Washington & the Necessary, But Insufficient, Signs of a Market Bottom

Feeding the optimist can be a long and frustrating task, but a necessary one. I am taking on this task to help others as well as to reinforce my upside bias. This bias is based on the old US Marine Corps belief that the best defense is an offense. Like most analysts, I am a reviewer of history; and I believe that even in history’s darkest moments, the human condition has been on the rise.

In the midst of our deep financial problems, we may be in the best position ever to deal with solutions. The current mood of investors is shifting to the view that the light at the end of the tunnel is not a way out, but rather an oncoming train. Historically this feeling of hopelessness is a required backdrop for the scene at the bottom. With that thought in mind, I was thrilled to see a story entitled “Bear Market’s Bite Could Go Deeper” in the online version of The Washington Post. “It is unlikely the market has hit bottom,” the article begins, continuing with the opinion of a chief technical analyst at S&P, “The current market environment is showing few signs that have characterized previous lows—high price volatility, high volume of trading and even higher levels of fear.” “Bear market bottoms tend to be violent affairs.”

Why am I thrilled with this article? First, the Washington Post is the single most respected source of perceived wisdom, therefore it must be politically correct in the Washington Beltway. Second, based on the high regard the American investing public has for the media in general, people now search for truth in the opposite direction of media pronouncements. Third, the S & P analyst is accurate only if one is dealing with a cyclical bear market where the search is for a violent bottom to wipe out the weak holders as a precursor to a sharp rise. This kind of bottom is not logical if one believes, as I do, that this bottom is the terminal set of points at the close of one era. The most logical type of bottom after the damage of the corrective phase is a dull exhaustion bottom, created by the absence of buyers at any price. The pessimists are exhausted and possibly sold out; and the optimists, like me, feel the prices are fine, but the time may not be quite right.

One of the many signs of a tectonic shift in the structure of our investment markets crossed my desk late this week, driving home the impact on our conservative and senior population. I received a notice from the American Funds Group announcing that their Balanced Fund was reducing the dividend to its fund holders. The explanation for the cut was the curtailment of dividends from the high quality stocks they own, as well as the current low interest rates on high quality fixed income securities in their portfolio. As many of you know, the American Funds are managed by Capital Research one of the largest investment management groups, with a long history of distinguished results.

A word about the origins of Balanced funds. This type of fund was an extension of the trust accounts used in both the UK and the US, comprised of both stocks and bonds. In Boston, these were the types of accounts that Clipper Ship Captains left with their lawyers to manage while they were away. The income off the trust was to provide for the current needs of the family, and the stocks for growth of assets. In many ways balanced funds act more like fiduciary accounts than the single asset class type funds.

There are a number of important observations from this action to reduce the dividend:

1. The current market decline is now going to be felt by those who can least afford a change to their income level.


2. Many high quality stocks have cut or omitted their dividends. These are the very same corporations that were considered among the most reliable of our corporate citizens as recently as one year ago. Something fundamental has changed for the worse among our best.


3. The original investment concept of a Balanced fund was that stocks and bond prices would move inverse to each other. Bond prices would rise when stocks declined. Currently in the high quality corporate bond market this is not happening in a significant way. This is another example of the tectonic shifts in our marketplaces. The term tectonic is an apt geological term that that defines when the great plates that make up the earths’ crust move, which happens extremely rarely. We are now into something new and maybe for the first time in our investment lifetimes, something “completely different.”

In some ways we may be in a Revolutionary period similar to the French or scientific revolutions or even closer to home, the American Revolution. I am writing this blog on February 22nd, George Washington’s birthday. As my wife Ruth serves as a “Lifeguard,” a group devoted to fund-raising and introductions to the wonders of Mount Vernon, we often go there to celebrate the memory of our first President, the only one not to serve in the city named after him. For the moment I want to focus on this man, often called “the indispensible Washington.”

