Friday, December 23, 2011

Thirty Years and Counting


I will be on vacation next week, so this will be my final posting on Random Glenings in 2011. I thought I would take a break from the usual economic/market commentary and take a brief look back.

All the best for a happy and prosperous 2012!

Thirty years ago, in December 1981, I graduated from the Business School at Indiana University. Against the advice of my professors, I decided to head east, and start a career in investment management.

The investment management business was considerably different than it is today. After the "Go-Go Years" of the 1960's - when mutual fund managers like Gerry Tsai at Fidelity had achieved an almost cult-like status by achieving spectacular returns - stocks had fallen to earth in the 1970's.

The Dow Jones Industrial Average hit 1,000 in 1969. The market then started the slide that would take the Dow below 600 in 1974. Gradually prices improved, but it wasn't until 1982 - the year that I started my investment career - that the Dow returned to the 1,000 level.

Investors fled stocks in the 1970's for safer havens like bank accounts. The industry greatly suffered - Fidelity, for example, nearly went out of business in the decade, saved only by the introduction of money market funds.

There was more. Academic research indicated that markets were mostly efficient - that is, all available information about a stock was already reflected in its price, and there was no need for fundamental research. Why should anyone pay for investment advice if the markets were totally efficient?

Individuals were largely not involved in the stock market. In 1980, less than 10% of the American population had any of their net worth tied up in stocks. Stock market activity was an interesting news item, but it had a minimal impact on the daily lives of most people.

The firm I joined - Scudder, Stevens & Clark - was the oldest independent money manager in the United States. Scudder managed $12 billion when I joined it - the largest money manager in the country.

Scudder's investment business was largely focused on high net worth investors. We had some prestigious institutional relationships - the Ford Foundation and Harvard University were large clients - but most institutions were more comfortable with large passively managed bond portfolios.

Scudder too had experienced rough times in the 1970's. All of the partners had been required to pony up money to keep the firm afloat in the bear market that never seemed to end. Salaries were low - no one went into the money management business to get rich.

The firm was understandably frugal when it came to expenses. A sign in the Men's Room reminded users that "It only takes a little soap, and lots of water, to get your hands clean". The expense of personal long distance calls were the responsibility of the employee, and monthly phone bills were carefully monitored.

I was heavily in debt by the time I finished business school, and asked Scudder to help pay for my moving expenses. Reluctantly they agreed, but only after I got several competing bids from moving companies.

Even so, I had to wait more than a week after I started at Scudder for my furniture to arrive. A sleeping bag, and one pot for cooking, were the total sum of my furnishings during my first days in Boston.

It goes without saying that my salary was nothing special, either. Although I was one of the top students at Indiana, my starting pay at Scudder was well below average compared to my fellow graduates.

Scudder's attitude towards paying new employees was best summarized by Ted Scudder, in an excerpt from a speech that all new hires were required to read:

"Right now you are worth less than nothing to us, since you have no clients or investment expertise to help the firm. Still, we realize that you could not work with us if we did not pay you, but you should be aware of the sacrifice that the partners are making on your behalf."

Even with all of this background - low pay, crummy markets, frugal management - I was thrilled to be working at Scudder.

Scudder had almost a family-like culture. Everyone worked hard, but family and friends were important as well. When an employee suffered a personal loss - as I did in my early years - no one could have been more supportive than the management of Scudder.

But the business of Scudder was managing money. Fortunately for me, it was a great time to be an investor.

Stocks were trading at single digit multiples, and dividend yields were well north of 5%. Rather than talk about opportunities, however, the media largely focused on how poorly stocks had performed in the 1970's. No one had any interest in buying a piece of a business whose growth rate was far ahead of where it was being valued in the market.

Bond yields had steadily risen throughout the 1970's as inflation rates steadily moved higher. By the late 1970's, inflation was running at double digit rates, and new Fed Chairman Paul Volcker decided the time had come to slay the inflationary dragon. The Fed's policies eventually worked, but at a cost of extraordinary high interest rates.

Thanks to Paul Volcker, when I started at Scudder short maturity rates were nearly 20%, and long maturity Treasury bonds yielded more than 14%.

With record high short-term rates, money market funds were the rage. In 1981, money market funds had returned in the neighborhood of 15% to investors. Few observers bothered to point out that high short term rates would certainly be short-lived; in fact, Volcker started to cut rates in August 1982, and money market yields quickly followed suit.

My first assignment at Scudder was a corporate bond credit analyst. Investors could make serious money by doing fundamental research on bonds, and Scudder was one of the best. Since Scudder was literally the only investment firm that devoted any resources to bond research at the time, I can safely say that I worked in the best bond research areas in the country.

It is obvious in retrospect that investors should have been throwing any savings they had into the markets, but after the Lost Decade of the 1970's no one had the stomach.

For the period starting in January 1982, and ending at the end of 1999, stocks produced a 19% compound annual return. Even long government bonds gave anyone brave enough to invest in the market a 13% compound annual return.

If there is one constant that has remained the same over my 30 years in the business, it is this:

Investing on the basis of past returns is nearly always a bad decision.

And the corollary to this is:

Reversion to the mean is one of the most powerful forces in the capital markets.

Over most periods of time, stocks will outperform bonds. This only makes sense: an investor in a company should earn higher returns than someone who lends to the company. Returns from safe cash investments like money market funds have historically returned the rate of inflation, which also makes intuitive sense.

Or, put another way, no one ever got rich investing in money market funds.

Investors in 1981 were not interested in stocks or bonds because they had performed poorly over the prior decade. No one focused on valuation, or was able to see that most of the investment worries were already priced into the market.

Smart investment managers like Scudder tried to point out the opportunities to clients, but very few would listen.

Which brings us to today.

Similar to the start of my career, stocks have been disappointing performers for the past 12 years. Looking squarely in the rear view mirror, investment thinking today focuses largely on the myriad of risks in the market.

Investors would rather buy Treasury bonds yielding less than 1% for 5 years rather than subject their capital to any possible risk. Again, this is similar to where I started, when investors flocked to money market funds.

