Taking A Break

Hello,

Sorry for the lack of recent posts, but as I’ve been applying to grad schools, I have much less time. I will try to post an article in the coming months. Please don’t hesitate to email me with any questions.

Thanks

Boundedly Rational Investing

I often get asked about the meaning of “bounded rationality”, and how it relates to investing. This post will examine both the definition and relevance of this concept.

Bounded rationality is based on the premise that an individual’s rationality is limited by both his cognitive ability and environment: the purely rational economic man does not exist. Herbert Simon coined the term in 1955, and used the metaphor of a pair of scissors, where one blade is the “cognitive limitations” of actual humans, and the other the “structure of the environment”.  According to Simon, studying one blade is not enough; it takes both for the scissors to cut. Minds with limited time, knowledge, and other resources can be successful by exploiting structures in their environments (Selten).

“Boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information. A great deal can be learned about rational decision making, by taking account of the fact that the environments to which it must adapt possess properties that permit further simplification of its choice mechanisms.”

So, in complex environments (such as the stock market), we can say that humans are not “unboundedly rational” but “boundedly rational”; they must “satisfice” to the best of their ability. In truth, this lies somewhere between cognitive and ecological rationality, governed by simple and straightforward heuristics, which are often context dependent. There needs to be a balance, because using too few heuristics often leads to biases and sub-optimal decisions (Kahneman and Tversky), whilst the use of too many can often lead to confusion (Gilovich).

An illustrative example could be of some help here. Imagine we wanted to predict how an expert billiards player would hit a certain shot. We would measure the angles and distances, get the coefficients of elasticity of the balls and the bumpers, and we would solve a set of differential equations. But is that how the billiards player figures out what to do? I’m not so sure. We don’t know exactly what he would do, but surely optimization theory is not the most efficient way of figuring this out; the “fast and frugal heuristic” actually used by the billiards player would be much more useful.

Simon recommended that individuals think this way in order to make the most effective decisions in a given situation (that is, those with the highest expected value). He also recommended rethinking the norms as well as studying the actual behavior of minds and institutions. It is a multi-disciplinary concept, not unlike Charlie Munger’s idea of “multiple mental models”. Gigerenzer points out three distinct processes that these models specify:

• Simple Search Rules
• Simple Stopping Rules
• Simple Decision Rules

Using these rules as a foundation, individuals must develop an “adaptive toolbox” to deal with different problems in different circumstances – this is where the idea becomes relevant to investors. There are so many companies, with so many variables, that considering them all would be impossible. For this reason, investors must try to act as rationally as is necessary, but no more. “It is the mark of an educated mind to rest satisfied with the degree of precision which the nature of the subject admits and not to seek exactness where only an approximation is possible.” ~ Aristotle.

Boundedly Rational Investing involves beginning with a simple and straightforward screening process, made up of 10 to 15 points. It then involves shifting through masses of information and focusing on the few key elements which make a difference for the company in question (keep in mind, for instance, that all financial ratios are not relevant for all companies – adaptability is key). When analyzing a company, we are often dealing with the future, and therefore, with numerous assumptions. Starting with some checklist style tools – à la Charlie Munger – can help achieve a certain amount of clarity, which I  believe is necessary.

To help you get started, I have pointed out heuristics used by some great investors; think of them as tools for the adaptive tool box. By checking them repeatedly, investors should be able to act in a sufficiently rational way when making their investments, which should greatly improve their chances of success. Although the purely rational man does not exist in complex environments, the sufficiently rational man does.

When considering this “simplistic” approach, be aware that it is mainly a learning framework to help build an appropriate process. It should be combined with significant personal study and analysis to become most affective: investing can be simple, but not easy.

Warren Buffet:

“We selected investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business:

• Favorable long-term economic characteristics
• Competent management
• Purchase price attractive when measured against the yardstick of value to a private owner
• An industry with which we are familiar and whose long-term business characteristics we feel competent to judge”

Seth Klarman:

“We look for good businesses with:

• strong barriers to entry
• limited capital requirements
• reliable customers
• low risk of technological obsolescence
• abundant growth possibilities
• and thus significant and growing free cash flow”

Francis Chou:

“The investments that have proven most successful for us include:

• Above-average to excellent companies as measured by high ROE in excess of 15% sustained over 10 years or more.
• Companies run by skillful managers as measured by good controls maintained on receivables, inventory and fixed assets.
• Prudent deployment of capital as measured by a company’s capital expenditures, judicious acquisitions, and timely buybacks of its depressed shares.
• A stock price which is far lower than what a knowledgeable and rational buyer would pay.”

