Two Reversible Negatives

Introduction

For some time I have been worried about a market top in stocks. In a classic sense, a major decline is less likely today for structural reasons than I had previously thought. Two obstacles to higher stock prices are Politicians and Commodities.  Both of  these drawbacks are reversible, but could cause the “once in a generation fall” of my fears.

The Enemy = Politicians

All politicians, as distinct from statesmen or stateswomen, wish to avoid being tagged with unpopular political decisions. The very nature of human and animal life is one of periodic successes and failures. A student of financial history recognizes peaks and valleys. The current crop of political leaders recognize that job preservation and job creation are critical to their reelection. To deliver on these goals they have adopted a policy of bailing out large employers who have sufficiently poor financial conditions that there is fear of substantial job losses. Such bailouts ignore the historical fact that it is natural for businesses to expand and contract, and in many cases particularly good for their customers. When a significantly large number of voters in key areas are employed by a company that is in distress, the modern reaction is to bailout the troubled company or industry with taxpayer money.

The recognized problems of late 2007 and 2008 in the US led to massive bailouts of both major auto makers and very large financial institutions. The public was revolted by this use of its hard earned money in the face of needs for spending on infrastructure, education, and defense. To avoid future bailouts and to protect themselves, the politicians came up with the doctrine of preventing large corporations from becoming “too big to fail” so that the government would be politically forced to bail them out. From the standpoint of protecting the politicians, the various “reforms” such as the Dodd Frank legislation appear to be doing a good job currently, as we have not had a major failure since the financial crisis.

The Price

To fund the bailouts, the Federal Reserve bought almost all of the debt the federal government put out and in so doing increased money supply which led to materially lower interest rates, particularly hurting the retired population, living on fixed income returns from their savings and pensions.

As harmful as that policy was to an important part of the population, a much bigger price was paid by the retail investor. Over the five years that the Dodd Frank bill has been operating there has been a withdrawal from individuals buying individual stocks. This has been caused by two simultaneous elements. The first by making the investment community seem to be the sole source of the financial crisis without regard for the contributions of government policies, labor unions, and inappropriate education.  By demonizing the financial community many otherwise rational investors voted with their feet. In the past, this kind of withdrawal would have brought a response from the financial community.

Because of greatly increased regulation on large financial institutions they needed to add highly paid compliance people and capital buffers that made the cost of serving the middle income public sky-rocket.

For many brokerage firms, the retail cash agency business has become unprofitable. This in turn has led to a change in the nature of the sales force serving the public. They have shifted into selling packaged products that have higher margins and often include borrowing (leverage). This shift has led to a number of the older and more trusted sales people leaving to become fee-paid advisors, replaced with younger sales people with increased sales quotas (this did not sit well with established clients or younger would be-investors). The net result is that far too many investors did not benefit from the doubling of market prices over the last five years. Their absence is being felt today by their lack of enthusiasm for investing to meet long term retirement needs.

Despite various politicians’ beliefs, human nature has not been repealed. Eventually the animal instincts will drive greed over fears and we will get enthusiasm for risk taking. While it is likely to be more muted than what we have seen in China, it will become a force that will override the damage to investors’ psyche caused by the Dodd Frank bill.  (Retail investors own 80% of the small Chinese market often with substantial margin debt. The Asian institutional market is a heavy user of equity derivatives which did not help in the last couple of weeks.)

Commodities, the Second Reversible

I have not owned any commodity future for more than thirty years. Nevertheless, whenever I see the media coverage of a major decline with the expressed view that it will continue, my investment instinct is to look for exhaustion on the part of the late sellers which will create a bottom. To most investors, commodities and particularly futures are of little importance in developing longer term investment policies. With high quality interest rates being manipulated by the central banks, I wonder whether the fixed income market will continue to serve its historic role of alerting the equity market of on-coming problems. If that is the case I am beginning to examine whether there is useful information in commodity prices.

According to Calafia Beach Pundit, while commodity prices are down they are still substantially up from their bottom. For example, Copper, often called Dr. Copper because of its economic ties, is down 40% from it peak but still 290% above its 2001 bottom. The price of commodities is a function of perceived and actual scarcity. One of the students of commodities recognized that in truth, the only scarcity of mankind is “human ingenuity.” Over time technology has eaten away at the use of any commodity through improved mining and manufacturing techniques plus growing substitution of less expensive elements. Also history reminds us that higher prices bring out more supply including new discoveries.