Alternative investment vehicles like private equity or hedge funds have gained appeal among institutional investors based on past returns. Never mind that some of these gains have been earned by taking outsized risks.

Instead of buying large cap dividend-paying stocks offering all-in (earnings yield + dividends) yields around 15%, investment committees would rather place their funds which the latest "hot" manager - just like Gerry Tsai at Fidelity in the 1960's.

There is one major difference between today and 30 years ago: the public.

In 1982, most workers were covered by some sort of pension plan. It was not necessarily to invest in stocks since your employer paid your retirement benefits.

Today this has all changed. Pension plans have largely disappeared - even public plans are trying to force employees to convert to self-funded retirement vehicles. Workers may not want to learn about the stock market, but they really have no choice.

More than 70% of Americans today have some exposure to the stock market, and their recent experience has obviously not been positive. Convincing the average investor to focus on long term returns - especially when it comes to retirement savings - is obviously a challenge.

But in my opinion, if investors have any hope of having enough money to enjoy their retirement years, a significant portion of their savings will have to be placed in common stocks. The potential outcome of returns from nearly every other asset class is simply too unappealing to reach any other conclusion.

I've been lucky to be involved in the investment management business for the past three decades.

And while I'm not sure what is in store for the next 30 years, I'm looking forward to writing another long post about the past in 2041.

Thursday, December 22, 2011

Looking Ahead - Reluctantly


I have written several times over the past few weeks about the futility of forecasting.

However, investing is all about preparing for the future, so I want to share what I have been telling clients recently.

The basis of my strategy for 2012 comes from Ray Dalio, founder and president of Bridgewater Associates.

Bridgewater is the largest and one of the most successful hedge fund operators in the world. Managing $125 billion for large institutions and pension funds, Bridgewater's investment returns have consistently been among the best in the investment world.

Dalio wrote an editorial piece in the Financial Times in late October discussing the current state of the world. Here's how I described it in my post dated October 25, 2011:

Dalio believes there are three important trends to consider right now:
  1. We are in the midst of a massive de-leveraging process. Dalio notes that he is not only concerned about the huge government debts around the globe, but also the massive amount of debt that individuals also have amassed. In his opinion, the process of reducing this debt will be a drag on economic growth for years;
  2. Governments are largely out of ammunition. Dalio believes there is are few alternatives left for our elected officials to improve the current economic climate;
  3. We are at each other's throats. The tone of any policy debate has become incredibly nasty and strident, and no one seems to want to try to come up with any workable solutions. This, in Dalio's opinion, is probably the biggest danger to our economies and markets.
Here's the final paragraph of Dalio op-ed piece:

If we calm down and work together to properly manage this difficult situation....we can get through this deleveraging without great pain. If we can't, we may experience an economic, social and political collapse.


The reason I like Dalio's logic is that I believe it sets a very reasonable framework for investment strategies.

For example, in a world characterized by deleveraging, lenders are obviously at a disadvantage - hence, I would continue to avoid bank stocks.

Deleveraging - combined with massive liquidity injections by the central banks of the world - also means that the price of money will remain relatively cheap. Thus, interest rates will probably remain low for longer than people expect. Bonds will offer a good buffer if markets turn ugly, but returns can only be modest from today's starting levels.

Low interest rates also raise the attractiveness of dividend-paying stocks.

Points two and three relate to government policy.

Fed interventions in markets during the past two years were crucial for many reasons, but they were a major contributor to capital market returns.

Do you think it was just coincidence that the stock market swoon this summer came shortly after the end of the Fed's second round of quantitative easing? I don't.

But I would agree with Dalio - I doubt that the Fed could muster the political support for another massive market intervention except under the most dire scenarios. Investments in 2012 will rise or fall based on their own merits - no Ben Bernanke to the rescue.

The final point is being illustrated once again in Washington. I don't know where you stand on this whole debate on extending the payroll tax cut, but the partisan bickering is once again discouraging.

It's hard to believe that our political system will function any better next year, when Presidential campaigns are in full swing. Problem is, partisan politics could lead to poor policy decisions, and this to me is one of the major risks to investors next year.




Wednesday, December 21, 2011

Europe, Email, and Other Pressing Questions


Here's what passes for "good news" in Europe these days:

Banks in Europe have been under a severe liquidity crunch over the past few weeks as lenders across the world - especially in the United States - have pulled back their credit exposure.

A couple of weeks ago the Federal Reserve made hundreds of billions of dollars available to the European financial community who were starved for dollar funding, but this was still not sufficient liquidity.

Enter the European Central Bank (ECB), which also opened the borrowing window to banks with few alternatives available. And here's what happened, according to the New York Times this morning:

In its role as lender of last resort to banks, the E.C.B. allocated 489.2 billion euros, or $644 billion, to 523 institutions, through what are known as long-term repurchasing operations. That was well above the roughly €300 billion average estimate of analysts polled by Reuters and Bloomberg News, though estimates had been widely divergent.

The injection of three-year funds was one of the new measures announced by the E.C.B. on Dec. 8 to calm European credit markets, which have become increasingly frothy as the euro zone crisis wears on. It was the first time that the E.C.B. has extended such loans for longer than about a year. Banks will pay the benchmark interest rate, currently 1 percent.

http://www.nytimes.com/2011/12/22/business/global/demand-for-ecb-loans-surpasses-expectations.html?_r=1&hp

Initially European markets soared - the ECB to the rescue!

Then the sobering reality hit: borrowing from the "lender of last resort" (i.e., the ECB) can hardly be taken as an all-clear signal.

All it really means is that the ECB has postponed the Day of Reckoning for a few months.

But the market took it as good news anyway.

-------------------------------

That's not what I really want to talk about today, though.

Like millions of other people, I am an active user of email. The days of ringing phones and huge mail volumes have long gone. If you were in my office on most days, the most frequent sound you would hear would be the clicking of my keyboard as I respond to clients and analysts.

While I appreciate the efficiency of email, I must confess there are days that I wish the volumes would decline. On a typical day I probably get 150 to 200 emails a day, and nearly all seem to require varying degrees of attention.