William Ackman:

“We seek simple, predictable, free-cash-flow-generative businesses that trade at a large discount to intrinsic value:

• Mid and large-cap companies
• Typically not controlled
• Minimal capital markets dependency
• Typically low financial leverage and most economic sensitivity
• Often hidden value asset base
• Catalyst for value creation which we can often effectuate

At the right price, we may waive one or more of the above criteria. Our selection process is designed to help avoid permanent loss of capital while generating attractive long-term returns.

Our concentrated portfolio has many advantages:

• Best idea fund (we invest in our 8 to 12 best ideas; we are always willing to replace an existing holding for a better opportunity)
• Provides transparency to our investors (few investments + detailed disclosure)
• Simplicity (we need only a handful of new ideas per year)

David Einhorn:

“Our portfolio discipline is to construct our portfolio from the bottom up.  As value investors, we take long positions in good companies that we believe have clean and unlevered, or minimally levered, balance sheets and have misunderstood prospects.  Of course, should the economy weaken they may earn less than they would in a strong or normal economy, but we believe that a lot of bad news is baked into their valuations and that these companies will survive the cycle.  On the other hand, we are short companies that have significant problems of various sorts:  some have bad business practices or have played accounting tricks; others trade at very high multiples of earnings expectations that are unlikely to be achieved; while others have flawed business models and are unlikely to be long-term survivors.  We believe that over time, this is a sensible way to invest and will prove to be a lucrative portfolio construction methodology.  Our investment strategy has always reflected time arbitrage in that we position ourselves to benefit from having a significantly longer-term horizon than other market participants.”

“There seems to be some perverse human characteristic that likes to make easy things difficult.” Warren Buffet

The Self-Awareness Paradigm

“We know well that mistakes are more easily detected in the works of others than in one’s own. When you are painting you should take a flat mirror and often look at your work within it, and it will then be seen in reserve, and will appear to be by the hand of some other master, you will be better able to judge of its faults than in any other way” – Leonardo Da Vinci

It is important, in both investing and in life, to try to stand apart from yourself. Some call it “meta-cognition”, but most simply refer to it as “self-awareness”. It is the ability to think about your very thought process, and examine it as if from a third party’s perspective – unbiased. Stephen Covey points out that this ability explains why man has dominion over all things in the world, and why he can make significant advances from generation to generation: “This is why we can evaluate and learn from others’ experiences as well as our own. This is also why we can make and break our habits”. Making good habits, and breaking bad ones, is essential to long term success; in my view, the process starts with the awareness of common biases. The ability to act without bias is one of the hardest parts of investing – as they often lead to misjudgments and errors, of which we only become aware in hindsight (if at all).

For this reason, it is best to be pro-active and not reactive. This is to say that people often view evidence as supporting their beliefs, instead of examining all of the facts objectively, and actively. I would recommend approaching every idea tentatively, and always looking for disconfirming evidence. When examining a company for investment purposes, Warren Buffet recommends avoiding the market price, initially. Instead, one should examine the facts without any preconceptions, and come to a rational conclusion about the value of the business. Once you’ve put a price on the whole business, using the annual report, then compare it to the market price. By using this method, you will not begin your research with any pre-conceived notions, and you will certainly not be subconsciously “confirming” a thesis. Remember that human beings are best at interpreting all new information so that their prior conclusions remain intact.

“If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubts, he shall end in certainties.” ~ Francis Bacon

Note: How am I to find an interesting company without screening for low prices? You can start by using screens such as Joel Greenblatt’s, or simply examining 13-Fs. Just make sure to begin with doubts.

Process vs. Outcome

“Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision making can be encouraged by evaluating decisions on how well they were made rather than on outcome” – Robert Rubin

Given Rubin’s recent retirement from Citigroup, I thought this quote was appropriate. Research by Russo and Schoemaker has identified  a common trait amongst successful performers in probabilistic fields: they all emphasize process over outcome. Similarly, investors should try to judge decisions on how they were made instead of on the results they engender.

This is not to say that results don’t matter; obviously they are extremely important in measuring success. That being said, it seems as though many investors  don’t realize that certain positive outcomes, even strung together in successive numbers, are simply part of normal probabilistic distribution. Some believe that because they were able to select winning stocks consecutively, or have 2 consecutive high return years, they possess large amounts of skill. Often, investors fail to examine why they were winners because they are too busy recounting their successes. Remember, “All people are most credulous when they are most happy” – Walter Bagehot. By examining why an investment was (or was not) successful, you can reduce these inherent biases which cloud judgment.