This is not going to become a “gold letter” for I believe that there are a different set of constraints on gold than on other commodities. Nevertheless, the price of gold hugged the CRB Raw Industrials Index in lock-step from 2001 to about 2007-2008. At that point the industrial commodities declined in sympathy to the then economic slowdown. Gold continued to rise until 2011. One might suggest it is when those that view gold not primarily as a commodity but a hedge against the decline in the value of currency became the dominant buyer as the US entered various phases of “quantitative easing.” Since that peak the price of the metal has had a parallel decline to the industrial materials. Gold bullion may have suffered the ultimate substitution by the increase use of “paper gold” in the form of futures and Exchange Traded Funds (ETFs) which absorbed some of the demand for currency safety.

China has become the pivot for commodity prices including grains. The command society shift from manufactured exports and internal infrastructure to consummation of goods and services has changed the global demand for industrial commodities. At some point this shift will meet its logical end and we will see growth in commodity imports into China. In the meantime the other developing economies will need to import commodities to fill the needs of their growing populations.

I do not know when commodity prices will turn upward, but as a student of history, I believe they will. If that happens at the same time as the lust to own securities deemed in short supply, we could have one enormous market rise which we will need before we have a generational type of decline.

Question of the week: Where are you seeing signs of growing demand? (The Mall at Short Hills was crowded on a warm and clear Sunday, today.) 

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Nervous Investment Instincts and Cures

Introduction

One of the basics in US Marine Corps training is to develop survival instincts which should kick in during battlefield conditions. These are meant to save the lives of individual Marines, but more importantly for the other Marines he/she are responsible. As Ben Graham wrote in The Intelligent Investor, “We are in the battle for investment survival every day.” (Warren Buffett, wrote a subsequent Preface, and called the work  “By far the best book on investing ever written.” Jason Zweig added commentaries and additional documentation to the latest edition of this landmark title.)

An early warning

One of the frustrating emotions that comes from any long-term intensive study of stock markets around the world is that markets move differently than current economic trends and are not particularly good forecasters of economic movements. What appears to me a better forecasting device is extreme indications of sentiments. Remember that large drops in stock prices occur after large rises. Thus, an increasing level of enthusiasm may be interpreted as an early warning sign that some Marines would sense as a possible ambush.  

Bailouts not the answer

While I was preparing to give a US stock market view to a very experienced group of former stock exchange leaders, the Institute of Stock Exchange Executives Emeriti (ISEE), I was approached by a somewhat  sophisticated investor wanting reassurance that the market is safer now since the financial crisis. The mere question instinctively put me on my guard. (Perhaps I was reacting to my Grandfather's instinct. He had a high carriage trade NYSE brokerage firm that according to family folklore, got all of the his clients’ investment accounts out of the stock market before the 1929 crash.)

Since the 2007-09 "crash," various governments have been trying to build a defensive doctrine against "Too Big to Fail" bailouts. If anything these moves have increased the risk to long-term investors. The real purpose of the Too Big to Fail doctrine was to protect the politicians from their own folly. The public was incensed by the use of taxpayers' money to bail out commercial activities that created their own problems over many years if not decades. In the US the federal government bailed out Chrysler twice, one of the biggest commercial employers in the important electoral college state of Michigan and bailed out General Motors once. (DuPont bailed GM out of its over-leveraged position a long time ago.) In all cases a weaker company evolved while maintaining high relative prices for their merchandise. But the labor unions delivered the votes to elect Democratic presidents.

Mortgage underwriting debacle

When the financial community expanded the mortgage base as directed by Congress through the loosening of the underwriting standards of the federal mortgage companies, the somewhat expected financial crisis occurred. Instead of letting the private sector rescue the borrowers and some of the better servicers, the government elected to bail out the existing financial service companies. If they had not, following the tradition of financial bankruptcies, almost immediately new banks and mortgage companies would have been established taking over the loan books. They would have been populated by experienced middle managers from existing shops. Most of the equity owners would have lost almost all of their risk capital and some of the fixed income holders would have had meaningful haircuts. For the most part the depositors would have come out either whole or almost whole. Since this series of bailouts was directed to the hated Wall Street, the populists were particularly upset. They wanted to ensure that never again would there be a bailout of a large financial institution.