I have been reading more articles recently about how companies and people are trying to minimize their email involvement. Interesting, the companies at the forefront of the movement seem to be technology companies, which were the pioneers in email a couple of decades ago.

There was an article in yesterday's Financial Times describing the backlash against email. Entitled "The end of email"?", the piece discussed actions that people are taking to either avoid email messaging or are turning to other social media communications to discuss routine matters with colleagues.

Here's an excerpt:

However, for many companies, it is simply that email is seen as inefficient. "We believe email is fundamentally unproductive, you need to sift through too many documents and things get lost, " says Leerom Segal, president and chief executive of Klick, a Canadian digital marketing company. "It has no prioritisation, no workflow, and assumes that the most important item is the one at the top.

http://www.ft.com/intl/cms/s/0/5207b5d6-21cf-11e1-8b93-00144feabdc0.html#axzz1hBJ49JOw

The article goes on to discuss how some companies like Intel are experimenting with "no-email Fridays", encouraging engineers to solve problems by phone or face-to-face instead.

It may be that the problems in Europe are more important than email overload, but I suspect the latter will be easier to solve in the long run.

Tuesday, December 20, 2011

Forecasting Follies


Writing in his book Thinking, Fast and Slow, psychologist and Nobel Prize winner Daniel Kahneman discussed the perils of overconfidence.

He talks about the illusion that all of us to some degree share about our ability to forecast the future.

Although there is overwhelming historic evidence that many events - political, markets, etc. - are merely random, it doesn't prevent us from listening to forecasts from learned experts.

For example, here's one experiment that Dr. Kahneman describes:

For a number of years, professors at Duke University conducted a survey in which the chief financial officers estimated the returns of the Standard & Poor's index over the following year. The Duke scholars collected 11,600 such forecasts and examined their accuracy. The conclusion was straightforward: financial officers of large corporations had no clue about the short-term future of the stock market; the correlation between their estimates and the true value was slightly less than zero!

Kahneman goes on to describe how the professors asked the CFO's to give "confidence ranges" in which they were fairly certain that their forecasts would be accurate.

Here again, unless the CFO's gave a sufficiently wide range of potential outcomes (e.g., that the market would return somewhere between -10% and +30%), the actual results compared to the "highly confident" forecasts were often wildly different.

I bring this all up because year-end tends to be the time of year when you will see all types of forecasts, ranging from the markets, weather, or elections. However interesting these discussions might be, we should recognize that statistically most of them have little chance of actually coming to pass.

Writing on the blog Business Insider, former Wall Street analyst Henry Blodget discusses the fallibility of forecasting.

He cites a number of different areas where analysts and economists from the Street have been consistently wrong, yet continue to make forecasting that somehow continue to gain a wide following.

For example, he notes that most economists will forecast moderate growth for the coming year. The reason is simple: for a mature country like the United States, moderate growth tends to be the norm. Forecasting strong growth, or a severe downturn, may make headlines but can be severely career limiting if the forecasts prove inaccurate.

Here's what Blodget writes:

If economists can't predict the future, why do they always predict that the economy will grow about 4%? Because that's what the economy's long-term growth average is--and, therefore, that's the prediction that gives the economists the best odds of being generally "right" (or at least not too embarrassingly wrong).

Just as no one ever gets fired for buying IBM or hiring someone from Harvard B-school, no one ever gets fired for predicting that the economy will do about as well as it has always done. And, of course, staying close to the average also gives the economists the best chance of being close to right. So that's what economists predict!

Monday, December 19, 2011

Euro Fatigue


Although the news from Europe continues to be mixed at best, the markets seem to have accepted that the worst is over - for now.

Interest rates on Italian and Spanish debt have fallen significantly over the past week, for example, as the combination of European Central Bank intervention and the latest euro block decisions seem to have beaten back the bears.

What is not clear is whether the public at large is willing to accept austerity for the next several years in return for saving the euro.

This is one of the crucial questions, in my opinion: it is all very well and good for leaders to sit in a large ballroom and agree that cutbacks and tax increases should be imposed on the profligate countries like Spain, Italy, Portugal, et. al.

It is a far different matter to ask ordinary citizens to accept unemployment rates of 20% and a reduction in basic government benefit payments that had been already promised.

Yesterday's New York Times discussed the challenges facing most Europeans as a result of the euro crisis.

Written by an Italian commentator, here's an excerpt:

{Italian Prime Minister} Monti, a former university president, should be worrying less about defenders of old privileges and more about young people, who will bear the brunt of economic stagnation. Instead, his emergency package does little to end monopolies, shrink bureaucracies and reduce systemic corruption, reforms that would increase competition and spur growth.

Youth unemployment is already at nearly 30 percent. Mr. Monti is offering tax incentives to employers who create new full-time jobs for young people, and for women, who are underrepresented in the labor market. But with his package reducing demand, and older workers required to stay on the job longer to draw full pensions, it isn’t clear where those new jobs will be found. For years, young Italians have moved around Europe in search of jobs, and that outlet is closing as the Continent moves toward recession.

http://www.nytimes.com/2011/12/18/opinion/sunday/inside-the-euro-zone-bracing-for-austerity.html?_r=1

Just as in this country, there seems to be a growing sentiment in Europe that the burden of economic readjustment will be falling mostly on those least able to make sacrifices.

But for now at least it is nice to have a pause in the euro zone drama.

Friday, December 16, 2011

The Disconnect Between Stocks and Employment


Unemployment remains stubbornly high, and the eurozone crisis lurches from one bailout package to the next.

Quoted in this morning's Financial Times, IMF Managing Director Christine Lagarde gave a speech in Washington yesterday warning that the world faces the risk of "economic retraction, rising protectionism, isolation and...what happened in the 30s {Depression}".

With this miserable background, why does the US stock market remain reasonably buoyant?

There are many reasons, of course, but one might be the simple fact that profitability is at all-time highs, largely based on the incredible efficiency gains that technology has brought to Corporate America.

