Ray Dalio of Bridgewater

I had the chance to watch Ray Dalio of Bridgewater Associates being interviewed on the PBS talk show Charlie Rose last week.

Ray Dalio is one of the most successful money managers of our generation. Starting in 1975, his firm now manages approximately $125 billion for a wide variety of clients, including some of the largest public pension plans. Last year, Bridgewater was the top performing hedge fund in the United States, proving that size isn't necessary a deterrent to performance.

Unfortunately I was not able to figure out how to imbed the video from Mr. Dalio's appearance. However, if you have 37 minutes at some point, and want to hear from one of the Best, I would encourage you to visit http://www.charlierose.com/ and watch the entire interview.

Bridgewater is a "macro" investor, which means that they place their investment bets based on their work on global economic and market trends.

One of the most interesting parts of the interview, in my opinion, is how much Mr. Dalio says that his firm focuses on what they don't know. Unlike many investors - who make a specific forecast, then invest accordingly - Bridgewater considers a wide range of scenarios, and tries to figure out investments that will do well in a variety of different outcomes.

In this tendency Bridgewater is not alone. It seems to me most of the best investors - including Warren Buffett - spend more time on downside risks than they do opportunities. Despite their enormous success, Dalio and Buffett are humble enough to recognize that events often take place that virtually no can anticipate, and they make their investments accordingly.

Dalio has an editorial in this morning's Financial Times in which he repeats some of the themes that he discusses on the Charlie Rose program.

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.

http://www.ft.com/intl/cms/s/0/ed4439d4-fbeb-11e0-9283-00144feab49a.html#axzz1bnIVgYrW

Managers, Pigeons, and The Perils of Overconfidence

Let's start the week with a pop quiz.

I am going to sit you down in front of a screen where I will flash two lights: red and green. I will tell you the sequence is completely random, but 80% of the time the light will flash green.

And, oh, by the way: one of my assistants will be doing the exact same experiment in the next room, only she will be having a pigeon doing the guessing.

Who do you think will get more right? You or the pigeon?

Now we'll start our experiment. I will start flashing the light, and I want you tell what color is coming up next.

Here's what you should do: I have already told you that 80% of the time the light will flash green, and that the sequence will be totally random. So, the correct guess will always be "green", so you will be right 80% of the time.

But that's not what most humans do. They tend to look for patterns where none exist. Here's how Jason Zweig described our human tendencies in his book Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich:

Human, however, tend to flunk this kind of experiment. Instead of just picking green all of the time and locking in an 80 percent chance of being right, people will typically pick green four out of five times, quickly getting caught up in the game of trying to call when the next red flash will come up. On average, this misguided confidence leads people to pick the next flash accurately on only 68 percent of their tries. Stranger still, humans will persist in this behavior even when the researchers tell them explicitly...that the flashing of the lights is random.

Meanwhile, the other room, your pigeon competition is guessing correctly 80% of the time, since the bird automatically picks green every time. Mr. Zweig explains:

...birds seem to stick within their limits of their abilities to identify patterns, giving them what amounts to a kind of natural humility in the face of random events. People, however, are a different story.

In short, the pigeon probably wins.

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

I was reminded of this story yesterday, when I read a piece by Dan Kahneman in yesterday's New York Times about the perils of overconfidence.

Dr. Kahneman was awarded a Nobel Prize in 2002 for his groundbreaking research into behavior finance. He has also written extensively about how one should view any predictions about future events, especially economic or related to the stock market, with a grain of salt.

In my field, you often read predictions about the future course of the stock market, or the direction of interest rates. These pronouncements are usually made with great confidence, yet are often just as likely to be wrong as they are right.

Just as in the behavior experiment, we humans like to look for patterns where none exist. We might know, for example, that investing in stocks will tend to outperform other asset classes, yet we persist in trading in and out of the market based on our belief that we will be able to "time" the market.