None of these bailouts added any value to existing or future stockholders. As a matter of fact because of their restrictions on some money making activities; (e.g., trading) and the requirement to have large amounts of underutilized capital, the big banks operating under the new rules became less attractive as investments. Large money center banks currently have lower price/earnings ratios than mid size or smaller banks.

As there are bound to be future crises, the existing big banks or insurance companies are likely to have sizeable excess capital available to buy a large worthwhile financial in trouble. Thus future prospects around the world are less safe for equity investors than prior to 2007.

Additional signals

Recently at an institutional investment committee meeting, the main point of discussion was a hedge fund that was making unexpected moves partly due to their success but beyond the expected portfolio discipline. Overwhelming the professional members of the Investment Committee,  the meeting was concentrating on the expected further capital appreciation. There was only one member who was concerned about the risk that was generated by exposures beyond the expected.

While in this particular instant we were talking about investing domestically in the US, the institutional community appears to be betting on foreign stock prices but not on foreign currencies. In the week that ended Wednesday, March 18, three times the number of net dollars were invested in non-domestic ETFs than domestic ($18.4 Billion vs. $5.4 Billion, according to my old firm, Lipper, Inc.).  Most of the money going into the international ETFs went into two country index funds with their currency hedged by WisdomTree^* and one other ETF invested into the MSCI un-hedged. These to me, are short-term trading type of judgments.

^*Held by me personally and/or by the private financial services fund I manage

More conservative investors are also showing signs of becoming additionally comfortable with assuming risk. Domestic Health Care funds are up on a year to date basis +15.69 % and Global Health Care funds are up +13.0%, a continuation of last year's performance leadership that has benefited from spectacular M&A prices, though it raises some risk concerns.

Even in the high quality bond market we are seeing yields dropping much more than normal this week and for the latest 12 months. The lower yields translate to higher bond prices which is unsettling given the general view that eventually there will be a significant interest rate rise/bond price decline.

Cures

The best cures for nervous investors are:

1.  Understand the hyped enthusiasm

2.  Focus on the more important longer term, and

3.  Remember the implications from history.

One of our readers, Teddy Lamade, a fellow weekly blogger and an investment professional with Brown Advisory suggested reading Michael Mauboussin's More than you know: Finding Financial Wisdoms in Unconventional Places. The thoughtful book is a compilation of unconventional approaches to understanding problems from many walks of life-financial, sports, science, politics, and gambling. Below are thoughts from the first part of the book that I felt were particularly relevant to the nervous concerns expressed above:

You are better off focusing on decision-making than outcomes. (This applies to my concern about judgments of managers and therefore risks of repeated poor judgments as distinct from the potential of capital appreciation.)

Robert Rubin is quoted in a commencement address saying, “The only certainty is that there is no certainty...decisions are a matter of weighing probabilities...despite uncertainty we must act.”

In selecting investment managers it is important to understand both portfolio turnover and concentration. (The numbers themselves are the beginning of the discussion not the answer appearing on a screen.)

What is generally good for investors is not the same as what is good for the owners of the investment management businesses. Investors improve their odds by focusing on long-term horizons, (timespan portfolios should help), low fees and expenses, plus consideration of contrarian views as distinct popular choices.

Mr. Mauboussin also mentions one of my favorite investment anecdotes, that the year Babe Ruth set the home run record he also had a record number of strike outs. This highlights the concept that the frequency of correct decisions is less important than the magnitude of correctness. Warren Buffett and Charlie Munger have translated this into investment decision terms.
 

The probability of loss times the amount of possible loss vs. the probability of gain multiplied by the amount of possible gain is the way to make a judgment. (This is why in the long run Dedicated Short-biased portfolios underperform Long-only funds.)

Investors feel the impact of a loss 2½ times more than a similar gain. (Destruction of investment capital reduces the capital that can grow.)

One of the key differences between gambling and investing is that the more one wagers the greater the odds of losing; in investing the longer you invest the greater the odds that you will generate positive results. (Two reasons for this: first the more fees and expenses one pays, the smaller the capital in play. The second is that at least in the US equity market there is a long-term secular growth rate, which is why Mr. Buffett urges people not to bet against the US. However, he is increasingly willing to hedge that stake with international investing, a position we should all consider.

