Friday, April 18, 2014

The Greatest, Rarest, Awesomest Concept for Investing Success

Getting basic facts straight.

What drives markets? Let's line em up and knock em down, Che Guevara style.
  1. Free market fiscal policies, of course! Really? Then why did markets soar under corrupt, socialistic filth like LBJ and Barack Hussein Obama. Next!
  2. Confident inspiring political leadership is vital! Oh, really? Then why didn't markets blink when JFK took one to the dome? Obviously because his veep was such a prudent, small government, business friendly free-marketer.
  3. Geopolitical stability, absence of war, that kind of thing. Oh, this kind of thing [1]? "Fifty years ago, the Cuban missile crisis brought the world to the brink of nuclear disaster. During the standoff, US President John F. Kennedy thought the chance of escalation to war was "between 1 in 3 and even," and what we have learned in later decades has done nothing to lengthen those odds. We now know, for example, that in addition to nuclear-armed ballistic missiles, the Soviet Union had deployed 100 tactical nuclear weapons to Cuba, and the local Soviet commander there could have launched these weapons without additional codes or commands from Moscow. The US air strike and invasion that were scheduled for the third week of the confrontation would likely have triggered a nuclear response against American ships and troops, and perhaps even Miami. The resulting war might have led to the deaths of 100 million Americans and over 100 million Russians."
  4. It's all about valuations. So you're the guy who sold in 1995 when P/E's hit 20 and the market still had five more years of soaring to do?
  5. Seth Klarman: artificially low rates blow bubbles. Right, like when zero rates blew the Nikkei lower for a measly 20 years. [2]
Maxim #1: When a country's Central Bank executes its job with tolerable competence, relatively stable Nominal GDP is enabled, and valuations tend to rise.

That is the only macro market maxim not shattered by basic historical facts.

[1] That markets didn't move during the missile crisis boggles my mind. This much can be said with certainty. Many people thought Nuke war was quite possible, and markets didn't move. That's nuts. The explanation could be that it was already priced, or that markets knew better that it wouldn't happen, or...I don't know. But it's cautionary tale for folks basing market predictions on geopolitics.

[2] How is the "low rates blow bubbles" crowd unaware of the low rate secular grizzly bear Japan has experienced since 1990. That's what I mean by "get basic facts straight".

[3] Tax, spend and regulatory policy helps explain why the US is richer than France. But these fiscal policies accumulate. They accelerate like cruise ships. France can elect Barry Goldwater, and the US can elect Jacques Chirac, and guess what? Four years later France is still going to be more socialistic than America. In contrast, Central Bank policy can accelerate like a jitter bug. A new regulation is one tree in a forest of regulations. It is marginal. In contrast, a NGDP target rule is a complete and immediate break from, for example, a currency peg. It's not that the Central Bank matters more than the Federal Government in an absolute sense. It is that it can change must faster. The break from Carter to Reagan was symbolically large, superficially impactful. But the break from a "inflation is non-monetary" Keynesian Central Bank to an "inflation is a monetary phenomenon" Volcker bank is gigantic and immediate.

