Archive for August, 2010

Fisher Investments Analyst’s Book Review: Think Twice

August 31, 2010 Leave a comment
Once the intellectuals get a whiff of new psychological theories, look out. With Freud and the “discovery” of the unconscious, the twentieth century wasn’t long in the tooth before repression and daddy issues made common cocktail party witticisms. Today, the pattern repeats with the psychology of evolution—there are literally thousands of works circulating on how our natural “instincts” lie at the root of most behavior.

Going all the way back to the 70s, the field of behavioral finance (where evolutionary psychology meets money) has kept a fairly low profile. But in the last decade, particularly these last few years, it’s made a leap to the mainstream.

A few weeks back, I wrote a little about the inherent weaknesses in behavioral finance. Popular works like Freakanomics and Predictably Irrational are good entertainment, but be wary—most such books are built on shaky science and are reductive to the point of uselessness. Other prescriptive works like Richard Thaler’s Nudge can be borderline dangerous—recommending mass public policy on the basis of such findings.

This is hazardous because, and no matter how much the intelligentsia may crow against this fact, psychology is not a hard science in the same way basic physics or chemistry is. It’s not even close, really. We don’t understand ourselves yet, and the empirical studies we do are too often overly reductive or poorly executed.

So, the reason it’s ill-advised to prescribe policy based on behavioral studies is more or less the same reason socialism ultimately never works: The world is too complex and various, as are human psyches, and the notion that elite rule can consistently fashion the best economic or societal outcomes is nonsense. For better or worse, folks must be free to choose for themselves.

Don’t get me wrong—psychology in investing can be hugely useful, and we at MarketMinder use it daily. Indeed, the study of human behavior is at this point a must for market forecasting success. Essentially, the economy constantly changes, even at an accelerating rate, but the human psyche has features to it that are relatively static. Thus, the situations will always be somewhat unique, but the basic patterns of greed, fear, love, hate, and all in between, will out. It’s simply fascinating—observing each day how markets move—how fungible human behavior can be. Behavior during a bear market panic transcends time, culture, and place. This is part of what makes global investing truly possible, the baseline commonality of people.

The last two paragraphs may appear contradictory. Well, welcome to psychology! What I believe psychology can do for investors is offerheuristics—“rules of thumb.” Unlike, say, the laws of thermodynamics, human psyches are too inscrutable for ironclad rules. People will tend to hate losses more than they enjoy gains (aka prospect theory), but that’s not always true. There are tacit patterns, but situational anomalies and exceptions. Economics, as with psychology, loves to study the general, the “norm,” the average. But, in fact, we are always living in the specific, the now, this moment. In big systems like economies, specific can be unique. (The paradoxes of moving from the general to the specific are one of the main puzzles, to my view, of market forecasting. But we’ll save that discourse for another time.) That there are no ironclad rules should be self evident since no one—ever—can beat the markets every time.

So as investors we must bravely wade into psychology, but tread carefully and be selective about what is trusted. In comes Michael J. Mauboussin—one of the finest writers on behavioral finance today. His current offering,Think Twice, won’t get as much fanfare among the intelligentsia as with gurus like Dan Ariely, but ought to. This is a practical book from a real money manager. It’s short, clear, light, and makes use of real world examples effectively—as demonstrations of psychological concepts in action rather than literary ornament.

Mauboussin makes an important move most others don’t: He links psychology with the study of complex systems (like stock markets) instead of framing it in the light of neoclassical economics. This enables him to make useful observations rather than pointing out where stuff like “rational man” or “equilibrium” theories fall short. Behavioral psychology is at the point where it needs to create better theories, not continually criticize old notions. Let’s hope Mauboussin’s ethos rubs off on the Academy.

Mauboussin doesn’t offer a bunch of rules in the vein of “if X happens, do Y, and then you’ll be rich!” What he does, ultimately, is promote self-awareness. Higher consciousness isn’t just the stuff of Zen masters. That’s the end lesson of all useful psychology outside the pharmacy. Know thyself! Learn to study the quality and method of your decisions, stop focusing so much on the outcome (which, in stock markets often contains much noise and randomness). Seek feedback, ruminate upon your mistakes and successes—understand why you did what you did. Raise your self-awareness.

Investors don’t spend enough time mastering their own selves; they believe too much that numbers and metrics have definitive answers. It’s a tough thing to do and requires much effort and honesty, but no mathematical valuation metric on earth can replace self knowledge. If next time you don’t want to give in to irrational exuberance, or panic at the bear market bottom…figure yourself out. Don’t blame the outside world. With this book, Mauboussin offers us the particulars of why this ethos can give rise to smarter investing.