More insights

Another Michael, Michael Cembalest of J.P. Morgan Asset Management has written a very useful piece on his ten years of authoring market insights, three items of which are especially instructive.

1.  Mr. Cembalest expects a marked increase in the level of volatility. (We don't hear much about volatility during rising markets. The prevailing wish is that every price increase is fundamentally based and not a reaction to a trading imbalance.)

2.  Sentiment indicators are better forecasting devices than price/earnings ratios. He quotes five separate surveys each currently reporting at 90%+ of past records.   (As regular readers of these posts may remember, I am tracking the levels of market enthusiasm, which eventually builds to a peak prior to a major decline.)

3.  Central banks are determined to re-inflate their economies no matter what the long-term costs to their societies.

Question of the Week: what is your level of enthusiasm?

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All Rights Reserved.
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Investment Traps: More Evidence

Introduction

Last week’s blog suggested that the surge of Friday, June 29^th could have been a trap for unwary investors. There were three different baits in the trap. They were the relief caused by the US Supreme Court’s decisions on Obamacare, the surprise and pleasure that the latest European summit led to some agreements on loans to troubled banks, and favorable market enthusiasm and market volume. Today we examine each to see whether they are baits or poisoned fruit.

The Supreme Court did not provide needed answers

This is a blog for investors that have substantial, for them, investment portfolios; not for lawyers nor politicians, even though they have been known to have large portfolios from their private sector investing. The implications going forward are that there will be a tax that some wish to call a penalty. (Aren’t all taxes penalties?) The Court’s focus should be interpreting the US Constitution and the conflicts between state and federal law, not to make overt economic judgments. Nevertheless, the decision that taxes or penalizes people for not buying medical insurance has large and unknown economic impacts.

More to the point, I have little confidence in the supposed results of Obamacare. The annual costs to society will be large and disruptive, creating uncertainty in the reactions of individuals, businesses and the medical world. Thus far I see nothing that will lower the society’s cost or more importantly, improve the quality and quantity of healthcare. From an investment viewpoint the Court’s decision leaves open the impact of its actions and thus makes it easy to continue the indecision on the part of employers to hire employees. Over time I suspect that it will lead to more work being put out to small contractors that have exclusions in the present regulations. Bottom line, I see no reason that the markets should rise on the basis of the decision. 

Summit agreement is illusory

By the end of the day Monday, we will learn from the meeting of finance ministers in Brussels how they are going to create a single European bank supervisor. This is not a trick question but a trick that Germany played on the supposed agreement to allow the European Central Bank fund to grant loans directly to banks. This single supervisor would supervise the safety and soundness of all banks in the seventeen countries that use the lamented Euro and by implication all banks in the other countries within the European Community, e.g., the UK. With both the Finnish and the Dutch governments looking for specific collateral and other terms, there does not appear to be much confidence in the existing financial statements of at least some banks. In voting their support for these loans, the German legislators insisted on one of their pet projects: a European (and from their viewpoint, global) transactions tax. London is having enough trouble holding on to its prominence as a financial center with the growing LIBOR scandal that would prevent it from buckling under any continental scheme in the foreseeable future.  The highly respected but controversial economist from Citigroup, Willem Buiter, is quoted as saying “the EU summit measures still fall far short of what is ultimately needed to ensure survival of the Euro area.”

Read with skepticism and believe it won’t happen

I wonder whether we will see the burial of the “Too Big to Fail” concept and recognize the inevitable; that while painful in the long run, it is cheaper and more efficient to let various banks go under. Their smaller replacements will be sounder. I am probably too premature, but the odds are improving every day that this historic approach is still the best one.  I recognize that letting banks fail could in turn lead to some governments defaulting, perhaps as in the past after extraordinary attempts to inflate their way out. After inflation eventually comes deflation; either quickly or agonizingly slowly as in Japan. The lesson from distressed investing is that the quicker the filing for bankruptcy, the smaller the losses sustained by the creditors.

Probably all or nearly all of the summit participants will fight against the fundamental recognition of the structural problem. Thus the ministers in Brussels may find a way to paper over these issues on Monday, but confidence is once again low. (Even if gold drops to a bottom of $1200 an ounce before a subsequent rise as some predict, the trading loss will probably be less than holding so called high-quality paper, the principal reserve element in lots of portfolios.) 