I would recommend looking at fundamentals of valuation rather than stock price. Do not make the mistake of thinking that because the investment worked out, your analysis must have been correct (or vice versa). A perfect example is the internet bubble of the late 90s; many hedge funds believed they had inordinate amounts of skill, when in reality their success was the result of an extreme bull market combined with the human fallacy of hoarding and false expectations. The famous Wall Street adage goes: “Don’t confuse brains with a bull market”. When the bubble burst, they quickly saw that the skill they thought they had was in fact illusionary.

Here are Rubin’s four principles for decision making, which should provide a good basis for thinking about this:

• The only certainty is that there is no certainty: We need to train ourselves to consider a sufficiently wide range of outcomes.

• Decisions are a matter of weighing probabilities: We must realize that some high-probability propositions are unattractive, and some low-probability propositions are very attractive on an expected-value basis.

• Despite uncertainty, we must act: the point here is that we must base the majority of our decisions on imperfect or incomplete information. We must make such decisions based on an intelligent appraisal of available information.

• Judge decisions not only on results, but also on how they were made: A good process is one that carefully considers price against expected value.

Warren Buffet Speech to Florida Graduates

Another great talk, this time by Mr. Buffet. I have highlighted one of my favourite passages below.

Your Future

I would like to talk for just one minute to the students about your future when you leave here. Because you will learn a tremendous amount about investments, you all have the ability to do well; you all have the IQ to do well. You all have the energy and initiative to do well or you wouldn’t be here. Most of you will succeed in meeting your aspirations.

But in determining whether you succeed there is more to it than intellect and energy. I would like to talk just a second about that. In fact, there was a guy, Pete Kiewit in Omaha, who used to say, he looked for three things in hiring people: integrity, intelligence and energy. And he said if the person did not have the first two, the later two would kill him, because if they don’t have integrity, you want them dumb and lazy.

We want to talk about the first two because we know you have the last two. You are all second-year MBA students, so you have gotten to know your classmates. Think for a moment that I granted you the right–you can buy 10% of one of your classmate’s earnings for the rest of their lifetime. You can’t pick someone with a rich father; you have to pick someone who is going to do it on his or her own merit. And I gave you an hour to think about it.

Will you give them an IQ test and pick the one with the highest IQ? I doubt it. Will you pick the one with the best grades? The most energetic? You will start looking for qualitative factors, in addition to (the quantitative) because everyone has enough brains and energy. You would probably pick the one you responded the best to, the one who has the leadership qualities, the one who is able to get other people to carry out their interests. That would be the person who is generous, honest and who gave credit to other people for their own ideas. All types of qualities. Whomever you admire the most in the class. Then I would throw in a hooker. In addition to this person you had to go short one of your classmates.

That is more fun. Who do I want to go short? You wouldn’t pick the person with the lowest IQ, you would think about the person who turned you off, the person who is egotistical, who is greedy, who cuts corners, who is slightly dishonest.

As you look at those qualities on the left and right hand side, there is one interesting thing about them, it is not the ability to throw a football 60 yards, it is not the ability the run the 100 yard dash in 9.3 seconds, it is not being the best looking person in the class, they are all qualities that if you really want to have the ones on the left hand side, you can have them.

They are qualities of behavior, temperament, character that are achievable, they are not forbidden to anybody in this group. And if you look at the qualities on the right hand side the ones that turn you off in other people, there is not a quality there that you have to have. You can get rid of it. You can get rid of it a lot easier at your age than at my age, because most behaviors are habitual. The chains of habit are too light to be felt until they are too heavy to be broken.

There is no question about it. I see people with these self-destructive behavior patterns at my age or even twenty years younger and they really are entrapped by them. They go around and do things that turn off other people right and left. They don’t need to be that way but by a certain point they get so they can hardly change it. But at your age you can have any habits, any patterns of behavior that you wish. It is simply a question of which you decide.

If you did this… Ben Graham looked around at the people he admired and Ben Franklin did this before him. Ben Graham did this in his low teens and he looked around at the people he admired and he said, “I want to be admired, so why don’t I behave like them?”. And he found out that there was nothing impossible about behaving like them. Similarly he did the same thing on the reverse side in terms of getting rid of those qualities. I would suggest is that if you write those qualities down and think about them a while and make them habitual, you will be the one you want to buy 10% of when you are all through. And the beauty of it is that you already own 100% of yourself and you are stuck with it. So you might as well be that person, that somebody else.

Question: What makes a company something that you like?