On the other hand, looking at data going back to the end of World War II, labor compensation as a percentage of total nonfarm business output has never been lower.

Put another way: corporate profits have fully recovered to 2007, but labor's share of those profits continues to decline.

Even with stagnant wage growth, companies simply don't need to hire as many people as they had in previous recoveries to achieve the same levels of output. Moreover, some of the fastest growing businesses (i.e. technology) simply don't need that many people.

For example, Google employees around 27,000 people, and continues to hire at a fairly rapid clip. However, by comparison, General Motors in the 1970's employed well over 100,000 people through its operations.

I don't think this is just a political question. You can argue about worker retraining, or the need to improve our education systems to compete in the 21st century, but the huge amount of workers who cannot find work is a tremendous economic burden as well.

Here's how the FT put it yesterday:

{The share of income that has fallen to workers}has fallen to its lowest level after records began after the second world war and is part of the reason why incomes at the top - which tend to be earned from capital - have risen so much. If wages were at their postwar average share of 63 per cent, workers would earn an extra $740bn this year, according to FT calculations.

http://www.ft.com/intl/cms/s/0/1bf8e7ba-2578-11e1-9cb0-00144feabdc0.html#axzz1ghromZhS

And since the marginal propensity to spend is higher for lower wage workers, imagine how much stronger economic growth would (not to mention tax revenues!) if we can get the employment picture to brighten.

In the meantime, though, we will probably continue to have this disconnect between capital market performance and economic reality.

Thursday, December 15, 2011

The Fed and the European Banking Crisis


Fed Chairman Bernanke held a meeting with Republican Senators yesterday.

The timing of this meeting makes absolute sense, as always:

  • the government is on the verge of yet another possible shutdown over a trivial dispute over a payroll tax that both parties profess to want to pass;
  • The federal debt burden continues to mount as no serious solutions to our budget deficits have been proposed;
  • And the approval rating of Congress hovers around 8%, meaning that probably their own families think they're incompetent.
So what better time to head over the Federal Reserve Building and do a heart-to-heart with the head of the one institution in Washington that is at least trying to help the country's weak economic growth.

But I digress.

After the meeting, a number of the Senators indicated that while Bernanke is "very concerned" about Europe, he has no intention of directing any sort of Fed intervention:

Senator Bob Corker, a Republican from Tennessee, said Bernanke made it “very clear” in closed-door comments today the central bank doesn’t intend to rescue European financial institutions. Lindsey Graham, a South Carolina Republican, said Bernanke told lawmakers that “he doesn’t have the intention or the authority” to bail out countries or banks. Both senators spoke to reporters after leaving the one-hour session at the Capitol in Washington.

http://www.bloomberg.com/news/2011-12-14/bernanke-tells-senators-federal-reserve-has-no-plan-to-aid-european-banks.html

Left unspoken was the fact that the Fed already has intervened.

Just a couple of weeks ago, the Fed opened the dollar interbank market to all European banks, lending dollars to all who needed funding at essentially 0% rates of interest. Without the Fed, the dollar-starved European banks would have been on the verge of collapse.

And this is the real problem in this whole euro mess: No one really knows how vulnerable the banks really are.

New York Times columnist Jesse Eisinger wrote a piece last October about the banks.

In the column, he noted that by most conventional measures the banks and brokers seem to be in much better shape than they were during the financial crisis of 2008.

However, financial stocks keep falling, as investors have very little faith in both the numbers and the managements of our largest financial institutions:

Yet, the moment one examines almost any detail of the global financial system, faith falters once again. Take the uncertainty about the derivatives markets. Morgan Stanley has a face value of $56 trillion in derivatives. That’s really nothing. JPMorgan Chase has more — amounting to the G.D.P. of large countries — a face value of $79 trillion in derivatives. If something goes wrong with just one-tenth of 1 percent of those trades, it’s kablooie.

Now those are gross numbers. Many people would dismiss those totals as ridiculous and misleading. Anyone who brings them up is merely displaying ignorance. The banks’ derivatives portfolios are full of off-setting trades that net out at a smaller number.

Derivatives can be dismissed as a popular bugaboo, but they really are just a symbol of the larger problem. A litany of daily stories reveals all kinds of reasons that banks don’t trust each other. To take just one news item, almost at random: Bloomberg News reported the other day that a Danish bank was refusing French sovereign debt as collateral.

Nobody really knows how much exposure the American banks have to the European financial and political crisis, with the Treasury Department minimizing the issue while other outlets raise the specter of catastrophic problems.

http://www.propublica.org/thetrade/item/trust-bust-why-no-one-believes-the-banks

So Bernanke and the Senators can agree that Europe should fix their own problems, but the truth is elusive, and we're really all in this together.



Wednesday, December 14, 2011

Uh, Oh - Public Pension Funds Making Bigger Bets to Cover Shortfalls


The current market environment is incredibly frustrating for most investors.

Interest rates are at 60 year lows. Bank deposit rates are mostly below 1%. Stock returns will be flat in 2011 - again. The S&P 500 remains 17% below year end 2007 (talk about depressing!).

If you believe - as I do - in Regression to the Mean, and the under performance of stocks relative to bonds over the last few years will reverse itself.

In particular, I think that investors in large cap, dividend paying US stocks will earn good returns for the next few years, although it will almost certainly be a bumpy ride.

In other words, in my opinion, patience is the most important investment consideration at this juncture.

Unfortunately, if you're on the investment committee of a large pension plan, there is a constant pressure to improve returns, even if it means taking on more risk.

For example, this morning's New York Times discusses the increased allocation of public pension plans to private equity investments.

Private equity has an aura about it. The idea that a small group of incredibly savvy investors will be able to invest in the next Apple, Facebook or Google and deliver outsized returns is very attractive after the disappointing returns in the public market over the last decade.

Whether this is truly the case is debatable, but that hasn't stopped billions from flowing into private equity. Here's an excerpt from the article:

At the same time, pension plans everywhere are also desperate for yield. Pension plans are reportedly underfinanced by anywhere from $700 billion to as much as $4 trillion, depending on the calculations. Poor returns over the last few years have not helped. Over the last five years, the average state and local pension fund has returned 4.7 percent, according to Callan Associates.

