Archive for March, 2010

Heat Chasers and Happy Meals

March 31, 2010 Comments off

Investors chase heat. In and out of every market cycle, it never changes and is always fascinating to observe. Lately, I’ve heard a lot of investor questions to the effect of, “Why not load up the portfolio in more Emerging Markets?” After all, as a category they represent more than a quarter of global GDP, and their burgeoning middle classes—who are ramping up consumption on materials, goods, and services—are driving much of 2010’s economic growth.

Fair enough, but remember these are still developing economies. We often take for granted basic ideas about property rights, highly liquid equity markets, and so on. But if you think 2008 was scary with all the government interventions and confiscating of assets in places like the US …well, that kind of risk is on the table daily in most developing regions. As with all things, there’s a risk/return relationship. Emerging Markets right now has, on balance, tremendously attractive fundamentals and promises great performance…but the flip side is the basic risks of Emerging Markets are still there. For instance:

Google Runs Into China’s ‘Great Firewall’

Yuan’s Fair Value Debated Inside and Outside China

These kinds of issues remind us a place like China is still a communist command system. It’s not a great basket for all or even a significant amount your eggs, in my opinion. Chinese officials can make huge, punitive, protectionist, and property-damaging moves at a whim. Should that happen, you don’t want to have too substantial a component of your portfolio in an asset the state might wipe out.

Then again, China now has its very own “Hamburger University”, courtesy of McDonald’s. That’s a small bit of evidence atop a heaping stack that points to a bullish case for Emerging Markets as a category—China has, pardon the pun, millions of hungry consumers.

All this begs an important point about developing markets: all this talk about China …where’s the love for the rest of Emerging Markets? I don’t hear nearly as much about places like Brazil , which features rapid growth, rich natural resources, and a more liberalized economy than China . Scour the globe—there’s a lot out there besides just China .

No matter how sure you are about anything, always know you could be wrong, and never break the rule of diversification relative to an appropriate benchmark. That rule will save you from too much heat chasing. My preference for anyone with a long time horizon and needs stock-like returns: A global index, cap-weighted, like the MSCI World Index or similar. Absolutely look for opportunities in thedeveloping world, just don’t take it too far.

The Fed Might Be Out, but Government’s Not Done with Housing

March 30, 2010 Comments off

A big worry in front of investors today is what happens to US housing once the Fed’s program to buy mortgages expires (it’s happening this week).

It’s not clear housing performance is much correlated with other asset prices in the first place. After all, bull/bear cycles in equities don’t match up well with housing boom/bust cycles. Additionally, if you expand your view globally (knowing that global stock markets are highly directionally correlated), US housing doesn’t look so big and bad in context for the world economy (both US and global GDP are rebounding nicely without a housing revival).

But even if you don’t believe any of that, there are plenty of reasons to question whether the Fed’s exit means housing’s re-demise. Here are three articles of note:

· Cheaper Mortgages May Linger as Bond Investors Take Over When Fed Departs

· Mortgage Increases Blunted

· Subprime-Mortgage Debt Rallies as Treasury Boosts Loan Aid: Credit Markets

Essentially, just because one Fed program ends doesn’t mean the government’s role is finished. Also, between loan modifications (a dirty business, no doubt), and materially lower interest rates today for resetting adjustable loans (ARMs), I believe there isn’t as much to fear as, well, first feared. Also note that just because the buying program ends doesn’t necessarily mean the selling program begins. My guess is the Fed and its respective tentacles (hello GSEs?) will hold those mortgages for a long time—many probably to maturity.

Lastly, there are signs—not terribly robust, mind you—that housing prices are regaining some footing. Home prices according to the most recent Case-Shiller index (an index for which I have my doubts…just 20 cities???), showed slight improvement. Note too, there are a lot of other distorting elements in US housing right now—the Obama tax credit which originally would have expired in November now has a deadline of June 30, so housing may see some marginal benefit over the next months. Then again, many of those in a position to take advantage of the tax credit may have already done so before the original deadline.  Who knows.

In sum, my view is the Fed’s exit does put some upward pressure on mortgage rates, just less than first feared. But ultimately, these features are widely known, and markets have expected worse than this for a long time. When things aren’t as bad as feared is when markets tend to pop—and the last several weeks (not to mention the last year) have been great evidence of that notion.

