Change

•February 17, 2010 • Leave a Comment

“Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.John Kenneth Galbraith

The ability to change or adapt one’s strategy is extremely important in investing. Warren Buffet started out as a “Cigar Butt” investor, à la Benjamin Graham. Although it took over a decade, he gradually changed his strategy, and began focusing on the qualitative aspects of businesses such as management, competitive advantage etc. This is not to say that he pays no attention to intrinsic value anymore; he simply tries to buy great companies at very attractive prices.

I’ve noticed recently that various famed value investors have evolved in their investments. In a recent article, Whitney Tilson stated:

“I’ve come to a somewhat similar conclusion with respect to paying more attention to macro considerations in individual stock selection and overall portfolio positioning. Like many dyed-in-the-wool value investors, I have traditionally left macroeconomic or political forecasting to the pundits and focused almost exclusively on individual, bottom-up stock selection.”

Mohnish Pabrai, another famed value investor, has also evolved and rethought his strategy:

“There is a lot to be said for running a concentrated portfolio. Good investing ideas are scarce. It is very hard to find dozens of them. Also, as Buffett says, why would you invest money in your 30th best idea versus investing more in your very best idea? And Charlie Munger is on record stating that a well diversified portfolio can be constructed with just four positions.” Before continuing “One needs to be a learning machine and be willing to give up some of our best loved ideas when the evidence suggests they are flawed. Going forward, to temper volatility, Pabrai Funds will endeavor to size positions at 2%, 5% or 10% of assets. For new positions the norm will be a 5% investment. Stocks that strongly correlate (that is move in lock-step with one another) will be sized at 2% and once every few years positions will be up to 10% of holdings.”

Evidently, Tilson has changed his analytic strategy and Pabrai has changed his allocation policy. There is much to be said about investors who manage to overcome biases such as “rationalization”, “overconfidence”, “anchoring” and “confirmation”, and change their investment strategies to improve their results. These investors, like Buffet, are the most likely to find continued success. “When the facts change, I change my mind. What do you do sir?” JM Keynes

Note: The idea for this post is from Noise Free Investing,  an excellent blog, which I would recommend reading (link).

Soon

•November 2, 2009 • Leave a Comment

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

•July 1, 2009 • Leave a Comment

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

A few days go, this CNBC news anchor, 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 recent segment 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”. Now, it must be said that some are declining at a lower pace, however, they are still declining; 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). And even if the indicators do recover, it must be noted that the recovery will likely be due in large part to government stimulus, and should therefore be viewed with skepticism. It’s entirely plausible that we could see 2-3% growth in early 2010, before the stimulus wears off. Balance sheet recessions are drawn out processes, which often see brief recoveries followed by further economic stress – think Japan in the 1990s.

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

•March 10, 2009 • Leave a Comment

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:

Links 10/03/2009

•March 10, 2009 • 1 Comment

Links 18/02/09

•February 18, 2009 • Leave a Comment

Links 17/02/09

•February 17, 2009 • Leave a Comment