Pension plans hope to make up these lost years and reach performance targets that in some cases are still set at a hopeful 7 to 8 percent a year. Private equity has traditionally been a high-performing asset class, and shifting more assets into this and other alternative investments like hedge funds is seen as a possible solution. Wilshire & Associates recently found that the average pension fund had increased its allocation to private equity to 8.8 percent in 2010 from 3 percent in 2000.

http://dealbook.nytimes.com/2011/12/13/wall-st-s-odd-couple-and-their-quest-to-unlock-riches/?src=me&ref=business

I hope this shift works out, but past history is not hopeful.

Hedge funds were once thought to be the panacea to institutional funds, for example,but recent data indicates that more than 75% of the hedge funds in existence have produced mediocre, or no, returns to investors.

The problem is when large sums of money are allocated to areas where investment opportunities are limited, overall returns are usually disappointing.

Tuesday, December 13, 2011

Market Forecasts, And Regression to the Mean


I've been reading Daniel Kahneman's excellent new book entitled Thinking, Fast and Slow.

The book was recently listed as one of the best non-fiction books of 2011 by the New York Times. Based on my reading, I would agree with the Times.

Dr. Kahneman won a Nobel Prize in 2002 for his work on behavioral psychology. However, his book is very readable, and targeted for a larger market. For anyone interested in the quirkiness of how our minds work, and how we often make decisions that sometimes seem totally irrational, it will make an excellent addition to your holiday reading list.

One of the points that Kahneman makes in his book is that we often place too much time looking for causality in trying to explain events.

Sometimes events are just random - coming up tails nine times in a row when you're flipping a coin doesn't necessarily mean that the tenth flip will be heads; the odds are always 50/50, regardless of prior results.

At other times, though, changes occur that are the result of simply regression to the mean.

Kahneman discusses the fact in a large sample size you will often get data points that seem far out of the norm. However, overall results will very often return to the longer term averages, and that any interpretation of random results that doesn't include regression to the mean are usually incorrect.

I have been thinking of Kahneman's work when I am trying to come up with the best advice to help clients structure their investment portfolios.

The last 10 years have been relatively poor ones for stock investors, while bond investors have enjoyed a very healthy run.

However, over longer periods of time, stocks have produced much higher rates of return than bonds.

If regression to the mean holds, then, the next decade should be much better for stocks than bonds, simply because the magnitude of stock underperformance relative to bonds has been so unusual relative to historic norms.

Note that this forecast isn't based on guessing on economic outlook, Fed policy, euro, etc. No, all it's based on is simple statistics.

Think back to the end of 1999: Stocks had just completed one of the most remarkable runs in capital markets history, while bonds had been consigned to those poor souls who didn't understand the bull case for stocks.

As we now know, this was exactly the time that stock investors should have been heading for the exits and piling into bonds based solely on regression to the mean. And yet if you look back you will see few, if any, advisors were recommending an overweight in bonds.

Note that even if I had told you in late 1999 that the US economy would continue to thrive for most of the coming decade, you still would have been better off in bonds, not stocks.

Or, put another way, regression to the mean, and not economic or market forecasts, may be a more useful investing tool for investors truly focused on longer term results.

Monday, December 12, 2011

Blind Men, Elephants and Europe


You probably remember the ancient Hindu parable about blind men being asked to describe the features of an elephant.

Here's one version, according to Wikipedia:

A Jain version of the story says that six blind men were asked to determine what an elephant looked like by feeling different parts of the elephant's body. The blind man who feels a leg says the elephant is like a pillar; the one who feels the tail says the elephant is like a rope; the one who feels the trunk says the elephant is like a tree branch; the one who feels the ear says the elephant is like a hand fan; the one who feels the belly says the elephant is like a wall; and the one who feels the tusk says the elephant is like a solid pipe.

A king explains to them:

"All of you are right. The reason every one of you is telling it differently is because each one of you touched the different part of the elephant. So, actually the elephant has all the features you mentioned."

http://en.wikipedia.org/wiki/Blind_men_and_an_elephant

The situation in the eurozone can be likened to this parable.

After the conclusion of last Friday's conference, equity investors cheered: An agreement was reached! Stock prices soared.

But bond investors disagreed: Oh, no, the agreement has no teeth - better run from risk, and dive into the highest quality bonds possible! US Treasury yields dropped, and the Treasury yields remain at 60-year lows.

And it's hard to figure out what commodity investors were thinking, especially looking at the price of gold.

If we were truly approaching financial Armageddon , you would think that gold prices should be soaring - but they're not. There could be some technical reasons for gold's ambivalence (rumors said that European banks were selling or lending their gold hoards to raise dollars), but gold prices have declined by -6% in the past three months.

My wife and daughter headed out yesterday to do their part to spur economic growth (no signs of a spending slowdown in the Glen household!) so I had plenty of time to read papers, magazines, and blogs to try to sort this all out.

But to be honest, I feel a little like those blind men: judging where we are now pretty much depends on where you are looking.

Thursday, December 8, 2011

That's Fine, But Did I Make Any Money?


In late 1999, when I first joined Boston Private Bank, I had the chance to make a number of new business presentations with one of our top salespeople named Trip Hargrave.

Trip was successful for a number of reasons, but one of his best traits was his ability to help prospects come to decisions.

For example, often a prospect would make the first decision - yes, they wanted to open an investment account - but froze when it came to asset allocation.

The correct balance between stocks, bonds, and any other asset class is a very difficult decision, but Trip made it simple.

Here's the only question he would ask:

"Historically, stocks have returned 12% per annum, and bonds 6%. Which return would you prefer?"

Um, let's see: do I want 12% or 6%?

Easy, right?

But, as it turns out, that was the wrong decision, at least for the first decade of this century.

Starting at the end of 1999, the investing in the stock market - as measured by the S&P 500 - was a money-losing proposition. Meanwhile, bond investors nearly doubled their money, assuming interest payments were reinvested.