Buffett: I like businesses that I can understand. Let’s start with that.  That narrows it down by 90%.  There are all types of things I don’t understand, but fortunately, there is enough I do understand. You have this big wide world out there and almost every company is publicly owned. So you have all American business practically available to you.  So it makes sense to go with things you can understand.  I can understand this, anyone can understand this (Buffett holds up a bottle of Coca- Cola).  Since 1886, it is a simple business, but it is not an easy business—I don’t want an easy business for competitors.  I want a business with a moat around it.  I want a very valuable castle in the middle and then I want the Duke who is in charge of that castle to be very honest and hard working and able. Then I want a moat around that castle.  The moat can be various things: The moat around our auto insurance business, Geico, is low cost.

So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about in a general way where they will be ten (10) years from now.  If I can’t see where they will be ten years from now, I don’t want to buy it. Basically, I don’t want to buy any stock where if they close the NYSE tomorrow for five years, I won’t be happy owning it.  I buy a farm and I don’t get a quote on it for five years and I am happy if the farm does OK.  I buy an apartment house and don’t get a quote on it for five years, I am happy if the apartment house produces the returns that I expect. People buy a stock and they look at the price next morning and they decide to see if they are doing well or not doing well.  It is crazy.  They are buying a piece of the business.  That is what Graham—the most fundamental part of what he taught me.

Question: Why do large caps outperform small caps (1998)?

Buffett: We don’t care if a company is large cap, small cap, middle cap, micro cap.  It doesn’t make any difference.  The only questions that matter to us:

• Do we understand the business?

• Do we like the people running it?

• And does it sell for a price that is attractive?

Soon

Hello All,

I apologize for the lack of posts over the past month; work has been extremely busy. That being said, I’ve spent a lot of time preparing my  next post, which I hope everyone will enjoy. More to come, soon.

Mr. Kneale

My investment post will have to wait. The reason, I’m afraid, is Mr. Dennis Kneale.

A few days go, this CNBC news anchor – who, incidentally, does not have a business, finance, or economics degree – made a statement to the effect that the recession was over, and that the worst was far behind us: better times are here, and people should embrace “the hope”. Although this blog rarely criticises individuals outright, I felt strongly about writing a piece proposing a response to Kneale’s statement. I’m not predicting a continuation – or end – of the recession, I’m simply pointing out that investors should be cautious, especially since the markets have rallied over 40% in only 3 months.

In his segment from the 25th of June entitled: “The Recession is Over”, Kneale examins recent data, and points out the bullish implications for both the economy and the stock market. However, for someone who often criticises his opposition for lacking hard evidence to backup their claims, Kneale has very few tangible  facts – and uses the ones  he has in an extremely biased and misleading way (imho). His “pile of data” includes only 4 indicators, many of which are lagging. Oddly enough, he doesn’t mention a single indicator that the NBER (National Bureau of Economic Research) uses when examining recessions; he goes on to talk about Durable Goods, Capital Goods, Stocks and Consumer Sentiment.

Firstly, increases in Durable and Capital Goods orders are perfectly normal in this type of situation, and do not signal the comming “party” Kneale describes. It is a matter of inventories: businesses decided they had too much “stuff” in warehouses, so they slashed production well below final sales. Correspondingly, what we’re seeing is likely the result of the end of this de-stocking process, and start of a “re-stocking” one. Interestingly, both of these indicators describe business spending metrics, and not consumer spending metrics. Given that US GDP, in terms of aggregate demand, is approximately 70% consumption based, it would have been more appropriate to discuss consumer spending, or retail sales.

What about consumer sentiment? Often, in the past, in has been made clear that consumer sentiment is not a consistent and valid measure of future economic and business activity. Further more, it is extremely fickle; for instance, in late 2007, consumer sentiment was almost at an all time high, right before the economy began its largest recession in 70 years. Also, given the massive amount of consumer debt, decline in real wages, unemployment etc., even if consumers do feel better about the economy, can they actually afford to spend meaningfully? (where are they going to get the money to spend?)

Then there is the question of the stock market, which has rallied 40% from the lows. We must remember that the stock market is a discounting mechanism, and “prices future events in”. At this point, the market is clearly pricing in a sustainable V shaped recovery. If this does not come to be, we can expect this “indicator” to decline heavily.

In my opinion, Mr. Kneale has succumbed to some of the investment field’s most common biases: confirmation bias (the tendency to search for or interpret information in a way that confirms one’s preconceptions) and expectations bias (the tendency for experimenters to believe, certify, and publish data that agrees with their expectations for the outcome of an experiment). Also, he conveniantly shows data month to month, and only for the past few months, thus neglecting to show that the recent increases are very small relative to previous levels – and the large declines throughout 2008-2009. As an example, if a company’s earnings decline from $1 billion per year to $100 million, and then rise to $140 million, I would call that improvement. If I showed an investor the past few months of data, showing a 40% increase in earnings, he would probably be excited; that is, as long as I didn’t show him the prior year’s levels and decline. This, in effect, is what Kneale has done with his data, limiting it to the past few months. It is  essential that an investor examine data on longer timeframes, to get a more accurate picture. Mr. Kneale has, in fact, manipulated his audience via this extremely short term picture.