Here's Dr. Kahneman's advice:

We often interact with professionals who and confident predictions even when they know little or nothing. Overconfidence arises because people are often blind to their own blindness. ls who exercise their judgment with evident confidence, sometimes priding themselves on the power of their intuition. In a world rife with illusions of validity and skill, can we trust them? .... We can believe an expert who admits uncertainty but cannot take expressions of high confidence at face value. As I first learned on the obstacle field, people come up with coherent stories and confident predictions even when they know little or nothing. Overconfidence arises because people are often blind to their own blindness.


http://www.nytimes.com/2011/10/23/magazine/dont-blink-the-hazards-of-confidence.html?pagewanted=4&_r=1&ref=general&src=me

TIPS Are a Crowded Trade

Ned Davis - founder of Ned Davis Research, a market research firm that I highly respect - has three simple rules for investors:

1. Don't fight the tape (i.e., when the market is trending in one direction, don't try to fight it);
2. Don't fight the Fed (i.e., when Fed policy is easy, buy stocks, or vice versa);
3. Be wary of crowds at the extremes (i.e., when sentiment is overwhelmingly skewed in one direction, be careful).
   

I have often thought of Ned's rules, but I was particularly reminded of rule #3 this morning, when I read this sentence from an email sent by Brad Hintz, Bernstein's financial analyst (TIPS are "Treasury inflation protected securities"):

Yesterday, the U.S. Treasury sold $7 billion of 30-year TIPS at a record low yield of 0.999%. Demand was very strong as the bid-to-cover ratio was 3.06, well above the average of 2.40. Indirect bidders, a class of investors that includes foreign central banks, purchased 43.2% of the securities, above the average of 40.0% for the past four auctions

Think about that: there apparently is a large enough group of investors so convinced that inflation will be roaring back that they are willing to lock in returns of less than 1% for the next 30 years (!).

I know I wrote yesterday that investors should avoid predictions, but here's one that I can safely make: The world will look alot differently in 2041 than it does today.

So does that mean that bonds are overvalued?

Well, maybe, but I think with the Fed keeping short rates at 0% for at least the next couple of years, and deflation, not inflation, a bigger risk, bonds can still play a role in investor portfolios.

But for investing, it still seems to me that dividend-paying, large cap stocks are the way to go. So too does legendary investor Leon Cooperman, who is not a big fan of bonds.

Instead, Mr. Cooperman likes stocks:

“I wouldn’t be caught dead owning a U.S. government bond,” he said today during a presentation at the Value Investing Congress in New York. “Not because I have a problem with the credit. I have a problem with paying 35 percent on the 2 percent to Uncle Sam, and then have a 2 to 3 percent rate of inflation,” he said. “It’s confiscation of my capital. I think I’m too smart to play that game.” ...

Stocks are cheap relative to history, relative to inflation, relative to interest rates,” he said. “The recent facts suggest the economy is accelerating moderately.”

http://www.bloomberg.com/news/2011-10-18/cooperman-says-u-s-will-avoid-recession-stocks-appealing-1-.html

How Not to Set Investment Strategy

"Prediction is very difficult, especially about the future"

One of the biggest mistakes that investors make, in my opinion, is to try to overlay their views on the economy or interest rates on their investment strategy.

It seems to make logical sense: first you forecast the economy, then the direction of interest rates. Once you've figured this out, you turn your attention to what stocks or bonds will provide the best returns under the scenario that you expect.

Problem is, the accuracy of most forecasts - especially about the economy, interest rates and the stock market - are usually poor at best.

The academic literature is full of examples of how many of the most prominent and learned among us have failed to anticipate changes in the economy. It's not for lack of trying, but rather that it's just too complex.

Take interest rates, for example. Here's a short note written by John Carney the CNBC blog Net, Net:

The latest note from James Bianco points out that Bloomberg’s monthly survey of economists almost always forecasts high rates for 10-year Treasurys in the next six months.

Since 2002, Bloomberg has been asking economists where they think interest rates will be six months into the future. Out of the 104 surveys completed, 100 of them forecast high rates in six months.

Every single survey for 2011, for example, the majority of economists polled forecasted higher rates.

Interestingly, the economists are always right when predicting falling rates—although this has only happened four times so far so the sample may be too small to matter.

http://www.cnbc.com/id/44963277

Now, with interest rates at 60-year lows, what's the next direction for rates?

Truth is, no one knows for sure.

It seems to me that one should focus their investment attention on sectors that offer the most value under a variety of different scenarios, no matter how far fetched they might appear.