Market mechanisms no longer favorable

On the 29^th the reported volume on the New York Stock Exchange was 4.1 billion shares. This week the average daily volume was 2.7 billion shares, or a retrenchment of more than one-third. After Friday’s release of US jobs numbers, the lack of enthusiasm was palpable; pundits were stating that we have entered a stall speed. Experienced pilots and other flyers know that crash landings are probable in a stall unless there is rapid acceleration. 

We are seeing an increasing number of money market funds as well as hedge funds leaving the business. I am also seeing a small number of active equity funds being replaced by their shareholders or management companies with Index funds or ETFs.

To some degree all of this bearishness is a good sign. Bull markets begin when almost all are discouraged. Based on the past however, we need to see capitulation which we have not yet seen. We might if interest rates were higher.

Please share with me your views as to the opinions expressed.

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Size or Commitment: What Matters Most?

In response to last week’s blog, a long term and very perceptive reader from a country that is also wrestling with the size of government asked whether I favor large or small government. I believe that size does matter. The single biggest determinate as to whether any current government eventually stays in power is the size of the perceived services it delivers to its people. There is a line that is attributed to a Roman poet that chronicled the need for “bread and circuses.” What went without saying were the primary needs of protection against foreign and domestic enemies. In the current era, the bread and circus line can be translated more simply to “finding and filling satisfying jobs.” I suggest that the size that matters is the size of the demands placed on the current political leaders.

Today’s appropriate size is governed by two constraints, the willingness to pay and the skills to deliver. With the exceptions of some small populations with large amounts of easily delivered but scarce natural resources, deficit production is threatening the current leadership of governments around the world. Whether the government is freely elected or not, it does not seem to matter much. The size of the current deficit is the widening gap between spending and revenue generation. Spending is for the aggregate services provided by the government to fill the perceived needs of the people that tolerate the political leaders. As discussed in last week’s blog, each of us acts as our own special interest group advocating for spending to fit our needs to be added to those of others. This is another size that matters. ‘Austerity’ is the government’s reason for not fulfilling all those current needs. Many societies are at the point that if large scale revenues are increased, it will force the private sectors to cut back their spending, reinforcing the downward spiral of austerity. While the need to sharply curtail spending is increasingly apparent and unpopular, there is some practical recognition that could save the day.

“Too big to fail?”

The first recognition is that there is little to no multiplier effect when government is the direct employer. Job leverage is much better supplied by the private sectors that are likely to bring all sorts of capital and management skills to bear on satisfactory job creation. The second recognition should have come as a result of the whole discussion regarding “Too Big to Fail.” That misplaced focus was on the potential irreparable harm that would have come from the financial failure of some 700 banks, two large American iconic auto companies, and the largest casualty and financial insurer in the world. At the time when poor decisions were made, I believe these groups had begun to manage successfully. If these companies were too big to manage, I suggest that governments, at many levels have become too large to manage. (This is particularly true when most governments cannot count on successfully recruiting the most qualified people at various levels.) Coming from these recognitions is the realization that many activities conducted by the government could and likely would be done better by customer-oriented private companies.

Thus, the answer to my reader’s inquiry: I am in favor of reduced size and scope of activities by various levels of government, but by no means am I advocating a cottage industry government.

Commitments

As a long-term investor in funds with Asian securities, I have been concerned with the financial/investment news media echoing various investment and economic leaders about the prospects for Asia. These opinions are largely based on too-similar views as to the progress of China. As an analyst, any time I find too much agreement on a topic, I get nervous. I do not like to be in crowded trades.

While it is too early to have a well-defined view of the future, I am happy to share some thoughts prior to reaching any conclusions. These thoughts are about current commitments. On the positive side, in discussions with a couple of managers I learned how they are investing in their own businesses, which are showing their commitment to investing client money in Asia for the long-term. I have been visiting Hong Kong over many years, and with my previous firm, had a fund data and marketing office there. I used to think that in many ways Hong Kong was like a suburb of London. Investment leadership appeared to be plugged into “the great and good” UK investment houses; with some minor leadership from a handful of US firms, often hiring UK ex-pats. This week I learned of one investment house having a dozen local analysts, including three in Shanghai, plus global industry analysts. What was most encouraging for me was the use of a number of business intelligence agencies to verify what many Chinese companies are saying or reporting to shareholders. With this firm’s commitment to investing in consumer goods companies, for the local market, a feel for what is actually happening as distinct from reading and believing press releases becomes critical to produce good relative performance. A second firm, in this case mid-sized, with only twelve investment people, has opened an office in Mumbai and staffed it with four analysts. The leader of this firm believes that this is the best investment that the firm has made, even though they currently have only about 8% invested in India. These two firms are making significant investments with their own operating money, being able to produce “long horizon” investment returns for their clients.