If we are truly in a revolutionary period, where are our leaders like Washington, Hamilton and the others? The politicians and most of the patriots turned to General Washington for the leadership of what could be laughingly called our army. It was a bold step to choose a military leader who had been defeated in the last war, but he was possibly the richest man in the colonies. His fortune was earned by brilliant land speculation in many of the thirteen colonies and other nearby regions. During the Revolution we had better tactical generals, but none better on a strategic level. Interestingly, Washington was constantly out of sorts with Congress, and threatened to resign on numerous occasions if provision was not made for the meager funds to pay his troops.

The war was won largely due to the quality of Washington’s leadership, a fortunate break in the weather and the threatened presence of the French fleet. Washington’s leadership created trust on the part of his soldiers and perhaps the one-third of the population that supported the cause. At the moment what we are missing is faith, or if you will, trust in our institutions, media, economy and markets. Each day many of us start the day with low trust in that list, and the actions of the day lowers the trust even further. What we need now during what appears to be a revolutionary period, is faith that things will get better. Let us hope so. History suggests that eventually the optimists win.

For the Greater Good: Frugality vs. Stimulus, T.A.R.P. and Foreclosure Relief

In this Sunday’s New York Times, Cornell Professor Robert H. Frank wrote an article entitled “Go Ahead and Save. Let The Government Spend,” in which he discussed whether taxpayers should resist spending their last dollar and let the government spend through the stimulus package, TARP and similar programs including the expected foreclosure relief package. In the article, Professor Frank referred to the John Maynard Keynes essay, the “Paradox of Thrift,” which argued that increasing individuals’ savings rates has the effect of reducing aggregate demand, and because of the negative multiplier effect, actually reduces personal income. Over the past seventy years many academics and politicians have used this analysis to conclude that government should stimulate a declining economy with grants. Keynes would individually have us spend our last dollar to lift the economy. In the Times article, Prof. Frank disagrees, “Taxpayers shouldn’t feel bad for putting their own savings first.” He stresses that personal savings find their way into the financial system, usually through some form of deposits. These deposits will force banks to compete for good loans by lowering interest rates which helps some existing borrowers as well as new borrowers.

I agree with the thesis that we should let the Government spend our money first, whether it provides optimum benefit to the economy or not. However, there are two stronger arguments that Professor Frank could have made. The first has to do with the contrast between the multiplier on consumer goods and services purchases as opposed to the multiplier on capital goods purchases. The largest part of consumer spending is for immediate or near-term consumption, which pays for the human labor already expended. Compare this impact to spending on capital-producing investments, such as mining or manufacturing, which may produce much larger revenues and earnings in the future. Those who favor immediate satisfaction by spending today are following the same pattern of over-spending and under-saving that is one of the causes of our current calamity. In effect, this is a consumption based philosophy that does not look to the needs of the future. In contrast, savings that support capital production does grow the size of the pie.

In order to make wise capital expenditures, business people assume various contingencies when building their calculations for cost of capital and expected returns on their capital, including sweat equity. I believe that from an economic measure, the return on private capital spending is materially higher than consumption expenditures. Thus, we should all be increasing our savings for the long-term benefit of the economy.

The second reason we should encourage savings is that frugality has its own reward. In my recent book Money Wise, I suggest that the second most important way to convert riches into wealth is by controlling expenditures. If your goal is to increase your savings from the current 5% to 9%, you will need to find the other 4%. You will do this by either expanding your gross income or finding some expenses you can do without, or can delay. In other words you will become a much more efficient purchaser. This more efficient mind set will stay with you for a much longer period of time than will the pleasure of consumption, and thus will have a more lasting benefit to you, yours and your charitable endeavors.

Financial Community Restructures

For close to fifty years I have participated in the financial community as a worker and/or investor; in the U.S. markets and as an investor overseas. I see our financial world undergoing massive changes, both as a unit and through its interactions with organizations and individuals. Amidst these changes, I have been formulating a course of action for the money I have been, or will be, entrusted to invest. Some of my ideas are starting to congeal into view. These thoughts were reinforced by Jason Zweig, the always thoughtful and well-researched author of “The Intelligent Investor” column in the weekend edition of The Wall Street Journal. A friend for many years, this weekend Jason points out the hopelessness of trying to control the level of bonuses on Wall Street. He recognizes that the large firms inflicted by the TARP will out-source most of their high compensation work to firms in which they have some ownership.