Thursday, April 17, 2014

Cuban Missile Crisis, Monetary Policy, and Stocks

Guess how much the stock market dropped during the Cuban Missile Crisis? Lars Christensen:
According to the history books one of the most scary events during the Cold War was the so-called Cuban missile crisis, where the according the the history books the world was on the brink of nuclear armageddon. 
However, the history books might be wrong – at least if you look at what happened to the US stock market during the crisis. If we indeed were on the brink of the third world war we would certainly have expected the US stock market to drop like a stone. 
What really happened, however, was that S&P500 didn’t drop – it flatlined during the 13 days in October 1962 the stand-off between the US and the Soviet Union lasted. That to me is pretty remarkable given what could have happened.
But Russian markets are tanking on the recent upheaval in Crimea. Lars explains why (hint: it's monetary):
The recent sharp rise in geopolitical tensions is a significant negative supply shock to both the Russian and to the Ukrainian economy – visible in the sharp weakening of both countries’ currencies. However, unlike in the case of the US stock market in October 1962 the Russian and Ukrainian stock markets have sold off dramatically. 
Given the amount of regime uncertainty it is not surprising that investors have become a lot less happy to hold Russian and Ukrainian stocks. However, central bankers in the two countries are not making life easier for anybody either. Hence, the Russian central bank (CBR) has reacted to the sharp sell-off in the Russian rouble by intervening heavily in the currency markets and thereby tightening monetary conditions and the CBR has also increased its key policy rate by 150bp to prop up the rouble and more rate hikes might be in the pipeline. And this week the Ukrainian followed the (bad) example from the CBR and hiked its key policy by 300bp. 
So what both of the central banks are doing now is to tighten monetary conditions in response to negative supply shock. Obvious page 1 in the central banker’s textbook tells you not to respond to supply shocks in this way. Unfortunately most central bankers never read the textbook and hence are happy to make things worse by “adding” a negative demand shock to the negative supply shock. 
And this of course is going to be negative for stock markets. Monetary tightening causes nominal spending to drop and hence causes a contraction in nominal earnings growth and that of course is bad news for stocks.
At a CFA Forecast Dinner I attended a couple years ago I recall presenter Daniel J. Fuss predicting poor US equity returns based on his anticipation of war between Greece and Cyprus. That war didn't happen, and even if it did it's doubtful markets would've cared. I mocked him then. And his claims seem even sillier in light of market behavior around the Cuban Missile Crisis. His prediction was driven by the ego-fluffing need to say something interesting, accuracy be damned. Anyway, back to the competent guy, Lars:
The story of the 1960s: The stock market is a nominal phenomenon
Returning to the Cuban missile crisis it is helpful to have a look a the development in nominal GDP to understand what was going on the US stock market during the Cuban missile crisis and in the aftermath. 
In 1961 US NGDP growth had been accelerating significantly – with NGDP growth going from only 0.5% y/y in Q1 1961 to 9% y/y in Q1 of 1962. That reflects a rather massive monetary expansion. However, from early 1962 a monetary contraction took place and NGDP growth started to slow significantly. This I believe was the real reason for what at the time became to be known as the Kennedy Slide in the stock market. This was prior to the Cuban missile crisis. 
However, as the geopolitical crisis hit the Federal Reserve moved to ease monetary policy – initially not dramatically but nonetheless the Fed moved in a more accommodative direction and NGDP growth started to accelerate in towards the end of 1962 – a few months after the end of the Cuban missile crisis. I am certain this help keep a floor under US stock in the later part of 1962. 
In fact it is notable to what extent geopolitics came to determine monetary policy during the 1960s and might of course equally argue that geopolitical concerns to some extent was a driving force behind president Kennedy and particularly president Johnson’s expansion of the welfare state measures in the US in the 1960s. The Federal Reserve during the 1960s actively supported the expansion of government spending by trying to intervene in the US bond market to give bond yields down for example through the (in)famous operation twist. The Fed’s policies became increasingly inflationary during the 1960s. 
During the early period of the 1960s the easing of monetary conditions primarily boosted real GDP growth (in line with the acceleration in NGDP growth), but as the negative impact of war spending and spending on social welfare schemes started to be felt US productivity growth started slow significant and as a result the continued expansion of nominal spending led to a significant increase in US inflation in the second half of the 1960s. 
In regard to the US stock market is it notable to what extent the development in the stock market follow in the development in nominal GDP. In fact from 1960 to 1970 US stock prices rose 80-90% – more or less in line with the development in NGDP. This is illustrated in the graph below.
NGDP SP500 1960s
 This illustrates that higher geopolitical risks are not necessarily negative for stocks, but it might make central banks make stupid decisions. That is certainly the case of the Fed during the 1960s. Whether that is any guide for what will happen to global monetary policy today if we continue to see an escalation of geopolitical tensions is certainly not easy to say.
In sum, short and medium term economic and asset market outcomes are entirely determined by monetary policy, and monetary policy responses to perceived shocks.

Wednesday, April 16, 2014

Worse fraudsters: Guidance Counselors or Bernie Madoff?

Bryan Caplan offers advice that's simple, obvious and ignored:
A friend tells you, "I'm thinking of starting a restaurant. Advise me." You know that about 60% of new restaurants fail in their first three years - and have no reason to think that your friend would be anything other than average. How should your knowledge affect your advice?

