Investorwalk

Low Volatility = Delusional Equilibrium

Dylan Grice recently replace James Montier as Soc Gen's resident behavioral finance guru. As much as I enjoyed Montier's insights, Mr. Grice is doing a decent job of filling his shoes so far.

Last week he very nicely pointed out the difference between the wisdom of crowds and the herd phenomenon. Although on the surface these two phenomena seem diametrically opposed (how can one random crowd be smart and the other be stupid?), Grice shows us the clear distinction between them. Groups of individuals making independent estimates, uninfluenced by each other or a common belief, tend to on average produce very accurate estimates. For example, the crowd at the fair that guesses the weight of a prize bull. A famous experiment showed that they could in fact guess the bull's weight if enough samples were averaged. However, if all the participants in this study had been influenced by each other's guesses, or by some other common belief, their guesses would've been skewed. This is what happens when we observe herding on Wall Street. Investors are influenced by what others are doing, by the media, etc, and hence all tend to form a large herd doing the same thing. This is clearly different from the wisdom that a crowd can produce.

Today's paper expounds on random events, knowing that we don't know (the market DOESN'T know that it doesn't know right now), and the coming inflationary environment. Grice first points out that arguably predictable disruptive events are typically set in motion by completely unpredictable and seemingly insignificant random phenomena. He uses the examples of Ceausescu's fall and the toppling of the Berlin Wall - both were precipitated by such events. Of course avalanches, landslides, etc also follow this model. I go back to April 2000 - the massive tech bubble was pricked when Microsoft made some unfavorable comments on an earnings call. Up until that time the market was in "hear no evil" mode.

Grice quotes Buffett from early March of this year, when a Bloomberg interviewer mentioned to Buffett that analysts were compaining that they couldn't value their companies since they had no way of predicting the future, and that even CEO's were not making forecasts because they had no visibility. Buffett characteristically put this complaint into perspective, by saying that:

"we didn’t have any visibility in 2006 either, we just thought we did … people say “Oh,
the future’s too uncertain now” … Well the future was uncertain then, or in 2007 too, they just
didn’t know it was uncertain.”

Note that volatility was at a historic high at that time - it was high because the market knew that it didn't know what the future held... Right now, volatility is at historic average levels, which Grice equates to delusional equilibrium. The market thinks it can see the future right now, and it is benign. Certainly the market is at least half wrong. The future is as uncertain as ever.

Grice is concerned that a seemingly insignificant and unpredictable random event could tip us into an inflationary spiral. The 30 year implied inflation expectations right now are 2.4%, whereas inflation has averaged 3.7% since 1951, and >3% since 1981. Does anyone really think that recent events and actions by our government "leaders" have set us up for years of low inflation? And as Dylan rightly says, if inflation is mispriced, so are all risk assets.

He is quick to point out however that the timing of this random event and its consequences are as unpredictable as the event itself. Agreed. I also agree that in the face of all this, it is difficult to get excited about taking on very much risk.

The Fed is Trapped

Does Bernanke need to give the big boys a "wink wink nudge nudge" before the rest of us?

This stuff isn't my area of expertise, but it is my Bond -trading officemate's. He thinks the Fed's actions have backed them into a rat hole, and are hurting the housing market and all forms of credit. His arguments seem very logical to me. Far more so than Najarian saying on CNBC this am that the Fed is keeping rates low to help credit card customers?! Huh? When the likes of Citi are raising card rates to 25% on their best, high credit score decade + customers??

Ponder this:

The Fed continues to say it will leave rates near zero for a LONG time. Hence big buyers are scooping up huge amounts ($44B per month) of 2-yr notes at absurdly low yields and a very tiny spread to the already pinned Funds rate. If the Fed were to suddenly change its tune, the owners of these (big banks, sovereign funds, etc) would get crushed. So the Fed is trapped - it can't publicly signal rates are going up without first secretly telling these big note holders that they are going to do so, so these guys can start unwinding. If they even signal this publicly, it'll be too late. Not to mention what would happen to the massive Fx carry trade bubble when the dollar strengthens.