My thought pattern is more encompassing, and to some extent a throw-back to a Nineteenth or early Twentieth Century model. My basic concept might be called the “Single Capacity Approach.” First, an entrepreneur or group of entrepreneurs would find a banker (most likely a merchant banker or venture capitalist) to provide the next level of capital and to offset risk from its own resources. Once additional capital was needed, then an investment banker would be sought. In the old days, this firm would be called a buying firm, somewhat analogous to the role often played by the old First Boston. Up to this point, as all of the participants would be using their own, relatively small amounts of private capital, one would think they would exert a reasonably high level of prudence in their risk aversion. There would not be much systemic risk if any participants failed.

In this model, the buying firm would have no direct customers and would turn to a selling firm who has commissioned brokers to sell the new merchandise. As the selling firm would only have investors as clients, they would research the prospects of their underwritings very carefully. Because of the need to underwrite these issues, some public ownership would be desirable. If the selling firm would go bust, it would not create a major failure. The ownership of selling organizations has always been problematic for the marketplace because of the over-zealousness of commissioned sales people, or the risks of the selling organization pushing its own proprietary products. (The latter event can create a major risk). Recently, there have been press reports that Bank of America turned to its newly-owned Merrill Lynch to sell Bank of America’s own capital-raising issue. Similar lapses in judgment are ill-advised and may quickly bring the reversal of the repeal of the two sections of the Glass-Steagall Act that prohibit commercial and investment banking from cohabitating. When properly supervised, the selling firms, as well as commercial banks could provide custodian services, including margin lending and securities lending to their clients.

To protect the public investor in these underwritten and publicly traded securities, there should be a bunch of intermediaries/fiduciaries independent of the commercial bankers, investment bankers, venture capital firms and most important of all, the selling organization firms; they could be independent advisers, mutual funds and hedge funds with enhanced disclosure. While the need for substantial capital for these intermediaries is not enormous, they could be publicly traded to facilitate internal transfers of ownership and the settlement of estates.

The structure that I outline is far from perfect, but it has the advantage of keeping the required capital relatively small and reduces the need for TARP-like intervention in the capital base and compensation tables.

I look forward to hearing your views, please comment.

The Next Big One - FX

The Madoff scandal and other similar grand thefts come as a complete surprise to people, but they shouldn’t. Why? Bad behavior is part of the human condition. Large scandals happen because they can happen. Investors believe first in people, and second in their own understanding of the perpetrator’s personality. In the back of these investors’ minds is a belief that there are effective, long-established controls that would prevent any large frauds to take place. Often the mind of an outright criminal, or more likely someone who “temporarily borrows money” from the unsuspecting, is smarter than the best of the designers of financial/trading controls. Most of the large losses experienced over the last ten years grew because the perpetrator(s) understood “the back office” systems better than those in charge of various compliance functions. Some may have actually been motivated by the battle of man vs. machine, where the lone mind can beat the machines and their watchdogs. I will let the lawyers and the forensic accountants supply the blueprints to the Madoff scandal, if they can. I am attempting to spot the next big, unexpected fraud.

One of the attributes of securities fraud is that the ultimate size of the transfer of wealth is usually large. In most cases of embezzlement, the initial transfer is small and is designed to cover an error or unauthorized trading loss. However, once the person learns how easy it is to cover the tracks, the need to fill an ever larger hole or desire often prompts a continuation of the transfers. Until conditions and compliance functions change, these activities will continue. Most of these frauds “go with the flow” of enthusiasm in rising markets.

Showing both my age and my experience as an aerospace analyst, I was attracted to the competition to build the next experimental fighter aircraft, which led to a procurement of thousands of aircraft, translating into tens of billions of dollars. Another, larger weapon system is also labeled “FX,” and has a similar order of magnitude cost. This second FX is Foreign Exchange transactions, not a weapon that can travel the world in supersonic speed, but one that can span the globe in milliseconds.