You could say, "Open the restaurant and work like mad, because the odds are against you." Slogan: Try Harder. 
Or you could say, "Don't open the restaurant, because the odds are against you." Slogan: Do Something Easier. 
Neither recommendation is crazy. But as the probability of failure rises, the case for Do Something Easier gets stronger and stronger. Why tell your friend to work his fingers to the bone when he's probably going to fail anyway?

This is especially true on the plausible assumption that people are more likely to heed advice about one-time discrete decisions than day-to-day continuous decisions. Saying "Marry her" is more likely to sway behavior than "Be good to your wife every day" - and saying "Do Something Easier" is more likely to sway behavior than "Try Harder." 
Why then are advisers so reluctant to say "Do Something Easier"? Because Try Harder sounds better - and most advisers would rather sound good than genuinely help their advisees. 
Advisers aren't held accountable for predictably disastrous advice if the advice implied idealistic optimism about some poor kid's prospects. A financial adviser's idealistic optimism about the NASDAQ...not so forgivable.
This analysis clearly applies to starting a business or choosing an occupation. But it works equally well for educational decisions. Suppose a kid at the 30th percentile of the high school distribution asks you if he should go to college. You know that kids at the 30th percentile have a dismal dropout rate. Should you respond with Try Harder or Do Something Easier?
As measured by the number of people (kids, actually) predictably bankrupted by mendacious advice, guidance counselors are the ultimate financial fraudsters. Compare the number of your acquaintances victimized by financial advisers to those with crushing student loan debt.
In our society, "Try Harder" is the socially acceptable - nay, socially mandatory! - slogan. Don't tell kids to give up on their dreams; tell them to work for their dreams. On reflection, though, this just exposes advisers' vanity: They'd rathersound helpful than be helpful. Do you really imagine that chanting "Try Harder" will induce weak students to devote themselves to their studies, day in, day out? No? Then urging weak students to "Try Harder" barely differs from "Make an expensive investment that will fail at its normal high rate."

To be fair, most weak students will ignore you even if you urge them to Do Something Easier. But some will probably listen to you - and refrain from making a very bad bet.

What about the tiny minority of weak students who would have blossomed in college? Obsession with this group is the height of pious folly. Suppose you convince a lot of people to stop buying lottery tickets. Should you lose sleep over the likelihood that - but for your advice - one of your advisees would have won the jackpot? Of course not. "Advice that works on average" is also known as "good advice."
Say it with me: Risk of failure is a reason not to try. Not a decisive reason, but a reason nonetheless - and the higher the risk of failure, the stronger the reason. True, if you have no alternatives, you may as well try your best and hope for the best. But would-be restaurant owners and would-be students always have alternatives. And as long as you have alternatives, willingness to Do Something Easier in the face of crummy odds is not cowardice. It is good economics - and common sense.
Wishful thinking and ego fluffing - not malice and greed - are the root of modern problems.

Tuesday, April 15, 2014

German success? No NGDP deviation from trend, no problem.

Sumner asks why German employment beats America's since 2007. It's puzzling because German nominal and real GDP has expanded slower than America's. Sumner credits labor policies. Germany has been relaxing labor regulations for awhile, there's no minimum wage, and they subsidize low wage work. Thus, the impact of the rise in wages relative to NGDP triggered by the recession was blunted in Germany compared to the US. In the US, we see rises in labor market regulations, and minimum wage laws. And America prefers to subsidize idleness rather than work.

Nunes points out that though Germany's NGDP growth is relatively lower than America's, it has remained on it's own pre-recession trend. The absolute level of a country's NGDP growth matters less than its deviation from its own prior trend.

Sailer says they ignore immigration's effects. From 2000-2008 Germany's population declined, America's rose 8%, Spain's even faster. Germany noticed that Turks tended towards idleness and welfare and reduced their immigration rates.

I think Nunes' explanation is most salient. There is no puzzle to explain. Germany remained on their own NGDP trend, so why would you expect unemployment?

Why did Germany remain on their NGDP trend? Maybe because German voices are most influential in setting ECB policy. When did the ECB choose to tighten? Precisely when Germany's NGDP had reverted back to trend.
Mysterious German Recovery
from Marcus Nunes

Immigration would explain unemployment rate differentials, but not the fact that German employment increased most (employment rose 6% on no population growth).