Furthermore, by keeping the rates low, the Fed hurts the housing market. Banks do not need to, and are not, going out on the risk curve to make money. They can gather deposits for nearly nothing and make a big fat spread in treasuries. The long end of the yield curve is staying high (curve is very steep) because the bond vigilantes are afraid of inflation due to the Fed's easy money policy. Who needs to make mortgage (or small business etc) loans when there is a "risk free" 3-400 bp spread ripe for the picking? Risk free that is until the Fed raises rates. Which they can't. But they have to at some point. Hence they have to give a "wink wink nudge nudge" to all the big players. Which they can't - that wouldn't be unethical and would hurt those not in the know.

Trapped indeed...

Wall Street: Dumb as it Ever Was

I had to take a few moments away from shouting at the circus-of-the-inane on CNBC to vent. All the focus on this jobs number this morning should confirm to any rational person that the great majority of what goes on in Wall Street is a complete waste of time at best and a criminal destruction of value at worst.

Being trained as a scientist in a former life just makes it harder to watch this garbage. Yesterday afternoon some random NYSE floor monkey, CNBC's "expert of the moment", expounded that if the unemployment rate came in at 9.9%, the market was going to the moon, Alice. But (God forbid) if the rate was 10%, we're all doomed. At which point my left eyeball began twitching followed by my Bond-trader office mate and I embarking on a 30 minute session of throwing things (Literally and figuratively) at the TV. Only a session of cranking some classic reggae could calm us.

10% vs 9.9% - this my friends is far less than a rounding error. It means less than nothing, It is simply a round number vs. a non-round number - NOTHING MORE. And based on this alone, truckloads of money is wagered on Wall Street. Consider that today's jobs lost were 190k vs a consensus of 175k. Good God, the unemployment rate is 10.2%!!! Head for the fallout shelters! We missed consensus by 15 THOUSAND jobs. Never mind that September was revised better by 44k jobs, and August better by 46k. And never mind that the consensus is a compilation of predictions made by economists that have no better way (or past record since the beginning of recorded history) to predict the economy than the seagull circling my building. The one advantage they have is that people ASK them to predict the future, and PAY them to do so. As far as I know, no one does the same for the seagull. That is, unless he "calls" (caws?) a market bottom of top. Then he'll be guest host on CNBC for sure. The only question then will be whether a gull can out-bellow Kudlow.

Please try to remember in the face of this noise that the only good INVESTMENTS (as opposed to speculations) are those that do not require you to predict the future. And these are getting tough to find.

Higher Learning Kicks Ivy League Endowments Right in the Teeth

Today the WSJ reports that the massive endowments of Harvard and Yale lost about 30% each over the past year. Recall that these fellas practiced a "new and wonderful" form of portfolio allocation that "diversified" their assets over a wide range of illiquid (oops) asset classes , including private equity, commodities, timber land, real estate, etc., and away from common stocks. The endowment managers, who were lambasted by their own trustees during the good times for their multi-multi  million dollar paychecks yet remained steadfastly confident in their own superior investing abilities, apparently farmed 70% of the management out to other managers.

This Pretty Much Says it All...

The Running of the Sheep

 New York, NY: - It's official, the oft-repeated yet chronologically irregular spectacle, "The Running of the Sheep" has once again begun on Wall Street. Although not as well known as Pamplona's "Running of the Bulls", the ROTS is no less dangerous, as "investors" (i.e., sheep) trample each other to pile money into, or in other examples, pull money out of the stock market at what has historically proven to be EXACTLY the WRONG TIME. As recently as 5 months ago, the market was at absolute low levels not seen in more than a decade, and at low valuation levels not seen in a generation. Yet "investors" climbed over each other to pull money out of this arguably dirt-cheap market. Today we get word that equity fund inflows this week have been HUGE - the largest since August 2007, shortly after which the market peaked, followed by a sickening plunge. Now that the market has run up some 46% since the last Running (away) of the Sheep, the wooly stampede as reversed direction. Will the carnage be just as bad this time? History says yes...

