes of people and their attitudes in the investment world. More so than believing in their statistical record.

 

This week was a good example of changes that largely invalidated the past record of the entire global financial sector. As an analyst, investor, and portfolio manager, I have always had an interest in financial services securities. Stock Exchanges have been at or near the center of the financial sector and thus were always of interest. There have been five Lipper brokerage firms that have been members of the New York Stock Exchange. (Never has a son or younger brother succeeded the founder, and consequently none extended to a second generation.)

 

In most commercially viable countries, there are stock exchanges. Considering all I know about these exchanges; none are making most of their money exchanging securities. At best, most make single digit returns on this revenue. This week I attended a capital markets conference of the 300-year-old London Stock Exchange. While it is interesting looking at their history or past performance, it is of no value predicting their future.

 

Unlike racehorses and most people, some companies can be rejuvenated into something quite different than their past history. In the case of the London Stock Exchange, it has grown into the London Stock Exchange Group (LSEG), primarily through a merger with a Thomson Reuters spin-off. (In 1998 Reuters purchased our fund data business. We and our accounts still own Thomson stock, which has a major position in LSEG.)

 

The spinoff included a number of unintegrated number-crunching entities, labeled Refinitive. It was a comfortable fit because the London Exchange had previously acquired a number of similar unintegrated and under-marketed numbers-companies. To this mix they added “expert” management from various financial and tech companies, including a cooperative agreement with Microsoft based on their plans and/or dreams.

 

The CEO believed he had identified all the problems that could delay them. The current management group is investing heavily in new products and services, including the marketing of them. It would not be difficult to improve on the record of its two major founders. LSEG deserves to be ranked highly in its present efforts. I will leave it to others to predict its future.

 

This Week’s Signs of Stagflation

Despite the media and others chanting Good News, there is increasing evidence that smart professionals see an approaching decline in market prices. Whether we are just in stagflation or entering a significant contraction will be determined later. However, it is worth noting the S&P 500 Equal Weighted Index is essentially flat year-to-date.

 

The following announcements have to do with future revenues. The companies making these statements are addressing the second of two measures of their health, their investment performance and the prospect of generating new business, largely from new customers.

• Manulife is laying off 250 employees in its Wealth and Asset Management functions. (Manulife is a Canadian Life Insurance company with significant Hong Kong sales.)
• Wells Fargo is laying off 50 Investment Bankers.
• Burberry issued a sales target warning.
• A 2^nd Hedge Fund is cutting 150 of its 1000 person staff.
• Jim Chanos is closing his short selling hedge fund. (He said the market is changing away from his style.)
• Amazon is cutting several hundred from its Alexa staff.
• Another observation noted in the weekly list of prices in the Weekend WSJ. Only 8% are down, including the US dollar -1.65%.
• Fitch is negative on the investment management sector in 2024.

 

Note From London

At private investment discussions in London during the week, locals were most concerned about the US Presidential election, with differing levels of pessimism. I had two comments.

1. It is incredible considering the size of the US population that the present apparent candidates are such a poor couple. The locals agreed.
2. Much more important to me is that we won’t know the Chairs of key committees until later next year. This is more important on the Republican side, as the Democrats are bound by seniority. According to the intelligent people I talk with, a split Congress is likely, suggesting not much meaningful Legislation will pass, except for emergencies during the first two years of the new term.

 

Share your views with me and let me know what you are watching in terms of markets and votes.

 

 

 

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Mike Lipper's Blog: How to Find the Answer - Weekly Blog # 810

Mike Lipper's Blog: Preparing - Weekly Blog # 809

Mike Lipper's Blog: Indicators as Future Guides - Weekly Blog # 808

 

 

 

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Current View of 3 Past Lessons - Weekly Blog # 693

 

Mike Lipper’s Monday Morning Musings

Current View of 3 Past Lessons

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

What Little We Know About the Future

“The future” will be a series of never-ending episodes, some good, some bad. Each somewhat similar and different than the past. Analysts are a combination of historians, observers, and dreamers distinct from extrapolators. In pondering the future during a “dull market” week, I looked through three historical lenses searching for useful clues about what lies immediately ahead. Please remember my absolute right to be wrong, or perhaps worse, being half-right.