No NGDP deviation from trend, no problem.

Thursday, April 10, 2014

Bad Monetary Macro Weakens Seth Klarman's Bear Case

Seth Klarman is worried.
When Seth Klarman speaks, listen carefully.  
Very few hedge-fund managers are as widely and consistently acclaimed as is Klarman, the 56-year-old founder of the Boston-based Baupost Group. The fund has about $27 billion in assets under management -- after returning $4 billion to investors last year. In 2012, LCH Investments NV listed Baupost as the fourth-most successful fund in investment performance. In 2013, Klarman told his investors that he earned them a mid-teens net return, despite having almost half of his portfolio in cash. That’s impressive. 
Copies of Klarman’s 1991 classic, "Margin of Safety," a revelatory account of his investing strategy, can be had through, at prices ranging from $1,600 for a used copy to almost $3,600 for a new copy. Klarman solidified his street-cred when, in October 2009, he met privately for 30 minutes with William Dudley, the president of the Federal Reserve Bank of New York, to discuss financial market developments. 
So what does Klarman have to say about today's investing climate? The overarching message in his year-end 2013 investor letter, a compendium of wisdom, is that plenty of danger lies ahead, even though most investors are blind to it.  
Klarman thinks the stock market these days is akin to a Rorschach test. “What investors see in the inkblots says considerably more about them than it does about the market,” he wrote. “If you were born bullish, if you’ve never met a market you didn’t like, if you have a consistently short memory, then stocks probably look attractive, even compelling," he added. He went on to list many reasons that investors may be turning a blind eye: Price-earnings ratios, while elevated, are not in the stratosphere. Deficits are shrinking at the federal and state levels. Consumer balance sheets are on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence.  
With bonds yielding so little, equities appear to be the only game in town, Klarman continued. The Fed will keep holding interest rates extremely low, leaving investors no choice but to buy stocks, he added. "For now, there are no bubbles, either in sight or over the horizon.”  
We disagree about why rates are low. He thinks they're low because of recklessly stimulative policy. I blame low NGDP growth. Too tight policy in 2008 caused low NGDP growth. Looser policy is the way to restore normal NGDP and normal rates. This basic disagreement is the root of others.
But for those “with a worry gene,” and who have an understanding that markets can also go down, “there’s more than enough to be concerned about.” Klarman sees artificially high prices everywhere he looks in the stock and bond markets.
Since 2008 rates and stocks are positively correlated. How is that consistent with the idea that artificially low rates are boosting stocks? It fits my idea much better: an increase in NGDP growth expectations raises stock prices and rates because NGDP is too low. (BTW, if low rates cause bubbles, what's up with Japan since 1990?)
“A policy of near-zero short-term interest rates continues to distort reality with unknown but worrisome long-term consequences,” he said in the letter. “Even as the Fed begins to taper, the announced plan is so mild and contingent -- one pundit called it ‘taper-lite’ -- that we can draw no legitimate conclusions about the Fed’s ability to end QE without severe consequences. 
But vague predictions of severe consequences are legitimate? In 2011, Klarman worried QE would trigger runaway inflation and a dollar collapse- didn't happen. This pattern is typical. People are uncomfortable with QE on a gut level, and remain so even as their predictions don't pan out, rather than re-assess their basic assumptions.
Fiscal stimulus, in the form of sizable deficits, has propped up the consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to pay on juiced corporate earnings? Pretty clearly, lower than otherwise.” 
Nominal and real growth accelerated in 2013 while deficits contracted. How does that fit his claim that fiscal stimulus is important to consumers and profits? Nominal growth (sales) have grown more slowly since 2008 than any period since the Depression. How is that unsustainably good?
He noted that the Nobel-winning economist Robert Shiller has calculated that the stock market’s price-to-earnings ratio is more than 25, “a level exceeded only three times before -- prior to the 1929, 2000 and 2007 market crashes. Indeed, on almost any metric, the U.S. equity market is historically quite expensive.” 
Why have stocks reached historically high valuations three times since 2000? Maybe valuations have shifted higher. There is evidence this is so.
What’s more, Klarman wrote, “a skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix and Tesla. The overall picture is one of growing risk and inadequate potential return almost everywhere one looks.”
Agreed- there are pockets of insanity.
In “an ominous sign,” he said, there are fewer market bears now than at any time since 1987. “A paucity of bears is one of the most reliable reverse indicators of market psychology,” he continued. “In the financial world, things are hunky dory; in the real world, not so much.” 
I think sentiment is a better indicator than valuations, because valuations have permanently shifted higher by an uncertain amount. But lot's of optimism is bad. Relative sentiment is measured easier than valuations.
There is also wild speculation in the credit markets, thanks to the Fed’s seemingly endless quantitative easing program. “Even with yields in the cellar, investors snapped up a record $1.1 trillion of high-grade corporate debt in 2013,” Klarman wrote. He pointed out that the issuance of below-investment-grade leveraged loans (bank loans issued to highly leveraged companies) reached $683 billion, topping the 2008 record by almost 15 percent, and that more than half of those were covenant-lite (bank loans with few restrictions on the borrower). 
In addition, $63 billion of dividend-recap issues (in which companies float bonds to pay shareholder dividends) also set a record. Junk-bond financings totaled a near-record $324 billion. Bond buyers, desperate for return, bid up junk-bond prices to a record low yield of 4.97 percent, he wrote. 
Klarman is eloquent when describing the dangers lurking in the financial markets. He says giddy investors are living a “Truman Show”-like existence, where on the surface everything seems idyllic. In reality, the manufactured calm -- thanks to the “free-money” policies of Ben Bernanke, Janet Yellen and Mario Draghi -- anesthetizes us to the looming trouble. 
What is Klarman's interpretation of Japan's two decade, zero rate deflation? Is that loose money? Milton Friedman knew in 1967 that low interest rates meant money had been too tight. Klarman's basic assumptions in monetary economics ruin his macro.