Signs the Apocalypse Has Been Cancelled

March 29, 2010 Comments off
  • Useful factoid: as of Friday, the S&P 500 was up 5.1% for the quarter. If it doesn’t lose any ground from now to the end of the month (today was a nice up day as well), it’ll be the best Q1 return for the S&P 500 since 1996 (+5.4%). (Source: Global Financial Data, Inc.)
  • Consumers in the US keep spending: Consumption rose in February for a fifth consecutive month. This is without a big rebound in employment so far—which is almost totally contrary to the intelligencia’s normal view of how a recovery ought to work. Personal income was virtually flat m/m but rose +2% from a year ago. All this in the context of a very low inflation environment.
  • 2009 was so “too big to fail”. We’re over it. 2010 is all about…too big to succeed! If this isn’t a shining example investors have capital and are looking to put it back to work, I’m not sure what is…

Fisher Investments Analyst’s Book Review: Attack of the Quants!

March 26, 2010 Comments off
Books about “quants” are popping up everywhere, but Emmanuel Derman’s My Life as a Quant is best for neophytes.

Hedge funds are blamed for a lot of stuff these days. Open the paper and you’ll find regulatory head honchos across the globe recommending a ban on CDS (credit default swaps) and the like. Fisher Investments feels hedge funds and their black magic math are getting blamed for everything from the panic of 2008 to today’s Greek debt woes.

Fisher Investments believes the speed of capital markets’ development in recent decades inherently makes folks nervous—new and highly sophisticated products are based on complicated mathematics that aren’t intuitive (let alone comprehensible) to the lay investor. So it’s natural investors want to know who these folks are and what they’re up to, and it’s also natural to fear them. We tend to fear what we can’t understand, and populist media will happily stoke the fire. The more sensationalistic of contemporary quant books want to equate the strategies of all hedge funds (and the ubiquitously nerdy, greedy quants who run them) to a wanton, drunken night of Vegas gambling. Instead of making that point convincingly, these books are instead unwitting caricatures of how average folks tend to misunderstand this part of capital markets.

But Emmanuel Derman—one of the original quants—is not someone to fear, or distrust. His fantastically wrought My Life as a Quant: Reflections on Physics and Finance is a must read for any non-professional wishing to learn more about what quants are and how they do their job. Mr. Derman tells his tale in the form of a memoir: He starts as an ambitious theoretical physicist, but ends up on Wall Street in the mid-eighties, pioneering mathematical and computer programming breakthroughs—innovations that have since revolutionized capital markets.

The tale is told with tremendous deftness and aplomb—the tribulations of Mr. Derman’s life are presented with restraint yet are touching and universal. Through his narrative he weaves explanations of math and physics—of the most technical and flat-out-boring sort—in so simple and readable terms that a person with no background in such matters will come away both more learned and entertained. I’m willing to bet even the neophyte will grasp the Nobel Prize-winning Black-Scholes model and the problem of the “volatility smile” in pricing stock options. Really!

Here you will read about the origins and development of the quants on Wall Street, why those with highly theoretical backgrounds in physics and mathematics prevailed through this era, and what exactly they were up to, sans overt drama, politicization, or sensationalism. Readers will also come to appreciate that, along with math, this is the era where computer programming transformed all of finance.

In his heart of hearts, Mr. Derman is an academic, and he spends time talking about the personal and professional conflicts in making the transition to Wall Street. There is great humor here (they work 50 hours a week, lunches are always catered, and all that matters is the bottom line!), but it also makes for great perspective. Perhaps because of his experience in both worlds, Mr. Derman transitions between the aesthetics and beauty of theoretical math to the forced pragmatism of the market’s irreducibility lightly and easily.

The final chapter is a tour de force in the problems of dealing with models/theories versus reality. For anyone who believes in the primacy of mathematics as a mechanism for “figuring out” markets, Mr. Derman will put those notions to rest convincingly. Math is a description of reality, not reality itself, and therefore no model will ever describe how markets work in an ironclad way. Instead, what happens in real life (what the academy calls “phenomenology”) must drive finance—because it’s ultimately as much a social science as a natural one. At least for today, the human element cannot be so easily reduced to an equation. (For the truly brave and adventurous willing to sink their teeth into modern philosophical debates about math, I recommend Where Mathematics Comes From: How the Embodied Mind Brings Mathematics into Being by George Lakoff and Rafael Nuñez, or Is God a Mathematician? by Mario Livio. But don’t say I didn’t warn you—it’s heady stuff!)