Even in today’s world of expanding global trades, and the need to pay for goods and services in different currencies, the share of the FX market needed to settle these transactions is believed to be a small part of the total FX market.

The bulk of the FX market is made up of two components. The first is the exchange of currencies required to settle securities trades, e.g. the American buyer of a German bank share. The second component is those transactions that are undertaken to make a profit. In the most recent weekend edition of the Financial Times there is a long interview with George Soros, who I knew years ago as a struggling defense/aerospace analyst. The article includes a brief description of his $10 billion trade against the pound sterling. As a result, he and his funds made $ 1 billion, and received the title, “The man who broke the Bank of England.” The bank was on the other side of the trade, trying to support the pound. What is not publicly known is how much of the position was equity, and how much was borrowed. In those days and today, one can borrow up to 99% against currency collateral.

Numerous advertisements on financial cable channels point out that the FX market trades more each day than any other financial market, and is never closed. These purveyors will make their money by loaning capital to the retail investor who wants to take the relatively small daily changes in currencies and multiply it by the use of margin. The ads focus on the lack of regulation. In the scheme of things these activities can be described as small potatoes.

The big enchilada is the trades with and among the banks. To gain some insight into this size, we can learn from the fourth quarter statement of 3 trust banks that have large custodian business and whose foreign exchange earnings were in the hundreds of millions of dollars (one of the few earnings plusses for the quarter). The unknown players in this market are the investment banks’ FICC Groups (Fixed Income, Currency and Commodities), dealing through their proprietary desks and other hedge funds. Some or all of these use various derivatives including currency forwards.

My bottom line is that the FX markets are huge, largely unregulated, with complex compliance procedures which may not be fully water-proofed, and fueled by the prospect of large gains and oversized bonuses. As with my aerospace days, FX can be a major weapon of destruction. Don’t say that you weren’t warned.

Searching for the Comfort of Cycles

Our earliest experience has to do with being fed on a regular basis. After the very first drink, we learn there is a second which is followed by a third and so on. Thus we learn rhythms, albeit two separate notes between being fed and sleeping. A little later we start to identify the time pattern between feeding and sleeping, and the third state of waiting for either to happen. From this three stage development we learn about cycles, and to keep us in good humor, the predictability of these cycles. Now that we are larger, in many ways no less baby-like, we search for the comfort of the predictability of cycles. After all, we know about the cycle of day and night. In order to schedule joint activity with others, we introduced the primitive concepts of a clock which divided time into segments of hours. To effectively regularize our lives we introduced an abstraction of assigning 24 hours to a day. Using this abstraction one could be certain as to the future. There WILL be a six o’clock tomorrow morning, and for most of us that is comforting because it means that we will consume our first meal of the day.

The problem in applying this abstraction is that we don’t know whether the sun will be up over our horizon on any particular morning. We are unsure for two reasons. First, the “rising” of the sun, in reality is the rotation of the earth, a predictable cycle which is not based on our clock system. The second reason is that we may not have great light at dawn (or any other part of the day), as there may be clouds overhead, sometimes dark clouds. These primitive experiences help us appreciate the frustration of today’s investors attempting to predict market movements.

We would all like to have the predictability of being fed on time, in a pre-ordained way like the sun rising. We want to be able to believe that next Tuesday most stocks, or more importantly my stocks, will begin a ten year rise of historic proportions. The problem is that there are serious economic, financial, political, social and scientific black clouds overhead. We are not only losing money, but we are also frustrated about our inability to predict the future. While I can not predict the future, I can examine the nature of selected past cycles with you.

As usual, we can learn from the ancients who had to supply stories to worried people without the aid of Bloomberg and Blackberry devices. While the ancient Greeks looked at the stars and saw various perceived actions, in effect what they were doing was dealing with the mysteries of human behavior. But due to the unfathomed rotation of the earth, they “saw” movements with enough regularity as to make their stories predictable. Similarly, we seek predictability even though we don’t understand the reality of the mechanism that creates the predictability. We really don’t care why the market, and particularly our stocks, are going up as long as they do. (A lesson Bernie Madoff learned early and well.)