Back in my graduate years, I conversed one night with another psychology student over a few beers: “We’ve gone past Freud!” she exclaimed. “He was a master, but he doesn’t work for us anymore. We have science now.” This is folly. As it pertains to psychology, anyway, science (and ironicallyfaith in it) is the great religious impulse of the Modern mind—we want so much to escape our subjectivity and find answers outside, in objective empiricism. Yet, much of psychology’s wisdom today can be culled just as easily (often more so!) from the wisdom texts of ages ago. The scientific part of psychology is a noble enough pursuit, but deeper understanding about what makes us human, not the escape from it, has useful answers too. Or, as the old master Carl Jung said, “Unconsciousness of one’s true self is the seedbed of sin.”

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

US GDP: A New All-Time Nominal High

August 26, 2010 Leave a comment

Here’s a stat, straight from the BEA:

Q2 2010 Nominal GDP: $14.5977 Trillion

That number has never been higher. Said differently, a new all-time high. (And in an era of low or no inflation.)

I’d call this one of the most unappreciated economic stats in recent memory. I love it because there’s no data massaging or mining going on here: it’s just a stark, real number…that the public is largely ignoring. For stocks, which are still well down from their pre-recession highs…how long till the true economic situation is appreciated by the masses? And, shouldn’t you buy before then?

China is Selling US Debt, and Yields are Going…Lower!?

August 24, 2010 Leave a comment

With the ebullient bond buying going on (near record low yields on Treasuries, record bond issuance for corporations, record low yields for long-terminvestment grade bonds), an interesting story has fallen through the cracks:

China Doubles Korea Bond Holdings as U.S. Debt Sold


What!? Remember, just months ago, the financial world perpetually bemoaned Chinese ownership of US debt? And how, if the Chinese decided to start selling, it would be chaos for said US debt? Yields would spike, prices would plummet! And then the world would implode on itself. Or something.

Well, why isn’t it happening? One , China doesn’t hold as much US debt as you might think. In the neighborhood of 10%, which is big but not ridiculous. Actually the US —its citizens, its institutions—own way more…as in well over a third. Second, the sovereign bond market is one of the largest, deepest global markets in the world. There are many, many forces at work at any given time. Simply, there are other demand factors that are overwhelming Chinese US debt sales.

If China decided to dump all its US securities at once, of course that would bring big disturbance. But in reality, as China diversifies its holdings and works—in baby steps—to open its capital markets and un-restrict its currency, we’re much more likely to see this kind of measured action. It’s so benign it barely hits the popular media’s radar.

As is so often the case, “We worried about it, but nothing happened” never makes a good headline. This is a prime example.

Trend Continuation is the Economic Model’s Bread and Butter

August 20, 2010 Leave a comment

The Bundesbank (in Germany ) raised its estimate for German GDP to 3% for 2010 from 1.9%. Recall that about a week ago, German GDP blew past estimates in Q2, growing 2.2% q/q, which sparked this reassessment.

Many seem to believe this is a tame estimate, and anecdotal forecasts have ranged in the ~3.5% area. I should know better, but I’m still often left stunned and breathless at how fickle so-called economic models are. They quite literally take the recent past and extrapolate it into the near future. Which makes these things darn near worthless to investors, except in one important way: understanding market expectations. With economic models swaying in the wind as they do, they end up approximating what the world is anticipating. And that’s good because trying to understand relative expectations versus reality is what matters for stock market forecasting. So, in a bizarre way, these so-called empirical, math-based economic models function more like sentiment indicators.

Also, recall Germany approved an €80bn austerity package in June to balance their 5.5% budget gap (which Goldman Sachs now estimates will only be 3.4% in 2010). With growth moving so briskly and better than the world believed, one has to wonder how ‘necessary’ all that austerity will feel to politicians, who (particularly the likes of Angela Merkel) must be feeling beat up right now after a summer of PIIGS worries. Right now, the German government is standing pat on austerity, but look for that to change if things continue to improve more than expected.

To wit, the country that put the “S” in “PIIGS” is doing just that. Spain has decided to reinstate €500mn worth of Infrastructure Spending. The funds are purported to be spent in 2011 on a number of projects, the biggest being the development of the A8 motorway linking northern Spain with France . We aren’t even out of the summer of 2010 yet and the worst European debt offenders are already scaling back austerity on the back of stronger economic growth.

True, this is minor in size, but speaks directly to the idea that spending is less easy to cut than simply growing one’s economy in order to rectify budget problems. As ever, the easy answer is to grow the tax base. And by the way, none of these developments are consistent with the theme of a global double-dip recession— Europe ought to be the most prime candidate for it.