Green shoots, Mustard Seeds, Crocii - or Liquidity-Driven Mirages?

The market continues to confound the bears. Not only is is climbing a wall of worry, it's ascending as it tramples the backs and steps on the heads of incredulous investment professionals. After all, has anyone  REALLY seen any verifiable shoots, seeds, or flowers? Anyone other than  Larry Kudlow that is. It was 2007, at the peak of credit-driven euphoria, when he expected Goldilocks to carry the stock market ever upwards, just before she became lunch for Papa Bear. I often wonder if the shoots and seeds that fuel Larry's persistent optimism reside under gro-lites in the back room of his basement.

BNP Says Equities are a Bubble Waiting to be Pricked

Ahh the paradox: a market still way off its highs but at the top of a massive run from March 9 lows against the backdrop of a still-lousy worldwide economy fringed by tiny glimmers of improving fundamentals. Yipes. Add to that my bond-trading officemate's feeling that the bond market is teetering on a major technical precipice where it either has to settle back to lower rates or break out (sell off) to >3% on the 10-yr.

BNP credit analysts decided to throw in their two-cents, saying that equities are expensive, investment-grade corporate debt is cheap, and equity analysts are out of their minds. I certainly agree with the last part of that statement, but that's nothing new. The main thrust of their argument is that on reported earnings, which include writeoffs and charges, the market is at 30x PE or a earnings yield of 3%. Therefore there is no equity risk premium vs the risk free rate.

They also point out that Blackstone graciously marked the 2007 top by selling grossly overpriced equity to the public. I remember sitting here that day and discussing with Mr. bond-trader that the only reason those guys would do a PO was if they needed some suckers to help them monetize the then-raging private equity bubble. And we all know that in the Official Wall Street Dictionary, one finds the following definition: 

Main Street -noun

1. SUCKERS

2. The main thoroughfare in a town, esp. the business district

3. See #1

So now we have Goldman doing a secondary. Has a familiar ring to it...

My opinion? There are still plenty of bargains out there for the longer-term investor (a redundant phrase really). Nearer term? It wouldn't surprise me to see a "noticeable" pullback.

The NYT Butchers HOG

The NYT just did a real hack job on Harley with a very negative article that conveniently left out some positive aspects of the story. Yes, Harley has issues, and this article didn't hesitate to roll out the same hackneyed concerns: aging boomer demographic, expensive luxury item in a bad economy, questionable relevance to younger folks, and securitization issues at HDFS -  yadda yadda. Nothing new there. The stock has been crushed on all these issues. I of course think the concerns are overblown to varying degrees - I'm long, and have been from significantly higher prices unfortunately.

The Times somehow managed to ignore the fact that 32% of sales are conducted overseas, and have been growing strongly (albeit not as strongly as they were before the global slowdown).

From the Q4 earnings call (courtesy of Seekingalpha.com)

"For the full year 2008, retail sales of Harley-Davidson motorcycles in our international market were up 10.3%, the fourth straight year of double-digit international retail sales increases. For the full year, the Europe region was up 6.5%, Latin America region up 47%, Canada was up 11.7%, and the Asia-Pacific region was up 7.7%. Based on our expectation of continued economic weakness in many international markets and recent trends in our business, we expect a modest decline in overall international retail sales in 2009."

Even in the face of expected flattish overseas sales this year, those are some pretty solid results for 2008. The takeaway is that when the global economy improves, we will likely see strong demand return. It's pretty irresponsible of the NYT to ignore what is likely to be HOG's major growth engine going forward (maybe they're short). Looks like investors are ignoring the Times: the stock's up > 11%...

The Tao of Investing: What Works, What Doesn't

James Montier of Societe Generale recently published his ten tenets of investing, and I think there are some great lessons in there for every investor. If you're unfamiliar with Montier, he writes a thought-provoking weekly report entitled "Mind Matters, and is firmly grounded in the principles of Behavioral Finance and value investing. Too, he is amazingly unbound by the typical Wall Street "institutional imperative", and he despises analysts and economists (or at least their "work"). In other words, my kind of guy!