Investors should try to be as unbiased as possible when examining data, by using the most commonly accepted indicators for particular circumstances. As Mr. Kneale focused only on recent data, most of which is less relevant than those I am about to discuss, I will also use a shorter term timeframe (the longer term would require much more time, and would only serve to paint an even more dire picture. Let’s try to stay somewhat “positive”).

So, what data is mostly commonly used for measuring recessions?  The NBER uses 5 metrics:

• GDP
• Industrial Production and Capacity Utilization
• Retail/Wholesale Sales
• Real Earnings
• Employment Situation
  

Let me start by briefly describing each of these, and why they are extremely relevant in determining the future state of the economy.

• GDP: This is one of the most important indicators of all, and is released quarterly. The gross domestic product (GDP) is a basic measure of an economy’s economic performance, it is the market value of all final goods and services made within the borders of a nation in a year. The source is the BEA and the report is released at the end of the quarter (3 month period). Link

• Industrial Production and Capacity Utilization: A very important indicator which often has an effect on the market. It is a measure of the change in production of the nation’s factories, mines and utilities. It also includes a measure of their industrial capacity and how much of it is being used (commonly known as capacity utilization). The level of industrial production divided by the level of industrial capacity equals the capacity utilization rate. The headline numbers are the percent change in production from the prior moth and the capacity utilization rate. The source is the Federal Reserve and the resport is released in the middle of the following month, around the 15th. Link

• Wholesale Survey: The first report of the month on consumer spending; capable of big surprises. Consumer spending makes up 70% of all economic activity in the US, and retail sales account for around 1/3rd of that. If consumers can keep cash registers ringing, it is a sign of overall economic growth and prosperity. Retails sales has some shortcoming though; it represents only spending on goods, such as those found at department stores, gas stations, and food service providers such as restaurants. The report tells us nothing about what’s being spent on services such as air travel, dental care, insurance etc. Also, retail sales is measured only in nominal dollars, which means that no adjustment is made for inflation. It is computed using surveys sent out randomly to 5000 large and small retailers around the country. The government receives a certain percentage back and releases an advanced report. Another 8000 retailers are surveyed a few days later, and a revised report is released, usually four weeks later. Wholesale numbers are, for the reasons described above, a better metric, and are used by the NBER. The source is the Bureau of the Census, Department of Commerce. The report is released about two weeks after the month ends. Link

• Real Earnings: This indicator represents real income. Data on average weekly earnings are collected from the payroll reports of private nonfar establishments. Earnings of both full-time and part-time workers holding production or nonsupervisory jobs are included. Real average weekly earnings are calculated by adjusting earnings in current dollars for changes in the CPI-W. The source is the Bureau of Labor Statistics. It is released mid-month. Link

• Employment Situation Report: The most eagerly awaited news on the economy, which measures if jobs are being created and the situation of American workers. It has great economic and political significance for various reasons: the more workers there are and the more they earn, the more they can buy and propel the economy forward. The report is rich in detail about the job market and household earnings, both of which are drivers of economic growth. It is computed using the Household Survey and the Establishment Survey. The source is the Bureau of Labor Statistics, Department of Labour. The report is usually released the first Friday of every month. Link

Now that we know what each of these is, let’s examine the most recent data in each category (the June reports have not all been released as of right now. I will update the post when them become available):

• GDP: decrease at an annual rate of 5.5% in Q1
• Industrial Production: decrease of 1.1% in May (capacity utilization dwn. to 68%)
• Wholesale Sales: decrease of 0.4% in May
• Real Earnings: decrease of 0.3% in May
• Employment: Unemployment increased to 9.5% in June (with non-farm payroll cuts at 475k, compared to the 350k estimate)

Simply put, none of the 5 indicators used by the NBER point towards an imminent recovery, or the “end of the recession”; not one. Now, it must be said that some are declining at a lower pace, however, they are still declning; until they begin to rise, we must be very cautious about the so-called recovery. Above all, we must avoid making brash statements with carefully selected and less than relevant data (Mr. Kneale).

I’d like to talk, briefly, about recessions, as there are in fact different types. As described recently by Karl Denninger, the types of recessions are inventory driven recessions, the most common, and credit driven recessions.