But whatever you do, don’t let contemporary rancor blind you to the importance, beauty, and complexity of today’s capital markets and their instruments—they are a wonder to behold, and ultimately a boon…even if sometimes they bust.

*The content contained in this article represents only the opinions and viewpoints of theFisher Investments editorial staff.

Take 3 Thursday

March 26, 2010 Comments off

1. This is beyond amazing. From the guys who said “New Normal” last year. Now they’re bullish on stocks!

2. A great, if snarky, view on US banks and moral hazard. One of my favorite lines of the year so far:

“Not only is the federal reserve subsidizing the replenishment of your bank’s [Bank of America] capital by confiscating yield from savers/depositors so you can earn monstrous spreads on your loan book, but now you are rewarding those who bit off more than they could chew, while those who did not take on excess leverage, or who kept their income-to-debt ratios manageable, see no benefit, even as their home equity values have declined.”

3. The plight of many traditional forms of media over the last decade has been a major contributor to the pervasive pessimism of this era. After all, if you were a journalist and saw a decade straight of your industry getting chopped down, and many senior editors getting laid off, you’re a lot less likely generally to see the world as a great place these days. It’s all doom and gloom.

They Missed It Again

March 24, 2010 Comments off today published an enlightening survey:

Americans Say They Missed 73% Rise in S&P 500 as Economy Surged

by Mike Dorning

A couple of my favorite parts:

“By an almost 2-to-1 margin Americans believe the economy has worsened rather than improved during the past year, according to a Bloomberg National Poll conducted March 19-22. Among those who own stocks, bonds or mutual funds, only three of 10 people say the value of their portfolio has risen since a year ago.”


“A sense of despair pervades perceptions of the economy and nation. Barely one-in-three Americans say the country is on the right track. Fewer than one in 10 say they believe the economy will be strong again within a year. Just 4 percent of Americans who cut back on spending during the recession now say they are confident enough to open their wallets, according to the poll, which has a margin of error of plus or minus 3.1 percentage points.”

Indeed, for as bizarre and brutal as the bear market was, this is prototypical behavior in the beginning stages of a recovery. Stocks tend to recover before the economy, leaving those who believe “it’s different this time” with light pockets after the first year of a bull. It’s tragic because the biggest gains in bulls tend to be front-loaded in those first years where disbelief is most prevalent.

Who Says Housing?

March 24, 2010 Comments off

If the last few quarters haven’t been ample evidence the economy (and stocks) can recover without the housing boom, I’m not sure what would be.

According to The Wall Street Journal, sales of existing homes fell a third month in a row in February. Home resales are sitting at about a 5.02 million annual rate—basically halved since the peak of the boom. Meanwhile, new home construction also remains anemic at an annual rate of about 575,000. At this point things are perhaps stabilizing for housing, yet, second estimate Q4 2009 GDP came in at 5.9% (the final one will come in a few days).

With residential housing construction now at a mere 2.5% of GDP, I believe looking to housing activity as a catalyst of recovery is more of a populist thing than a substantive one. (Theoretically, you could wipe out the whole thing—literally take it to zero—and still have GDP growth.)  I do have some sympathy for the notion that housing velocity spreads its tentacles into many parts of the economy—fees, taxes, materials, moving costs, and so on. But the basic GDP breakdown overwhelmingly shows what matters right now is the recovery in business spending and net trade activity—both of which are currently recovering in V-shape fashion. And that makes sense because those fell the most during the recession. Believe it or not, consumption doesn’t matter that much right now because it never fell that much to begin with. And, well, higher government spending is a given for the foreseeable future.

You can see it all in the most recent release on US GDP from the BEA (Bureau of Economic Analysis). On this kind of thing, try to get the data straight from the horse’s mouth—not through the lens of a newspaper journalist or third party. And be on watch for the final revision to Q4 ’09 GDP next week.

Sources: Wall Street Journal, National Association of Realtors, BEA


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