And really, he wants Draghi to tighten?
Morphine is like that, I hear. “Inside the giant Plexiglas dome of modern capital markets, just about everyone is happy, the few doubters are mocked and jeered, bad news is increasingly ignored,” he wrote. “The longer QE continues, the more bloated the Fed balance sheet and the greater the risk from any unwinding. The artificiality of today’s markets is pure Truman Show.” 
What does artificial mean in this context?

Here's what artificial would mean to me. If NGDP accelerates to 7%, inflation to 4%, which delivers lower deficits, lot's of confidence and low unemployment, that's artificial. Artificial = necessarily temporary. The benefits of high inflation are temporary. There's nothing temporary about the benefits of boosting NGDP growth from 3% back to 5% through QE.
It isn't often that Klarman’s investment letters slip through his fund's carefully constructed walls of confidentiality. Because this one did, and it is so uncommonly wise, mere mortals should stop and take note. “Like a few glasses of wine with dinner, the usual short-term performance pressures on most investors to keep up with the market serve to dull their senses, which makes it a bit easier to forget that they are being manipulated,” he concluded. “But what is fake cannot be made real.”
Klarman's a proven stud, but he gets a lot wrong here. Why? Two reasons:
  1. Confabulation. QE is new and not understood well. People associate it with government programs intended to deliver short-term benefit and long-term pain, like fiscal stimulus, and welfare spending. (The initial miscategorization is understandable, since most government programs are band-aid time bombs.) Thus, the typical gut reaction to QE is negative. From there, people rationalize their instincts. Specific predictions destroyed by subsequent evidence- inflation, dollar collapse- are discarded and replaced with new rationalizations. 
  2. Conservatism and wishful thinking. Klarman is a disciplined man. He won't buy that which is not cheap by historical valuations. Markets have been expensive for 20+ years. This annoys Klarman. He wants to believe it is temporary, so he blames QE, bubbles, whatever. But it may not be temporary. Maybe valuations have permanently bumped up a step. 

