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.

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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.

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!

Read more: http://www.businessinsider.com/economist-forecasts-wrong-2011-12#ixzz1h56NPkie

Consider yourself warned!

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.

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.

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.

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.

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.