Agriculture, with its dependence on weather, has always been a cyclical activity. Farmers and herdsmen want to supply their markets with substantial volume at high market prices. Their desire is to develop a bumper crop, when many others don’t for whatever reason. If successful, these farmers would be living in what is today called Fat City. I will let the various religious and scientific authorities determine whether the seven fat years followed by the seven lean years is mathematically accurate or just a very useful allegory. From a humble analyst’s point of view, the Biblical story deals with a beautiful description of both secular cycles and a tendency to reverse directions when a trend becomes historically excessive. Let me point out that small market caps seem to move in periods similar to the seven good years followed by seven bad years. Again the explanation for this cycle is a lot like the ancients looking at the nighttime sky for human answers; we could be looking at the wrong place.

I believe the small cap cycle is really a function of recognizing that prices are full for large, seemingly mature capitalization stocks, while searching for alternatives before the economic cycle turns down. My evidence is that operating earnings, if any, of small caps do not lead small cap stock prices. The best coincident indicator for small cap stock prices is the frequency and intensity of Initial Public Offerings (IPO), excluding the IPOs of closed end funds. Thus, when we examine the records of venture capital funds we see certain vintage years standing out as big winners.

The different types of cycles, and the various abstractions used to explain the cycles, in truth do not yield a useful understanding of what really drives the cycles. All we want is predictability! In particular we are searching for a predictable turnaround for a depressed and depressing market.

Allow me to look at the nighttime sky and suggest that the conditions are favorable for a turnaround. Since 1920 there have been 17 designated recessions in the U.S, including the present one. Only four of the sixteen recessions have lasted more than the current duration of 13 months. Narrowing the focus to exclude the recessions that began in 1920 and 1929, there were only two modern day recessions which lasted more than the 13 months, and they were both finished in 16 months.

There are lots of things wrong with these predictions, including:

1. Stock prices and the movement of the economy are tightly correlated. Our bullish friends point out that stock prices have a discounting of the future function, and often the market anticipates the economy by three months or more.


2. The current global economic malaise seems to be more like the destabilization period which began in 1873, when financial and political power was shifting from agriculture to the industrial sector. (Perhaps the real meaning of the US Civil War).


3. The absence of an identified cause for the reemergence of consumer faith, that is faith in a better future.

Even though I do not have appropriate answers to my own questions, I want to believe in a turnaround as well as the availability of my next meal. The danger in searching for simple declarative, forceful answers is that we become vulnerable to the new Great Policy, Man or Party. (Now more than ever we need the minority to protect the majority.)

As they said on “Star Wars,” which really dates me, “Let the force be with you.” I say, “Let the cycles be with you.”

Are There Big Traps in the Credits and Foreign Exchange Markets?

Serving on numerous non-profit boards, investment and finance committees as well as being investment advisor to various wealthy investors and financial institutions provides me with the advantages of having a wide source of information, opinions and talents. By regulatory definition these clients qualify as “sophisticated investors.” As each investment pool is designed to meet the specific needs of an account, there is only a minor degree of overlap in investments. Thus when I hear from different groups the desire to add a specific type of investment product or strategy, these desires become an important trend to consider.

Recently this development occurred when members of diverse groups from both coasts wanted to add investments in credits to their portfolios. They were not focusing primarily on bonds, except those that were in distress. Instead, they were focusing on mortgages, asset-backed loans, bank loans and other credits perceived to be in trouble. My concern is that both the credit and FX markets have similar characteristics which have been troublesome in the past. These are:

• Over-the-Counter trading without central price reporting and settlement of trades


• Unfamiliarity to most institutional and individual investors


• The availability of high margin (up to 99% in some cases)


• A largely unregulated global market without fixed market hours


• Apparent hedging through complex derivatives


• Trading requires specific skills and broad networks


• Many, but not all, of the players are working for unfamiliar names

Note that often these credits are not in the form of securities and may not be under the aegis of the SEC. In most cases the search for such investments leads to managers who are not used for high quality investments and are often engaged with low fees. None of the managers have relevant track records, but all share the characteristics of wanting high fees and/or profit participation roles.