This is not to pick on Trip - who remains a friend of mine, even though he no longer works here at Boston Private - but rather to highlight the problem of using past performance results to make investment decisions.

Fortune magazine had a good article discussing this issue. Fortune focused on Legg Mason's legendary stock investor Bill Miller, who for 15 years straight outperformed the S&P 500 but then stumbled in the last few years.

Fortune asked a simple question: Yes, Bill Miller's performance numbers were great, but investors in his fund on average make any money?

Here's what they wrote:

{Mutual fund consultant} Morningstar crunched Miller's numbers for me, showing that his average investor had a considerably lower return than the fund posted during his long hot streak.

The fund made 16.44% a year in gains and reinvested dividends during that period, but the average investor made only 11.34%. Miller's average investor actually underperformed the S&P (which returned 11.51% annually during his streak), even though his fund way outperformed the index...

"It's human nature for investors to act this way," says Don Phillips, Morningstar's president of fund research. "When stocks are popular and the market is rising, everyone wants to invest." Then, when the market hits a bad patch, many fund investors sell near the bottom, giving them the worst of both worlds: buying high and selling low.

http://finance.fortune.cnn.com/2011/12/07/bill-miller-legg-mason-returns/?iid=SF_F_LN

Today people are generally wary of the stock market, which is not suprising given the anemic returns of the last few years.

And yet, looking forward, are you more likely to produce better returns by investing in stocks or bonds?

Or, as my friend Trip might say, bonds are now trading at yields not seen in 60 years, and stocks largely yield more than corporate bonds and valuations are not unreasonable.

Which area do you think makes the most sense?

Wednesday, December 7, 2011

Message From the Markets?


Trying to understand the "message from the market" is, in my opinion, a little like looking at modern art: you see what you want to see.

For example, bond yields on Italian and Spanish debt have plummeted in the past few days. After rocketing past 7% a couple of weeks ago, the combination of European Central Bank intervention as well as a dollar infusion from the Fed has caused a large bond rally in the offerings of both countries, and yields are back below 6% this morning.

Many analysts are pointing to the action in the bond market as a clear signal that creditors are becoming more convinced that a clear and decisive action will be taken by euro zone leaders by the end of this week.

I hope this is true, but there is another possibility.

The German solution for the troubled sovereign borrowers in the euro zone is austerity: cut government spending and raise taxes. The near-term economic pain might be significant, the Germans are arguing, but fiscal responsibility is the only long-term solution.

On the other hand, as the New York Times pointed out this morning, the cure for the euro crisis might lead to significant economic malaise.

Yields might be falling because investors now believe the German solution make bonds a superior investment to most other asset classes.

Here's what the Times editorial said this morning:

But the Franco-German recipe will exacerbate Europe’s fundamental problem: lack of growth. While German officials insist that budget discipline will restore markets’ confidence, markets understand that a deepening recession will make it even harder for weak nations to repay their debts.

Europe’s deeply indebted nations certainly must get their budgets under control, reform labor markets, sell state properties and become more competitive. But that can’t be done without any growth. Germany could provide some of the needed boost: saving less and spending more; absorbing more imports from neighbors. But the plan provides for no German stimulus. In fact, the International Monetary Fund expects Germany to spend less: cutting its budget deficit to just over 1 percent of gross domestic product next year.

http://www.nytimes.com/2011/12/07/opinion/the-wrong-fix.html?_r=1&ref=opinion

Trading volumes in the stock market this week have been remarkably light: investors know that the next direction for the market depends on the announcement from the euro group later this week.

Tuesday, December 6, 2011

All Europe, All the Time


As I look back at some of my recent posts, it seems that the majority are focused on Europe and the euro zone crisis.

For better or for worse, the European community is the whole game for the markets right now.

If the European leaders can come up with a workable plan to save the euro, the equity markets will probably rocket ahead. The alternative, of course, is pretty bleak and dismal for the world's economies.

But this might just be my opinion, speaking as an American.

Ezra Klein of the Washington Post had an interesting column yesterday discuss the almost unnatural calm that he witnessed in Germany last week:

In more than a dozen discussions with policymakers, I’ve noticed that Germans just do not talk about this crisis the way anyone else does....

They seem serenely confident that it will all work out, and this will end with a stronger, more united Europe. There’s less panic than you would expect. Less panic, certainly, than there is among American economists and policymakers.

http://www.washingtonpost.com/business/economy/germanys-calm-in-the-face-of-europes-debt-crisis/2011/12/05/gIQAxUohXO_story.html

It could be that the German government is simply aware that it holds all of the cards, and that its positions will ultimately carry the day.

The problem I have is that most of the German ideas focus on austerity and economic pain. Here's Wolfgang Munchau writing in yesterday's Financial Times:

Contrary to what is being report, Ms. Merkel is not proposing a fiscal union. She is proposing an austerity club, a stability club on steriods. The goal is to enforce life-long austerity, with balanced budge rules enshrined in every national constitution. She also proposes automatic sanctions with a judicially administered regime of compliance. She rejects eurobonds on the grounds that they reduce pressure on fiscal discipline.

http://www.ft.com/intl/cms/s/0/874af280-1cde-11e1-a134-00144feabdc0.html#axzz1flJRsTSD

American rating agency Standard & Poor's warned that Germany and five other members of the eurozone that they face the possibility of losing their AAA credit rating if a responsible solution to the current crisis is not announced.

The cynic in me was unimpressed by S&P's announcement. Interest rates in the United States plummeted after S&P downgraded the U.S. last summer to AA+.

At the end of the day, it seems that all of this drama boils down to asking the citizens of numerous countries to accept austerity and poor economic conditions for many years in order to pay back the bankers.

And while no one doubts the moral righteousness of this position, I wonder how long before popular backlash begins.

Ireland is often cited as the model for some of the other debt-burdened countries, the New York Times reports this morning, yet the Irish are less than thrilled with how the burden of debt repayment has hurt their daily lives:

Pain is inevitable in any nation overwhelmed by its debts, which in Ireland continue to climb rather than fall as a percentage of gross domestic product. But the Irish example shows the dangers of taking from ordinary people to pay off creditors rather than sharing the burden more broadly.