1. “The Dow Theory”

Charles Dow, the first editor of The Wall Street Journal and founder of Dow Jones in1896, spent time trying to interpret the stock market and what it foretold about the future. His analysis revealed that there were two stock markets, those of pragmatists and dreamers, using my terms. Today we might call them “value” and “growth” investors. To arrive at this conclusion he boiled down the price performance of what would become two limited indices, the Dow Jones Transportation Average and Dow Jones Industrial Average. He concluded that for the general market to have a sustained movement both averages had to move in the same direction and eventually reach their prior established peaks and troughs. One had to confirm the other’s move.

 The logic behind this view was the industrials being priced on the collective view of their future, believed only when the rails carrying their freight to customers confirmed it. We might have labeled the two indices as quality and speculation. (Some of today’s readers would not believe that the rails were the quality portion of the market. Some years earlier, Columbia University had an endowment devoted to the most prudent of all US investments-----railroad bonds!! It is worth noting that almost every significant railroad subsequently went bankrupt.)

Today, pundits still regularly comment and contrast stocks/funds that are value and growth oriented. With that in mind, it is useful to look at charts published each week on the price movement of the Dow Jones Transportation and Industrial Averages. (Both have evolved, with major changes in their composition. The Transportation Average includes airline companies, logistic companies, shipping companies, and package delivery companies. The so-called Industrial Average, in addition to including manufacturers, also includes entertainment, financial, credit card, and software producers.)

From the beginning of the current year into the middle of May, both Averages rose meaningfully. However, since then the DJIA has risen slower, being essentially flat in July and only reaching a slightly higher peak on Friday. The Transportation Average on the other hand has been falling and is now approximately 11% below its May top. Thus, as of now we have a non-confirmation of the Industrial Average Friday breakthrough. 

The May peaks in the two averages made sense as the rate of gain of the recovery topped out. This was primarily due to concerns over inflation, politics, and slowing sales resulting from shortages. While the NASDAQ also went to a record levels on Friday, on most trading days its price movement has been less ebullient than the DJIA. One of the characteristics of a top or bubble is high-volume traders going up while others lag or fall.

2. Jeremy Grantham (GMO)

Jeremy is an iconoclast thinker and portfolio manager. He has made some brilliant calls on the market and has been out of phase with markets for extended periods of time. More than a year ago he made a favorable call on the price of timber. As a member of Caltech’s investment committee, we have profited and enjoyed his performance. He is currently worried about a market bubble. Recognizing that many who attempt to read crystal balls concerning their future eat broken glass, his views are well worth considering:

• Bubbles occur when periods of very long and strong economic expansions are extrapolated into the future. (The current expansion is being fueled by government stimulus, with the advocates not identifying any termination of the expansion.)
• Much of the global expansion of the last several years has resulted from bringing low-cost labor from China and eastern Europe into production. (Unless they can cheaply be replaced with Africans, Latin Americans, and those from Southern Asia, we will suffer from wage inflation.) 
• Perceived wealth makes consumers and investors think they are wealthier than they are. While seasoned market investors understand that prices “temporarily” decline, few appreciate that housing prices can fall for a long time. In terms of future spending, housing is a worse investment than securities. (It is my personal view that we don’t own our homes, they own us. We must pay to maintain them and pay taxes on them.)
• He lists other parallels in a recent podcast and his writings.

3. My Own Experience

My first job on Wall Street was at 63 Wall Street, working at one of two very special brokerage firms. With rare exception the two firms were odd lot brokerage firms, executing share transactions of under 100 shares. Other members of the New York Stock Exchange (NYSE) found this task cumbersome in a pre-computer era. To free themselves of this burden they allowed the odd-lot broker to charge an eighth or a quarter, depending on the price of the closest qualifying trade executed by the other floor members. With their level of commission determined, the two firms competed to get orders from other firms by providing services to their customers. During this period the only record of stock prices was on Mr. Edison’s ticker tape, which was not mechanically stored. My job, along with an army of clerks, was to record the tape prices and volume for a handful of stocks useful to our brokerage firm customers, proving they got the best possible price at the time of the trade.