*This quote is usually attributed to Niels Bohr, a prominent Danish physicist, although Bohr himself attributed it to others. Whatever - I like the quote.

What to do about Bank Stocks?

I first wrote about this topic last March. Fortunately, I concluded that it was not yet time to dive into the sector, despite the fact that the valuations appeared very attractive.

Here's what I wrote then:

Problem now is that the very same problems that nearly destroyed the system are still very much evident. There still remain thousands, if not millions, of home mortgage loans that are underwater, and the outlook for housing is still very poor, in my opinion. Derivative products tied to mortgage loans also are pervasive in the system.

Then there's the problem of growth. Speaking as someone who works at a bank, we have lots of money to lend, but face a real paucity of credit-worthy borrowers. This is part of the problem the Fed is facing, by the way: the central bank can keep adding money to the system, but it is largely being reinvested in Treasurys, which doesn't do too much to either help the economy (or help bank profits, for that matter).

http://randomglenings.blogspot.com/2011/03/what-to-do-with-bank-stocks.html

Lots has happened in the last 6 months, but nothing (in my opinion) has changed in terms of the headwinds facing my industry.

Loan growth remains sluggish. Low interest rates are killing bank net interest markets. Credit metrics for the banks are starting to show deterioration again, after several quarters of improvements.

And recent results from the money center banks appear attractive, yet once you dive into the numbers much of the recent bank profitability has been achieved through "special items".

Consider Bank of America, which posted stronger results than expected, and BAC soared by +10%. However, according to this morning's New York Times:

Still, the story behind {Bank of America's} $6.23 billion profit was mostly a tale of one-time gains from accounting changes and asset sales, including $4.5 billion from positive adjustments to the value of its outstanding debt, a $1.7 billion accounting gain on the perceived riskiness of its debt and a pretax gain of $3.6 billion from the sale of half its stake in China Construction Bank....

Without the special items, Bank of America would have earned about $2.7 billion, which included pulling back $1.7 billion it had set aside, largely for borrowers who fail to pay their consumer and credit card loans.

Jason Goldberg, an analyst with Barclays Capital, counted 15 special items in the quarter, down from 16 in the second quarter but more than the 12 in the first quarter. “It’s a big company undergoing a transformation.”

http://dealbook.nytimes.com/2011/10/18/bank-of-america-gives-up-its-title-as-biggest-in-u-s/?scp=4&sq=bank%20america&st=Search

Now, I am a fan of Jason Goldberg, but is it really a positive that the number of special items in Bank of America's earnings has fallen from 16 "one-off" items to 15?

Then there's this: I asked Rich Sipley, a fellow portfolio manager here at Boston Private Bank (and loyal reader of Random Glenings) a simple question yesterday.

Me: "If bank stocks are so cheap, why are we seeing more acquistions?"

Rich: "No one wants to sell at these prices."

That's why Rich is a good portfolio manager.

That said, there is more feelings that the longer term outlook is for a large increase in bank merger activity, simply because the costs of banking in this country are rising significantly at a time when revenue growth has been nonexistent.

This morning's Financial Times carried a piece this morning discussing the need for the banking sector to shrink in the U.S.

According to the article, a recent report by turnaround specialists Alvarez & Maral suggests that large U.S. regional banks will "need to cut expenses by up to 40% to cope with slower economic growth, increasing pressure to cut staff or merge with rivals".

Here's the problem:

Companies such as Regions Financials - which is trading at about a third of its book value - and Sun-Trust banks - trading at about half of its book value - will be among those facing pressure either to pare back their operations significantly or merge with competitors. Many already have announced cost-cutting measures to placate investors.

From 2002 to 2006, banks' ROE was about twice as high as their cost of equity capital, according to Alvarez & Marsal. Since 2008, the cost has exceeded the return, a trend that is forecast to continue until 2013.

http://www.ft.com/intl/cms/s/0/63b17772-f353-11e0-
b11b-00144feab49a.html#axzz1bA0s3gvl

So for now I remain very defensive in my bank positions in portfolios.