For example, welfare payments have steadily been reduced even as the unemployment rate has ticked up to 14.5 percent, and is forecast to remain high at least through next year.

The Irish are not prone to protest, but now more are being organized, inspired by the Occupy movement in the United States.

http://www.nytimes.com/2011/12/06/business/global/despite-praise-for-its-austerity-ireland-and-its-people-are-being-battered.html?pagewanted=2&_r=1&ref=business

Finally, there is this quote at the end of the Times's article which sums it up best:

“The euro zone is entering a very serious slump, and it is not certain the euro will survive in its current form,” said Simon Johnson, a professor at the Massachusetts Institute of Technology’s Sloan School of Management and a former chief economist at the I.M.F. “Why Ireland would want to spend its time being a model student in the context of the broader European mishandling of the situation, I don’t know.”


Monday, December 5, 2011

Question Authority


As we approach year-end, you're certain to see a wave of news stories offering perspectives on the outlook for the coming year.

True confession: This exercise drives me crazy, as I feel it is almost always a waste of time.

As that great philosopher Yogi Berra once said: "It's tough to make predictions, especially about the future."

But still people persist in trying to forecast the next 12 months, and since apparently someone reads these, it's worth going back and seeing how well the "expert" predictions fared for 2011.

Here was one that was a favorite of many market strategists a year ago:

Historically, the third year of a Presidential cycle has been good for stocks. If you go back to the third year of a President's term - either Republican or Democrat - stocks have usually produced attractive returns. Ergo, stocks should do well in 2011.

So what's happened in 2011? Writing in this Saturday's New York Times, Floyd Norris took a look:

Through November, an investor in the stocks in the Standard & Poor’s 500 had a small profit of 1.1 percent this year, including reinvested dividends. But that figure was a 6 percent loss a week earlier, before investors took pleasure from positive reports of post-Thanksgiving retail sales and became more optimistic that another round of European summit meetings next week would reduce the threat of a new financial collapse.

http://www.nytimes.com/2011/12/03/business/as-a-market-predictor-a-trusty-guide-falters.html?_r=1

Psychologist Dan Kahneman points out that it is a natural human tendency to look for patterns where none exists. Could the "Presidential Cycle" be a perfect example?

Oh, and was there a single strategist that thought that interest rates would plummet to 60-year lows?

And what about those confident predictions that U.S. investors should plunk a large sum of their funds in overseas markets? The world's markets have almost all been money losers this year - the US market returns may be weak, but at least they're positive.

I could go on, but you get my point.

My advice: Recognize that predictions of the future are best left to soothsayers. In my work, I try to find investments that will fare well in a number of different scenarios, including those that might seem wildly implausible at the time.

Friday, December 2, 2011

What Are The Mortgage-Backed Securities Markets Telling Us?


For several years I managed portfolios of mortgage-backed securities for institutions and mutual funds.

Mutual funds investing in mortgage-backed securities guaranteed by GNMA ("Ginnie Mae") were very popular in the late 1980's and early 1990's. Ginnie Mae carries the full faith and credit of the United States government, so investors are protected from losses from mortgages. Other funds backed by FNMA ("Fannie Mae") and FHLMC ("Freddie Mac") also were very appealing, even though these agencies carried the implied, but not direct, government guarantee.

The appeal of high dividend payouts from government guaranteed mortgages was very attractive to investors dependent on income, especially retirees. For example, I was lead manager on a Ginnie Mae mutual fund targeted to AARP members which grew to a peak of $8.2 billion in five years.

(Of course, Ginnie Mae funds can still lose money if interest rates rise, like they did in 1994. After investors learned this harsh reality, the popularity of Ginnie Mae funds understandably waned).

There are several dynamics to managing mortgage-backed securities, but one of the most important is to try to anticipate prepayment speeds.

As we all know, mortgages can be paid prior to maturity for any number of reasons. When you sell your home, for example, you typically pay off your mortgage. Or if mortgage rates fall, many homeowners will refinance their existing mortgages into new, lower rate mortgages.

One other reason for the early prepayment of mortgages is something that we used to not focus on too much: namely, existing mortgages on a home that is foreclosed will be paid off early when the home is resold at auction.

If you're a manager of a mortgage-backed securities portfolio, then, trying to figure out the approximate rate of prepayment can make the difference between a successful investment and one that produces only mediocre results.

In a period of declining interest rates, the older higher rate mortgages are typically refinanced, but at varying rates of speed. Today, with so many homeowners facing the unpleasant reality that their homes are worth less than their mortgages, refinancing speeds have been considerably slower than economic models would suggest.

While this has resulted in very attractive returns for mortgage-backed investors, it also tells a fairly dismal tale of the state of the housing market in the United States, as Floyd Norris points out in this morning's New York Times:

In normal times, old securities with relatively high interest rates would have virtually disappeared as owners refinanced, paid off the old mortgages and took out loans at lower rates. But these are not normal times, and speculators now are profiting from the woes of homeowners who cannot refinance but have not defaulted. Because Fannie and Freddie guarantee the loans, buyers of those securities are sure to recover the amounts lent.

Prices of high-coupon mortgage securities rose to unprecedented heights earlier this year as investors concluded that those who had not refinanced by then would never be able to do so, and that owners of the securities would be able to collect above-market interest rates for a long time. Those prices have declined, but not by very much, since the administration announced its refinancing plan.

http://www.nytimes.com/2011/12/02/business/time-to-accelerate-the-housing-recovery-floyd-norris.html?pagewanted=2&ref=business

As Mr. Norris points out, many economists in agreement that true economic recovery in the United States will not begin until housing improves.

The unfortunate truth is that until some resolution is reached on how to handle underwater mortgages - and take some of the "juice" away from mortgage-backed investors - our economy recovery seems destined to be muted.




Thursday, December 1, 2011

Are The Banks Now Bailed Out?