“Inventory-driven recessions are primarily about excessive industrial capacity for demand.  That is, manufacturers and suppliers of services get too bullish about prospects, build too much capacity and inventory, and wind up engaging in a destructive price war in an attempt to “win”.  This drives down profits and ultimately forces the weaker firms out of business, ergo, recession – GDP and employment decline.  Having cleansed itself of the excess, the economy recovers.   The trigger for these recessions is often (but not always) an external shock such as the oil embargo in the 1970s or the collapse of the Internet fraud-and-circuses games in 2000.

The second sort of recession is a credit-driven recession.  Excessive credit creation – that is, loans going too far toward “fog a mirror” qualifications (and in some cases, such as the most recent event, actually reaching “fog a mirror”) drives one or more asset bubbles.  These pop when effective interest rates in the economy reach an effective level of zero, usually because the amount of leverage available becomes for all intents and purposes infinite (Bear and Lehman at 30:1, Fannie/Freddie at 80:1, AIG at god-knows-what, and duped “home buyers” buying with zero down for a true infinite leverage ratio.)  This excessive credit creation drives a speculative asset bidding war which in turn causes prices to go sky-high for one or more types of asset.

The latter sort of recession is triggered because the cost of borrowing money is never actually zero, even if people pretend that it might be.  As a consequence the lenders begin to earn a negative spread and lose actual purchasing power.  This is an unsustainable situation because cash flow cannot be fudged nor can anyone sustain a negative cash flow for very long; no matter how much you start with if you spend more than you make eventually you go broke.

Recessions cannot end until the conditions that caused the recession are removed from the economy.  This is elementary logic and obvious to anyone with an IQ larger than their shoe size.

For an inventory recession growth returns when enough capacity is destroyed through layoffs and inventory selloffs to bring capacity and demand back into balance.  Employers then hire new workers and the economy recovers.

For a credit recession, however, there is a much larger problem: The reason real interest rates went negative is that debt has a carrying cost and consumes free cash flow; so long as the debt taken on in the credit binge remains the cash flow impact also remains.

Default and bankruptcy clears excessive credit (debt) from the system – if it is allowed to occur.  But if it is not, then the bad debt remains on the balance sheets somewhere and the cash flow impact remains in the economy.  Employment remains weak, capital spending restart attempts falter as demand fails to return and credit quality continues to remain insufficient to support new credit demand.

The consumer is 70% of our economy, give or take a few points.  The consumer’s “savings rate” (which government blithely declares as income minus spending), which was in fact negative (that is, consumers were spending more than they made through taking on more and more debt), but is now solidly positive at 6.9%.

The impact of this (6.9% X 70%) is an immediate 4.83 decrease in real GDP. This is the math, and the math is never, ever wrong.

The truly bad news however is that most of the time saving in fact turns into capital formation – that is, it becomes investment.  But government doesn’t differentiate between actual savings and debt repayment – their formula is simply “income less spending = savings rate.”

Consumers are not saving, they are paying down debt in a furious attempt to avoid defaulting on nearly $1 trillion in outstanding credit card balances that have gone from 11% interest to 29.6% along with OptionARMs that are experiencing a tripling of payments while the home’s value is underwater and precludes refinance, all while consumers are being laid off by the hundreds of thousands monthly.”

I hope this makes the current situation clear (er). I remain very cautious in the current environment, and whilst I think that a slight recovery is possible by the end of this year, it is likely to be short lived, as the infamous “double dip” recession could take hold (that or an L shaped recovery, which could last for years). A great investor once told me: “Let the price come to you, don’t rush it”. I think the same thing can be said for economic indicators, and the market. We should always wait for the data to clearly tell us what is happening, instead of anticipating something thay may or may not materialize.

I will end this with my usual quotation, this one from Ludwig Von Mises on Credit based recessions:

‘The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression (recession), is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.’ -Ludwig von Mises

P.S: The “Golden Cross” that Kneale mentioned is likely to be invalid, as the 200 Day Moving Average is declining. Merryl Lynch has posted research on this, and doesn’t seem to find upside in the market anywhere near 20% following a cross (link). I’m surprised that a journalist for CNBC is not aware of these implications. I question where he gets the “20% increase” number, as other studies I’ve read haven’t found this to be true. In fact, in his research regarding the Golden Cross with a decling 200 day MA, Goepfert concludes:

“…the returns going forward, up to six months later, were little bettern than random and not statistically significant. In fact, in the shorter-term they were a little worse than random. Only when we look out a year do we see some out-performance.”