The other set of commitments are even longer-term and much more difficult to produce satisfactory results. Governments in China have not lost power from battles with foreign invaders, but from large-scale social disruptions. With over 50% of the current population living in the cities, with more wanting to live and work in the cities, China's urban development is critical to social stability. The government is particularly focused on the inland cities. With their lower wages, they could become major job creators and socially stabilizing forces. The government has a desire that many of these cities should be able to ship their manufactured product and natural resources to coastal ports within five hours travel time. There is, at least, one problem with the execution of this desire. Most existing railroads generally run in a north-south direction, however east-west routes are needed to bring merchandise to the ports. The recent series of crashes of the “bullet trains” has led to major changes in China’s infrastructure planning, including rail speed and management. To the extent that the central government’s change in emphasis in favor of consumer spending as contrasted to the prior focus on exports, there could be some relief beneath the social surface. The pace of development will need to keep pace with the speed of electronic communication to prevent an increase in the reporting of social disruption.

We need to do more research. What happens in China will impact the rest of the world.

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To Avoid Moral Hazard: Buy Asian Equities, Hold Cash for Redeployment and Sell High Quality Bonds

This week’s blog is based on thinking about the signs shown for “Occupy Wall Street,” seeing the video rendition of “Too Big to Fail,” remembering the insight of a blind leader, looking at extreme numbers and watching the NY Jets beat a better team. Part of the intellectual handicap we all have is that our views of history are shaped by commentators who lack full understanding of what they thought they saw or heard.

D/F + TBTF + OWS = Bigger failures - - bigger opportunities

By now the media savvy recognize "OWS" stands for Occupy Wall Street which has gone global as sites of anger, frustration, and the willingness to break laws. "TBTF" abbreviates the title of the book entitled Too Big to Fail, which was made into a movie which was rebroadcast last night. "D/F" is my symbol for the Dodd Frank law that is being imposed on the US financial and economic community, which has implications to financial communities around the world. This witches’ brew of maladies will, in my opinion, lead to bigger failures and greater disruptions to global progress and at the same time open up new opportunities for the wise to make money.

The complaints

Two of the complaints coming from the inhabitants of the various “rescue encampments” are first, the banks got bailed out of their problems and we “ordinary people” did not; and second, we have selected various financial institutions to receive future bail outs whenever they get into trouble. I do not expect the strident to allow me to share my personal historical perspective from both fifty years of professional investment experience and having listened to other professionals who went through the changes in the financial community for over one hundred years.

Ever since the “Money Panic of 1907,” (if not before), financial people have been concerned about the potential damage that a concerted “run on the banks” could do to individuals, themselves and the community as a whole. In its simplest form, banks collect deposits and loan most of their deposits back out to the community in the form of demand loans or term loans. Banks require interest income from these loans to pay for deposits, other expenses and to build reserves to cover for periodic credit losses. No bank keeps enough cash on hand to meet redemptions of all its deposits. Thus, if there was a “run on the bank,” the bank would attempt to call all its demand loans and as much of its term loans as possible. The news of a run on one bank is likely to cause a run on other banks. This fear is what led to the founding of various government financial agencies like the Federal Deposit Insurance Corporation (FDIC) in the 1930s. Those of us who have spent our lives in the mutual fund world have harbored the same fear about “money funds.” As a matter of fact, Jack Bogel, the first president of the Vanguard Funds, has told of his fear of one day turning on a Philadelphia television news program and seeing a helicopter reporting on a long line of people formed around Vanguard’s Malvern offices who want back the billions in their money market funds. Both the current US administration and its immediate predecessor felt that they had to “do something” to prevent harm to ordinary citizens. In the government’s eyes, it was bailing out individuals and small businesses. One could argue that the government and financial community leaders should have let various banks fail, and individuals lose the value of some of their deposits. Such inaction could well have led to a lack of confidence in the financial community that supports the government’s funding requirements. Bank failures and government defaults have been going on since their creation without total loss of economic progress.