I learned a great deal that summer which shaped both my later career and more importantly how the real commercial world worked. Some of these insights were:

• If commissions are fixed, one competes on services that are a burden to customers.
• With the right sales attitude, it is a distinct advantage working for a limited number of professional customers in geographically close offices, rather than dealing with public customers spread around the country, if not the world.
• Internal industry competition can regulate the marketplace faster, fairer, and more insightfully than regulators.
• Develop respect and appreciation for skilled hard working people with different levels of formal education and experience.

Many years later, when assembling a financial services portfolio for family and clients, I did not limit it to brokers, banks, insurance companies and fund managers as most financial services portfolios do. I also included financial service companies with specific expertise useful to the professional market. In a recent performance review of that portfolio, some of the leaders were what I would call critical common denominator service companies with limited competition, e.g. Moody’s, Thomson Reuters, and S&P Global in personal accounts,  which have gone up multiples of our original cost.

The reason for mentioning these positions in a blog focused on what could cause the market to decline, is that almost every business is overregulated compared to other financial services businesses that are relatively lightly regulated. This is due in part to the same customer regulation that the odd-lot firms enjoyed. If some of the comments by Senator Warren and members of the current administration become law, it will make these companies less attractive investments and worse suppliers to the market.

Updates

Some of the signs of extreme inflation are possibly temporary. The runaway JOC-ECRI Industrial Price Index declined this week by 3.64% and is only up 68.27% year-to-date. I don’t know how much of the decline is from certain lumber and oil prices. Personally, I am much more concerned about service sector inflation due to rising wages. Some of this is overdone, but it is unlikely these hard-earned increases will meaningfully reverse short of a major depression.

When I talk with young people these days, they focus on trading to get rich quickly. I try to bite my tongue for I believe that investing is an art form, where each artist learns how to control their actions to reduce the probability of losses and the possibility of gains overtime. To me, trading is an inside game for professionals who believe that they have a demonstrable edge capable of overcoming expenses and taxes. Many of these young people go to or graduate from “good schools”, where they are taught and schooled, but not necessarily educated. Being schooled is what you have been taught, whereas education is what you have learned. Unfortunately, most of us only get education through our own or others’ losses. I am not worried the youth won’t get the benefits of losses, as that is almost inevitable through trading. What concerns me is that this generation will stand shoulder to shoulder with those who lived through the 1930s Depression, stoutly proclaiming “never again will I trust the market and its participants”. Some of these types of people were still at the Bank I joined after The Marine Corps in 1957. They relatively quickly past by those of us who were learning to be good analysts and not bad investors. My fear is that many of the youth today will never be good investors,  which may be the real loss resulting from the oncoming decline in markets around the world.

In Conclusion

The odds favor a major decline in the future. The issue is one of timing and we continue to learn that the duration of cycles of all sorts appears impossible to predict, but one should be prepared.

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2021/08/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/07/mike-lippers-monday-morning-musings_25.html

https://mikelipper.blogspot.com/2021/07/correcting-impression-and-gaining-some.html

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The Art of Portfolio Construction - Weekly Blog # 615

Mike Lipper’s Monday Morning Musings

The Art of Portfolio Construction 

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

This week had attention getting headlines that might be important to prudent investors.

1. The Barron’s Confidence Index dropped by an unusually large 2 points as high quality bond yields rose less than intermediate credit yields.
2. The 30-year yield to 3-month yield spread narrowed. 
3. The Baltic Dry Cargo Index was down 30% from a year ago (negative for world trade). 
4. SoftBank failed to raise the capital anticipated.

Despite all the news that has made headlines this week, we professional managers and serious investors must continue to manage the portfolios entrusted to us. Many professional journals are full of articles about Artificial Intelligence (AI), suggesting the management of investment portfolios can be done entirely “by the numbers”. Contrary to that view, I believe that portfolio management is an artform, similar to life in general.

That is not to say that math and related science has no place in portfolio management. The great artists of the world, either consciously or not, use mathematical principles in producing their art. It is the same with portfolio managers. Just as a painter looking at a blank canvas needs to contemplate the organization of the space, selecting the right colors to convey his/her point of view, so too do portfolio managers, particularly the successful ones.

One of the first choices the portfolio manager must make is whether to utilize many choices or just a few. Some portfolio “artists” will fill the space with many details, while others only use a few, concentrating on a limited number of opportunities. As someone studying investment portfolios for most of my life, I have come to some working observations.