I would also suggest reading research by Robin Griffiths (well respected technical analyst, and former senior technical analyst at HSBC) and Deborah Owen (Fellow of the Society of Technical Analysts) concerning the cross, as he clearly states that both averages should be rising:

“A cross of the shorter moving average over the longer one can be used to generate buy and sell signals. If both averages are rising when the shorter term average breaks above the longer one, it is known as a “golden cross” and suggests that bullish sentiment is growing stronger.”

Obama and the Swedish Solution

I don’t often discuss politics or political figures, and the reason is simple: when people discuss politics, emotion overtakes stoicism, often leading to anger and conflict. Very rarely do people discuss politics in a calm and rational manner; it is an area in which biases are all too prevalent, and opinions are very seldom changed. That being said, I wanted to post a very brief piece commenting on an Obama interview I saw recently. Please note that I am as close to a political polygamist as they come, I therefore hope to be as unbiased as possible. Also note that this will not be a recurring type of post…

TERRY MORAN: There are a lot of economists who look at these banks and they say all that garbage that’s in them renders them essentially insolvent. Why not just nationalize the banks?

PRESIDENT OBAMA: Well, you know, it’s interesting. There are two countries who have gone through some big financial crises over the last decade or two. One was Japan, which never really acknowledged the scale and magnitude of the problems in their banking system and that resulted in what’s called “The Lost Decade.” They kept on trying to paper over the problems. The markets sort of stayed up because the Japanese government kept on pumping money in. But, eventually, nothing happened and they didn’t see any growth whatsoever.

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you’d think looking at it, Sweden looks like a good model. Here’s the problem; Sweden had like five banks. [LAUGHS] We’ve got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would — our assessment was that it wouldn’t make sense. And we also have different traditions in this country.

Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America’s different. And we want to retain a strong sense of that private capital fulfilling the core — core investment needs of this country.

And so, what we’ve tried to do is to apply some of the tough love that’s going to be necessary, but do it in a way that’s also recognizing we’ve got big private capital markets and ultimately that’s going to be the key to getting credit flowing again.

President Obama’s response shows a reasonable amout of consideration. That being said, it seems as though he may be misinformed here.

First, the 6 largest Swedish banks in 1991 (SE-banken, Handelsbanken, Nordbanken, Gota, Sparbanken Sverige and Foreningsbanken) and the 6 largest American banks today (BAC, C, MS, GS, JPM and WFC) have (or had) similar economics relative to GDP. Although there are indeed thousands of banks in the US today, the majority of toxic assets can be found on the balance sheets of the banks mentioned.  Examining the Swedish solution is therefore appropriate.

So how did Sweden solve its financial crisis in the early 1990s? The first noteworthy step was that government auditors were required to immediately write down bad assets in order to make clear, from the get go, the extent to which banks were solvent. The current crisis has been ongoing for over one year in America, and the public (and government) still has no idea of the extent to which these major banks are solvent.

Once the Swedish government had figured out which banks were zombies (Nordbanken and Gota), and which assets were toxic, they embarked on a 3 step plan which included additional recapitalization – for banks that were not insolvent, nationalization – for insolvent ones, and an aggregator bank to buy up bad assets. Note that the key here was the immediate write down of bad assets. This way, regulators were fully aware of what needed to be done, and balance sheets were thoroughly cleaned out as assets were taken over (or bought) at realistic prices.

What about the cost of the Swedish plan? Yes, the plan was expensive (amounting to approximately 6% of GDP). A similar plan in the US would likely cost more, but even if it were to amount to 10% of GDP – say $1.5 trillion – it seems as though it would be much more effective than throwing money every which way, hoping that it solves the problem. If this were a problem of illiquidity, the “plan to have a plan” outlined by Geithner could possibly work. Unfortunately, the plan as described will not respond effectively to the insolvency issue, which is at the heart of the problem. As stated by James Kwak, “Even if an insolvent bank has access to credit, it is still an insolvent bank, hoping somehow to become solvent, so it’s unlikely to lend or, even worse, it may be tempted to make extremely risky loans as the only possible path to solvency.”

Of course, there are differences between Sweden in 1991 and the US today. For one, the organisation of the US banking system is far more complex. Also, today’s international economy is heavily globalised and flows of capital between nations have lead to an intricate cross-national web. Sweden’s minute economy did not have to deal with such complications. I’m not sure how this would play into the solution; it could possibly call for much more unilateral cooperation between governments.