Market Volatility

The blog Zero Hedge posted an excerpt this morning from Michael Higley's weekly "By the Number$" newsletter:

During the first 4 months of the year through 4/29/11, the S&P gained +9.1% (total return). From 4/29/11 to 10/03/11 (i.e. approximately the 5 months that ended just 2 weeks ago), the S&P 500 lost 18.6%. But in the last 9 trading days through last Friday (10/14/11), the stock index gained +11.5%. The net YTD result: down 1.1% as of 10/14/11.

http://www.zerohedge.com/news/some-market-fun-numbers-art-cashin

Put another way, net-net, stocks have gone nowhere this year, but its been a helluva ride.

To me, this year's volatility illustrates the futility of trying to time the market. Others, however, continue to try to trade the market, despite the overwhelming evidence that most trading makes money for the broker, not the investor.

I continue to think that dividend-paying, large cap stocks are the only game in town for most investors who can take a longer term time horizon. I don't know what the market will do next week, or next month, but I find it hard to believe that over the next three to five years stocks will not be the superior asset class.

One of the more bullish market analysts this year has been Lazio Birinyi, but he wrote a piece in this morning's Financial Times modestly changing his tune.

Mr. Birinyi now describes himself now as being only moderately bullish. He is concerned about data showing an economy that is decelerating, and the possibility that the European and Asian markets will also drag on the US stock market.

That said, Mr. Birinyi would not abandon the market, noting that some of the bearish arguments that are currently making the rounds have been made for years. Abandoning the market based on current sentiment, as Mr. Birinyi notes:

I don't know how and when this will end. One clue might be to look for negative reports. On March 9, 2009, at the bottom, the Wall Street Journal's Money section headlined "Dow 5,000? A bearish possibility."

And one of the longest market stories in last year's New York Times - again at the bottom for markets that year - was subtitled "Wall Street tallies new losses with a bear market in mind."

http://www.ft.com/intl/cms/s/0/fc1da9e2-ef78-11e0-941e-00144feab49a.html#axzz1bA0s3gvl

Investing in Farmland

In the early 1980's, when I was just getting started in the investment business, there was widespread consensus about where all "smart" investors should have funds: gold and oil.

Gold hit a high of $850 in 1980, while oil had reached $39 a barrel in the same year. The thinking among most institutions was that commodities in general, and gold and oil, in particular, were only destined to move higher in price, especially since they had outperformed all other asset classes in the prior decades.

Then reality hit. Gold prices started to fall, and by the year 2000 gold was priced at $250 an ounce, or nearly -70% lower than two decades earlier.

While gold prices have recovered recently, investing in gold in 1980 would have yielded a return of less than 1% per annum for the past 30 years, far below traditional investments in either stocks or bonds.

Oil prices, too, had peaked in 1980, even though it was not apparent to anyone at the time. Oil prices fell by more than -75% by 1986 to less than $10 a barrel, as oil supplies far outstripped demand.

Like gold, oil prices eventually recovered, but here again the returns from investing in oil have been barely higher than 2% per annum over the last 30 years.

Which brings me to farmland investments.

The current investment du jour is farmland, according to Gillian Tett of the Financial Times. In her piece last Saturday, Ms. Tett notes that TIAA-CREF, the huge pension fund targeted largely to educational and non-profit institutions, is now apparently the largest owner of U.S. farmland today.

Other large institutional investors have joined TIAA-CREF in their appetite for farmland. According to an OECD report, notes Ms. Tett, 54 investment funds now have $7.44 billion of agricultural investments around the world, and this is "expected to double or triple in the near to long term".

The logic of investing in farmland is to me eerily reminiscent of the same reasoning that lead investors to pile into oil and gold investments a generation ago: the world is changing, the amount of farmland is finite, etc.

Oh, and the historic returns from investing in farmland have to date been far better than investing in stocks or bonds.

Now, it could be that I am too cynical, but after growing up in the Midwest I can tell you that farmers tend to be pretty good judges of the value of their land.

And if farmers are selling to the "shrewd" money managers from New York, I would be more than a little cautious.

Past performance, as people in my industry constantly remind us, is no guarantee of future results. I would be willing to bet that returns from indiscriminate farmland investments will be poor indeed relative to other alternatives in the years to come.