1. The need to quickly convert some of the portfolio assets into cash in order to meet responsibilities focuses attention on liquidity. In markets of limited liquidity and occasional sharp price moves, owning a large number of securities often suggests the portfolio has a good amount of liquidity. This is not always true, but many portfolios do not need a great deal of liquidity.
2. The next consideration for portfolio strategists is career risk, as portfolio managers are rarely employed under long-term contracts. This is particularly true in the mutual fund industry, my preferred research laboratory. Termination is often triggered in one of two performance directions, up or down, depending on which is the greater fear. By definition, there are a limited number of individual securities that will be up significantly in any given period. If that is your goal, the best portfolio structure is to own only the big winners. On the other hand, career risks could be triggered by falling more than peers or the market and/or exhibiting an unnerving level of volatility. In that case, portfolios might include a large number of individual issues in order to generate returns similar to peers or market indices.

As a manager of portfolios of mutual funds, we utilize both extremes in some combination to meet the expressed or perceived needs of the account. Where possible, we want to use concentrated portfolios to give us better than average performance, accepting some additional downside risk. We offset these concentrated funds with a selection of portfolios that have numerous securities. They often look similar to market indices or are actual index funds.

I have great empathy for the managers of concentrated portfolios, as I for many years have managed a private concentrated portfolio investing in global financial services stocks and funds. I am not soliciting new members, nor am I recommending the purchase of any of the financial securities I will mention shortly. I am using a brief discussion of my experience to highlight some of the attributes of one particular concentrated portfolio, which might apply to other concentrated portfolios. The following are elements that may be found in concentrated portfolios:

1. During a recent period of positive performance for the portfolio and negative results for the benchmark/peers, only 7 of the 19 positions rose. The portfolio outperformed in part due to the two largest positions being the two best performing stocks and totaling 25% of the portfolio. The use of weighting is an important tool.
2. More important than what we own, might be what we don’t own, life insurance and large commercial banks.
3. Financial services can be used effectively beyond brokerage commissions and deposits to address other needs or fears. For example:  
1. Using ADP and Berkshire Hathaway to participate in GDP growth
2. Using Franklin Resources and Invesco to hedge the value of the US dollar.
3. Using NASDAQ for a general level of speculation.
4. Using Allegheny Corp. and Berkshire to participate in rising casualty insurance premiums.
5. Using the London Stock Exchange through Thomson Reuters to participate in the evolution of global stock exchanges.
6. Some of these options could also be considered hedges in a financial services portfolio.

Conclusion: Concentrated portfolios can work both offensively or defensively when appropriately structured, but need to have better security selection than portfolios with a larger number of issues.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/02/significant-turnaround-two-fearful.html

https://mikelipper.blogspot.com/2020/01/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/01/is-it-always-brains-over-flexible.html



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Risk Controls Hurt Investment Profits

Investors are giving up too much on the upside

The financial world is being buffeted by credit risks. To protect investors from large unexpected credit failures, various risk control approaches are being used. A look at financial history suggests that hiding a problem only makes it worse when it is revealed. In the meantime, by hedging the risks, money is taken away from more productive investing at today’s low prices. Those that are doing the hiding, hedging and manipulating of the markets are concerned about career risk for themselves or their leaders.  I believe we should deal with the present unpleasant problems,  re-set our levels, and unencumber the potential upside.   

Questions for Jamie Dimon

I was one of the analysts and portfolio managers that attended the early morning analyst meeting masterfully presided over by JPMorgan Chase* CEO Jamie Dimon. Both in his presentation and the two accompanying presentations, attention as well as most of the analysts’ questions were focused on the CIO (Chief Investment Office) and the “London Whale” losses. Many who know me either directly or through reading this blog may recognize that when all or almost all attention is focused narrowly on one topic, I try to explore other areas that I believe can be more fruitful. Thus I asked two somewhat related questions about derivative exposure. The first was, “With some $86 billion in derivative assets and $76 billion in liabilities, how much was netted with the same counterparty?" The second question was how much of the June 30 statement included the CIO debacle?  The answer to my first question was that the subject was covered in a previous presentation to analysts as to the complexities of its management of derivatives. My second question was answered with the statement “very little.” The answers delivered were not satisfying.