Still, in my humble opinion, the ”nationalization solution” or “receivership solution” should at least be examined in detail. Today, leading economists are not claiming that every bank should be nationalized permanently (this is where the negative stigma comes from): they are simply pointing out that forthrightness and transparency should be prioritized, insolvent banks should be identified and, with the help of the government, should quickly be resolved through the necessary processes. I’m hoping that the “stress test” Geithner spoke of will identify such banks and act accordingly, but there is no assurance, based on his statement, that this will be the case.

Martin Wolf has pointed out that, in the 1990s, the US gave very specific advice to Japan: “admit reality, restructure banks, and above all, slay zombie institutions”. Perhaps we should take our own advice, lest the US enter its own lost decade. The FDIC has taken a large number of mid/small sized banks into receivership and has been doing so for quite a long time; why not do the same with larger ones? Obama mentions that this will not work culturally, however, bailouts and “give-aways” are also quite un-American, yet we’ve been employing them as of late because they are necessary.

In 1999, Greenspan stated that the key to Swedish recovery was a quick and adequate response. They planned for the worst, instead of hoping for the best. Right now, as the plan stands, we are clearly hoping for the best in America. Our goal should be to clean up bank balance sheets so that, even if the worst case scenario does occur, we don’t have to worry about bank insolvency. Cutting corners will do nothing but exacerbate the severity of the situation.

So, what type of solutions (plan) would work for America? Recently, the president of the Kansas City Fed posted this piece: Too Big Has Failed. I would highly recommend reading it, he makes some excellent points and provides an outline for what seems like an appropriate plan.

Note:

Austrian Economists describe economics as follows: “The art of economics consists in looking not merely at the immediate but at the longer effects of any action or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

There is a specific type of leader which, in my opinion, is most capable of delivering the kind of actions that fit best with the aformentioned description: level 5 leaders. These leaders, as described by Collins (2001), are known as “Executive Leaders”. They build enduring greatness through a paradoxical blend of personal humility and professional will (Collins). In essence, they put the “organisation” before themselves, and focus on the long term effects of their decisions. As of right now, I would describe Obama as a Level 4 leader (which is good, but not great – or sufficient.)

Level 4 leaders are known as “Effective Leaders”. They catalyze commitment to and vigorous pursuit of a clear and compelling vision, stimulating higher performance standards (Collins). These types of leaders can be very effective, and have very good results; however, in the face of serious problems, level 5 leaders simply stand apart, and manage to turn around struggling organisations remarkably.

Although I fully realise that it is difficult, especially within politics, to make decisions that are beneficial for the nation in the long-run – as they are sometimes unpopular in the short run, it is essential. As an example, I would say that President Lincoln was clearly a Level 5 leader. Many of his actions were unpopular at the time, but few question the positive effect they had on the long term development of our nation (it is also noteworthy that Warren Buffet has often been described as a Level 5 leader/thinker).

Many people believe that the long-run is nothing more than a succession of short runs. In truth, however, the things that maximize positive outcomes in the short run often serve to decrease positive outcomes and increase risk in the long run (Howard Marks). It seems as though, for positive long-term outcomes to materialize, one must have a long-term strategy from the get-go. It is apparent that immediate action is needed to help resolve the current crisis, but let us not confuse immediate with short-term; we can act swiftly and with long-term oriented policies at the same time. I realise that Obama has only been in office for 50 days or so, and it may be too early to pass judgement, but I hope that he can evolve into a Level 5 leader, and if (where) possible, adopt this kind of thinking.

Related Links:

• Paul Kedrosky
• Martin Wolf
• Naked Capitalism
• USA Today

Links 10/03/2009

• Why stocks still aren’t cheap
• In Pain and Joy of Envy
• Performance
• 10 Mistakes Investors Make
• Buffet’s Metric Does Not Say Buy
• So this is meant to reassure?
• Stress Tes Results Preditermined
• Possible Approaches to Nationalization
• Cancel the Card
• Citigroup Begs to be 40% Nationalized
• Where we are, where we’re heading
• Dshort Bear Market Udpate
• The Road to Ruin
• Privatize the Banks Already
• Bank Nationalization: A Viewer’s Guide
• The “Bezzle” Defined

Links 18/02/09

• Stimulus Package Explained
• S&P 500 Q4 Earnings Collapse
• Hussman Weekly Commentary
• Global Eco Analysis on Euro Banks
• Every Consensus Must End
• Tracking the Household Balance Sheet
• Europe is in Bigger Trouble than the US
• Geithner and Summers Consolidating
• Will Europe Trigger the Financial Meltdown?
• Obama to Neuter Bank Pay Restrictions
• US Going Down Japan Path
• There are no Real Stress Tests going on
• Another case of Fraud
• Accounting according to Barclays
• Failure to Save Eastern Europe