The way the potential run on the banks was headed off was to force Federal government or Federal Reserve Bank loans on the banks, which led to the belief that certain financial institutions were so important that the society could not afford to let them fail financially. In other words, they were too big to be allowed to fail. There is a term for this which is “moral hazard,” which means that the government will permit these groups to make significant financial mistakes and they will still be bailed out. This concept goes directly against the wisdom of a very successful regional brokerage firm. On the occasion of the annual meeting of its partners, I was paid to give a speech on how I saw the brokerage business evolving. This was in the early days of Power Point graphics which I used in my slides to support my conclusions. To my horror, no one told me the chairman of the firm (who was sitting next to me) was totally blind. Trying to recover in my conversation with him, I recognized he did not have to see the charts, he intuitively knew what I was talking about. We then discussed what his firm should do in the face of the increasing market share that larger brokerage firms and banks were taking out of his market. I inquired why his very successful firm had a small capital base, (where the substantial profits were paid out at the end of each year). He replied that he did not want to accumulate firm capital, for he feared that his partners would invest it poorly. Too much capital would lead to putting undue pressure on the firm.
Today, I wonder whether firms that get into financial trouble should be bailed out. The FDIC has a model that a failed bank’s deposits and sound loans get auctioned off to a competent nearby bank, and the losses to be absorbed by the bond and shareholders of the failed bank. In the UK, the banking authorities are trying to “ring fence” or separate the retail deposits and loans from the business loans and investment activities of the bank. (In some ways they are trying to put back in place the Glass–Steagall Act in the United States.) This weekend in Europe, the powerful countries are trying to determine how to help their national banks with faulty sovereign debt and underwater loans, either through a materially stronger bailout fund backed by a central bank, or a facility that would insure some of the value of the loans. To me, the insurance scheme has less moral hazard.

All governments need to be careful about changing established ways of conducting business. In the US, we have merged investment banking with commercial banking rather than keeping them separate and in some cases, competitive. Almost all of the losses suffered by the large investment banks were in their investments, particularly illiquid real estate. Similarly the Savings & Loan scandal of the 1980s was caused by pulling down the interest rate advantage the S&Ls had in attracting deposits for making local home mortgage loans. Once there were level interest rates, many S&Ls went into commercial lending that they were ill-equipped to do, and commercial banks built up their home mortgage business without the requisite local and personal knowledge of hometown people and properties. Further, when the SEC introduced price competition in brokerage commissions (as distinct from service and research competition), it changed the game which led to the need for capital to facilitate trades. The SEC compounded the problem when it encouraged multiple sites for trading, executions, and reporting. To some degree, the fragmentation of the market has led to increased volatility.

Many investors believe that the increase in volatility is a sign of increased economic risk. I think you have to look at volatility as any time series, and dissect it to derive meaning. In Saturday’s WSJ, which is what they are labeling the Saturday edition of The Wall Street Journal, there were two items that address volatility. “The S&P 500 would be up 16% for 2011 if the three biggest declines were excluded and it would be down 13% if the three biggest daily gains were excluded.” The message that I get from this data is that we have been in trading range markets with periodic extremes. For the technical or chart analysts, this pattern is either of a distribution where stocks move from strong (in theory, “bright”) sellers to weak (presumably dumb) buyers, or it is an accumulation by bright investors picking up bargains from tired or discouraged speculators. Only time will tell which is correct when a significant move breaks out of this trading range. My long term bet is for a breakout on the upside. In a contest, the bright or better team doesn’t always win. We just returned from seeing the New York Jets, with their home in New Jersey, play football against the San Diego Chargers. While I was cheering for the Jets for “hometown” and other reasons, I had to admit that most of the time the Chargers played a better game, except for two pass interceptions which led to a Jets victory. Thus, it is often better to be lucky than smart; and I hope that while I understand the negatives facing us, I hope to be lucky on the upside.

To put my neck out further, I was a member of an investment panel addressing a group of Caltech alumni and scholars. Our final question was what would we buy, hold, and sell. We ran out of time before I could answer, but as some of that audience are also members of this blog community, I thought I should very briefly give my answer which we can discuss in future posts. I would buy Asian equities, hold cash for redeployment, and sell high quality bonds.

What would you do?
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