What was the JPM CIO designed to do?

 

Purportedly the office, among other tasks, was meant to hedge some of the loans made by the bank. These loans of various maturities were with governments, central banks, commercial customers, and other banks. A bank can only stay in business by accepting some of the risks of making loans. JP Morgan does some of the best credit work of any large bank, thus it had to have some inkling as to the type of credit losses it was exposed to through its loan portfolio. Considering what has been going on in Europe for the last year, one would assume that JPM had some worries as to its loans to various European financial institutions. (Reportedly the large loss was in a derivative that tracked the credit of large US commercial entities. However this does not totally eliminate a concern about some large European Banks.) I do not know whether there were additional concerns about prompt payment from certain derivative counterparties, particularly if the originating derivative transaction was not executed through an exchange with a strong clearing house behind it.

*For many years I have owned shares in JP Morgan, but they are not currently owned in the private financial services fund that I manage.

JPM and Libor

Somewhat more understandable was Jamie’s ducking questions as to the ongoing Libor investigations. (Wouldn’t it have been interesting to hear his views from his place on the board of the New York Fed?) Some may not see the connection to the two probes, but I believe that they are getting to the crux of the overriding problem facing investors and financial consumers.

Too much fudge can make one sick 

As kids we all liked sweet things, I was particularly enthralled with brown sugar fudge. After a while it became clear to me that eating too much fudge made me sick.  As an adult, I find the “fudging” of data makes me equally unwell.

  

Since probably sometime in 2007 there was an attempt by some to manipulate the Libor rate. One of the repeated mistakes of the financial community is to use a particular metric designed for a specific purpose for other uses. (My favorite misapplication is the use of price/earnings ratios to identify cheap or expensive, growth or value stocks.) The original purpose for the daily setting of a US dollar Libor rate, was to estimate the rate that banks would pay for US dollar loans from other banks  on days when there were no known transactions. The methodology used was for sixteen specified banks with operations in London to indicate what it would pay for money. Reuters, now Thomson Reuters**, would collect the data, then drop the four highest and the four lowest samples and take the inter-quartile mean of the eight central results and report that calculation to the British Banking Association which authorized its publication as an estimate. 

The rate was never designed to be an interest rate arbiter for non-banking loans. When floating rate paper was being developed first at the wholesale level and then on the retail level, some “bright person” at a law firm or an investment bank grabbed Libor as a well-known daily fluctuating interest rate that the London market controlled rather than a US Treasury rate. Starting in 2008 some in the marketplace were getting concerned that the interest rate estimates were being influenced by traders for the benefit of their trading positions. At any rate the British government used its knowledge of the individual bank submissions as a possible indicator that a bank with a high rate needed to use the high rate to attract capital, for it was perceived to be having problems. It is alleged that the Bank of England, the central bank, did not want to have to rescue another failing bank, suggested to at least one bank that it need not always be the highest bidder for money. No one is publicly discussing that banks that submitted lower rates did not expect to get additional loans or equity through the marketplace and thus following a US Marine Corps tradition, “kept off the skyline.”  The rumors of these concerns probably entered the hedging practices in JP Morgan’s CIO as well as others who were in the business of making loans to banks. (Confirming this assumption would have helped in understanding what the CIO was doing in its proper hedging activities.)

** In 1998 Reuters bought the operating assets of my old firm, Lipper Analytical Services for cash. While currently a user of the firm’s data and an occasional columnist for Reuters, I have no contractual relationship with the company. Both the fund I supervise and personally I own shares in Thomson Reuters.

The Third Aberration To Sound Investing

In addition to the CIO errors and Libor manipulation, the very same concern for the safety and soundness of banks in major countries of the world has led to various central banks rescuing specific banks and banks in general by flooding their economies with cash as well as driving down interest rates. These low interest rates do not recognize the credit risks in the marketplace which has two impacts:  the first is to dry up the lenders’ willingness to lend to the borrowers, which slows the economy. The second and more insidious is that individual and institutional investors that we serve cannot meet their ongoing income needs in high quality investments. Thus they seek other investments with enlarged credit risks so that they can pay for people’s retirements, pay reasonable wages to those devoted to the non-profit areas and provide capital for future expansion of facilities and employment. 

What do you think?

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