Judging from yesterday's huge rally on Wall Street, and reports of highly successful French and Spanish bond auctions this morning, it would seem that yesterday's coordinated central bank intervention has turned the tide in euroland.

I hope so but I am skeptical.

I had a savvy client email me last night asking whether we should begin buying European bank stocks for his portfolio.

After all, he pointed out, the usual valuation metrics for bank equity analysis are all indicating a sector that is hugely undervalued.

If the central bank actions are effective, couldn't possibly see a rally in financial stocks similar to 2009, when financials nearly doubled from March 2009?

Well, maybe, but I think there are several factors considerably different from those in 2009.

First, I think that the political mood (i.e. anti-banker) is considerably less sympathetic to financials than prevailed earlier.

It's not only the protest movement "Occupy Wall Street" - even the President seems to be running for re-election on a more populist platform. Pushing through bank bailout packages similar to those of 2008-09 seem unlikely.

Second, the Fed is, in my opinion, largely "out of bullets". Interest rates are already at 60-year lows. The Fed's two rounds of so-called quantitative easing has pushed mortgage rates to multi-decade lows (yet housing remains in a funk).

Yesterday's actions added dollars to a world banking system that was starving for liquidity, but it will not change the fundamental credit issues that Europe faces.

Third, I'm not sure that the traditional bank metrics are all that meaningful right now. If the assets on the books of the major multi-nationals were worth anywhere close to reported values, why don't they just sell them to raise capital?

In fact, even in America there is considerable evidence to suggest that the mortgages on the books of US banks are not worth their stated values. Here's a note from this morning's New York Times:

A new analysis suggests that the tide of home foreclosures isn’t going to recede soon.

The report from the Center for Responsible Lending, “Lost Ground, 2011,” finds that at least 2.7 million mortgages loaned from 2004 through 2008, or about 6 percent, have ended in foreclosure and that nearly 4 million more home loans (roughly 8 percent) from the same period remain at serious risk.

Put another way, “The nation is not even halfway through the foreclosure crisis,” says the report, which analyzed 27 million mortgages made over the five years.

http://bucks.blogs.nytimes.com/2011/11/30/foreclosure-crisis-isnt-even-halfway-over-analysis-finds/?ref=business

Finally, several recent news reports have looked back to the period of 2009 and found that the "all clear" signals that were flashed by bank CEO's were, well, lies.

Here's the report from Bloomberg earlier this week:

The Federal Reserve and the big banks fought for more than two years to keep details of the largest bailout in U.S. history a secret. Now, the rest of the world can see what it was missing.

The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy. And no one calculated until now that banks reaped an estimated $13 billion of income by taking advantage of the Fed’s below-market rates, Bloomberg Markets magazine reports in its January issue.

And here's what the bankers were telling the press:

Bankers didn’t disclose the extent of their borrowing. On Nov. 26, 2008, then-Bank of America (BAC) Corp. Chief Executive Officer Kenneth D. Lewis wrote to shareholders that he headed “one of the strongest and most stable major banks in the world.” He didn’t say that his Charlotte, North Carolina-based firm owed the central bank $86 billion that day.

JPMorgan Chase & Co. CEO Jamie Dimon told shareholders in a March 26, 2010, letter that his bank used the Fed’s Term Auction Facility “at the request of the Federal Reserve to help motivate others to use the system.” He didn’t say that the New York-based bank’s total TAF borrowings were almost twice its cash holdings or that its peak borrowing of $48 billion on Feb. 26, 2009, came more than a year after the program’s creation.

http://www.bloomberg.com/news/2011-11-28/secret-fed-loans-undisclosed-to-congress-gave-banks-13-billion-in-income.html

Like the old axiom goes, "Fool me once, shame on you. Fool me twice, shame on me".

Even if today's situation is more dire than 2008, I think the popular mood will not support anywhere near the level of intervention.

I remain wary of bank and other financial shares.

Wednesday, November 30, 2011

Hurrah! The Fed To The Rescue - Again


Stocks rallied sharply today on the back of a coordinated intervention by the world's central banks, led by the U.S. Federal Reserve.

Market rumors suggest that at least one major bank in Europe was on the verge of failing due to not being able to secure funding.

This would not be surprising: across the globe, financial institutions including American money market funds and Asian pooled investment vehicles have been rapidly reducing their European financial exposure.

It is also apparently consensus opinion among the world's financial leaders that letting Lehman Brothers go under in September 2008 was a mistake.

Today's move puts government money behind this view.

The larger question, of course, is whether this intervention is simply buying time, or whether there is a larger, more comprehensive solution to the euro crisis in the wings.

At the same time, all of these hundreds of billions being tossed around the world is beginning to make me just a little uneasy about how dominant a role that central banks have become in the global economy.

Today's move, for example, effectively inserts our central bank into the midst of the euro zone crisis. Is that really part of the Federal Reserve charter?

Oh, and I understand the argument that says that money is truly a global commodity, and that the Fed is acting to protect US interests.

Still, the real reason the Fed and company needed to act was the refusal of the German government to take any action. And it is not clear that today's actions are doing anything more than delaying a Day of Reckoning for the euro zone.

The United States went off the gold standard* in 1971. President Nixon was desperately trying to figure out a way to frustrate the currency markets, which he believed was unfairly attacking the dollar. Nixon was initially successful, as the dollar rallied, but inevitably economic fundamentals won the day, and the dollar has steadily declined over the next few decades.

Fast forward 40 years. Today we think nothing of literally trillions of dollars being created by central banks around the world that stave off credit market dislocations. Ben Bernanke might be one of the smartest people to ever head a central bank, but the numbers have become staggering.

I don't know how this all resolves itself. Worries that massive injections of liquidity being added to the system will lead to inflation have to date been unfounded. The money has to come back out of the system but until the twin reasons behind our financial system woes are addressed - the American housing market, and the rapidly weakening state of European sovereign debt - it seems more likely that we will see more central bank interventions in the months ahead.

*As I have written numerous times on this blog, I am most decided not a huge fan of investing in gold. On the other hand, having a gold standard definitely created a brake on government actions.