Tuesday, April 8, 2014

Average your guesses; Temporary mental noise

Average your guesses- Hal Finney

Averaging your own guesses improves accuracy. How many hotels in downtown Boston? Take a stab. Wait a week. Re-think the question. Take another stab. The average of your first and second guess will be more accurate than your first. And it's not because you accumulated more info, because the second guess is less accurate than the first. Rather, your directional revision is likely to be correct; you correctly perceive the direction of your original error.
  • This suggests that judgement is affected by random, fleeting influences. (Temporary mental noise.)
  • I can imagine several such influences. For example, the tendency to latch onto the first method, or first plausible explanation which suggests itself. Or over-weighting some recent experience.
  • Re-researching a company several weeks after initial research makes sense. 
  • Re-researching from scratch - i.e. not looking at what I previously wrote - is sensible too.
Demonstrating the usefulness of independent judgement, and the harms of groupthink, a group tasked with estimating the number of jelly beans in a jar performs:
  • Better if individuals each writedown their guesses privately, and averages them later;
  • Worse if individuals call out their guesses, causing others to adjust their own guesses.
Averaged guesses are best if the guesses are independent. Independent means uninfluenced by other peoples' guesses. [1][2]

To summarize, your one lone guess is worst. Averaging multiple of your own guesses is better. And averaging guesses of several people is even better, especially if they're made independently. 

[1] My prior (investing) research of course taints my future research, but it will taint less if I don't review prior, and I try to look with fresh eyes.
[2] It's easy, but wrong, to interpret "independent guesses are best" as "ignore other people's opinions". Your private guess is not the best guess. Once you see other's private guesses, the best guess is to average them. But the best way to get the best guess is to force people to guess privately first.

UConn wins championship, campus riots prudently (limited use of high power explosives)

UConn wins, explodes.
The Connecticut men’s basketball team [click for photos] topped Kentucky 60-54 on Monday to complete its improbable run to the NCAA national championship, and — as expected — the town of Storrs, Conn., responded by going absolutely bananas. Thousands of students took to the campus streets after the final buzzer, with the celebration quickly morphing into a full-blown riot that included fireworks, car flipping and a good deal of property damage – including one group of fans using a street light to smash a window of an academic building.  Campus police had reported 30 arrests as of 1:30 a.m., according to university spokesman Tom Breen, and more were expected to come later. “A lot of it was alcohol-related,” Breen said, via CBS Connecticut. “There was breech of peace, destruction of property, and we had a fireworks charge.” But despite the bedlam, there were no reported injuries, and UConn police chief Barbara O’Connor said she actually was pleased with the way the campus handled its second national championship in four years. “By far, most of our students have conducted themselves safely and responsibly,” O’Connor said, via the Hartford Courant. “Although there have been some arrests and property damage, we’re pleased overall with most of our students’ behavior..."
View image on Twitter
UConn's Student Union
Now, before you old geezers vault out of your rocking chairs yammering about kids these days, let me show you something. This right here is Barb O'Connor, UConn's police chief, the gal that's "pleased" Phi Beta Kappa didn't celebrate the big W with a salvo of mortar fire and RPG's.

Barb is pleased
Geezer, notice this. As evidenced by her name (and nothing else) I do believe Barb is a woman. A girl police chief? How bout that! Second, note Barb's appearance: bear claws, man-jaw, 24 inch neck, and resemblance to Bruce Willis. Yep, Barb's probably a Lesbo.

How does a Lesbo police chief make you feel, Geezer? Nasty I bet! But at least she isn't black, right ;)

Geezer, that's why you're in no position to judge these kids, and their ruggedly handsome, approving sheriff [1]. Because these kids are good people, as defined by expressing the Right Opinions, as pertains Barb's lifestyle and job suitability. And you are not. [2]

Straight White Racists celebrating some meaningless old shit

[1] In all seriousness, 18 year olds are nuts by nature, always have been, always will be. What's new is that those with the megaphone, like Barb, approve. She says she doesn't approve. But I infer approval from the absence of billy clubs and police attack dogs in the photos of UConn's trashed campus.
[2] In case the sarcasm isn't clear, I'll spell it out. Is America in decline? Liberals say no and point to polling/survey outcomes showing a trend towards increased tolerance of all kinds of stuff (especially among students!). But, of course, checking the fashionable box in a survey is cheap; behavior is the bottom-line. That UConn's police chief is pleased with the severity of the riot - she expected worse? - crystallizes how the country's really progressed. Compared to 50 years ago, people behave worse in every way imaginable, yet congratulate themselves on checking off the politically correct box in surveys.