Certain aspects of this market may offer a prescription for high level, leveraged, and operationally intensive, price and fraud risks.

I have no doubt that there will be some money made in credits in the months and years ahead. (My definition of “money made” is the aggregate withdrawals that can be made after relevant taxes without invading inflation-adjusted principal.)

The search for credit opportunities is almost exclusively institutional in nature. The retail equivalent of this search is Foreign Exchange (FX). FX exists in the global 24-hour market whose heavy, cable-advertised drumbeats may mask some of its toxic nature. While there is a bit of institutional interest in trading FX directly, FX trading in size is usually conducted through bank channels. Many investors have learned to their dismay that price risk, with its relatively small movements, is not the only risk. In the credit and FX markets, counterparty risk should be examined; the other side may not be good for its trade. To many, the Lehman Brothers’ bankruptcy exposed the unfathomed depths of counterparty risk. The critical interrelationships of these markets are underscored by the name which many brokerage firms identify this combined market group: “FICC” standing for Fixed Income, Currency and Commodities. This group is traditionally a major user of its firms’ capital and a generator of profits, and more recently, large losses.

I am not advocating that one totally avoid investing in either credits and/or currencies. What I am suggesting is that instead of being a strategic reserve element to a portfolio, that these investments can prove to be high risk/high reward elements that should cause lowering the potential loss of permanent capital in other parts of the portfolio.

Did Fixed Income Confusion Create Madoff Victims?

There are three principal reasons to own individual fixed income securities or funds. The first is capital preservation. In the balanced accounts that we manage for institutions and wealthy people, capital preservation is our primary concern in our use of fixed income. For these accounts, fixed income is meant to be a strategic reserve against the chance of significant loss from irreparable declines in equities. For more than a year we have executed this strategy by directly owning very short term treasuries, or totally pure US Treasury money market funds. At some point in the future we will have to extend maturities a bit as yields go up.

The second reason to own fixed income is the need to produce income. Neither equities nor high quality bonds are producing enough income today to meet normal endowment and foundation pay-out needs on their own, and certainly not enough income for balanced accounts that are also invested in future-oriented equities. However, the yields on fixed income come closer to the goal than equities do.

The third reason to own fixed income securities in a managed account or fund is to make a bet on the skills of a manager to anticipate interest rate moves, or to rotate through the various sectors or types of fixed income securities. There are managers that have records of making these shifts successfully, however over the long term these skills are probably even rarer than selecting successful rotations by stock portfolio managers.

Each of these three basic reasons is modified by two other considerations. If one believes, as I do, that inflation is a major concern in the long term, then inflation-adjusted paper should be considered in this part of the portfolio or possibly in the equity portion. The second consideration is taxes, which may suggest to some a heavy portion of tax exempt bonds and an understanding of how inflation-adjusted paper increases taxable income without immediate cash generation.

Many investors are challenged by wanting to own fixed income to fulfill all three needs. No single instrument can deliver at the same time on these requirements. Many investors, both individual and institutional, recognize the problem and turn their money over to a manager or fund to accomplish the task. In the end they want capital preservation, largely predictable income, and the ability to take advantage of the rotation of values, both on the long and short side.

While neither Mr. Madoff nor the feeder funds or operations he used ever pitched their investments as fixed income, the supposed record was long enough, and co-investors comfortable enough, to generate fixed-income like confidence. Madoff’s stated performance results in most periods were not as good as what leading equity managers produced, however (at least on paper), Madoff’s results were such that some investors could view his product as a fixed income alternative. Even if true, the performance was supposedly based on the skill of the manager, which should have been a warning that there was a lot more specific risk.

I believe many of these investors should have been investing in dull, boring fixed income, with some portion invested for capital preservation, a smaller portion in the generation of income and a very small bet on manager skills.