Wary is Bullish

August 11, 2010 Leave a comment

This is the kind of headline shrewd investors often interpret (rightly) as bullish: Firms Spend More—Carefully. Just below the headline, it reads: Equipment Purchases Make Up for Recession Cutbacks, Not to Raise Production.

How’s that bullish? Because the simple fact is that equipment purchases are rising, regardless of the “wariness” surrounding it. Or, said differently, economic (and stock) recoveries don’t transpire in waves of high sentiment—the “all clear” never gets sounded until long after. This is as true for CEOs as it is for your average investor. Economies still feel sick even as they heal.

You can think of this still a third way: A recovery, by definition, is first a replacement of cutbacks, then of resumed growth. We’re in the part of the cycle that still features “replacing cutbacks”, which likely means, barring something big and bad not already widely acknowledged, we’re still in the front portion of a longer bull market run and a stronger (again, global) economic recovery than most are willing to realize.

Don’t let a big negative day like today spook you—that’s what the stock market does best. The puzzle pieces for sustained, global economic growth remain in place, and renewed worries over deflation and/or new recession are based more on this wary sentiment than reality. Even a potentially less robust recovery, as the Fed intoned yesterday, is still a great environment to own stocks that remain very cheap in my opinion.

Fisher Investments Analyst’s Book Review: Capitalism 4.0

August 6, 2010 Leave a comment
I’ll say up front that I’m a Anatole Kaletsky fan. He’s a founding member of GaveKal, a global investing and economic research firm. We at MarketMinder have been reading his work for years. Not because we always see eye to eye—we don’t. Instead, GaveKal is one of those unique firms that provides insights worth mulling over, yet very different from typical Wall Street claptrap.

Kaletsky’s new book, Capitalism 4.0, is a perfect representation of those features and more. It’s both a gutsy thing, and in some sense a foolish thing, to talk in grandiose, sweeping detail about theories of economic history, and then further, to forecast the far flung future with those theories. When this kind of thing’s at its best, we learn a great deal whether they’re right or not (see my review of George Friedman’s latest book); but when such endeavors fail, it’s just crackpot theorizing. Put Kaletsky’s book firmly in the former category.

Here’s the basic argument: Capitalism’s been through three distinct eras, and with the 2008 financial debacle, we’re witnessing the birth pangs of a fourth, even better era of capitalism. It goes: 1) the Industrial Revolution and pure laissez faire capitalism, 2) FDR era heavily-regulated capitalism, 3) Reagan/Thatcher free market fundamentalism, and 4) Capitalism 4.0, which will be a hybrid of two and three.

Got it?

That is, the period ahead will be marked by even-handed governments who use free market principles as their guiding light, but also see the need for strong oversight and regulation to prevent burnouts. Also, the decades ahead will be marked by stronger government regulation on the one hand, but smaller government on the other as deficits shrink down and politicians gradually reduce entitlement programs like social security.

At times, it feels like something only a politician could argue: “We need more regulation but more freedom! Free markets but more oversight! Bigger government but less spending!” It’s like George Lucas got a hold of an economics textbook and spun a tale of adventure! Somehow, despite being bitter enemies locked in intergalactic economic warfare forever, John Keynes and Milton Friedman were…gulp…brothers!

I just read the last few paragraphs back to myself and said, “Jeez. That sure sounds crazy!” And, yeah, it pretty much is. If you think about movements like the Industrial Revolution, or FDR’s quasi-socialism, or Reagan/Thatcher’s thundering free marketry, heck, even Marx’s communism, the prevailing feature is that these aren’t atmospheres of compromise and balance. They are movements. Psychological sea changes aren’t milquetoast events: They tend to be polar and move with some momentum. What keeps it all (generally) balanced is democracy. On that basis, I have a hard time envisioning a world where we sometimes decide capitalism’s good, and sometimes not, and that on balance we’re all happy centrists. Particularly that politicians will be true philosopher kings and have the wisdom to know when those times are. But we can understand the spirit of what Kaletsky’s saying: that pure form capitalism and pure form socialism are both undesirable, and the world might be poised to live in a more comfortable coexistence with government and free markets.

Kaletsky could end up right, but for the wrong reasons. So much of the world has become democratized, and so much of the world has seen its prosperity increase via capitalism in recent decades, those things are likely to persist in the period ahead, which produces a somewhat similar outcome to his views. Yes, global deficits are likely to come down, if for no other reason than they’re at historic highs right now, and yes, we certainly will see some new regulation (already are). I just expect it to be messy, quarrelsome, and with folks on opposite sides instead of some newfangled Middle Way Movement, a la Buddha. What that argues for, though, is not to regard the crisis of 2008 as a turning point in the history of capitalism, but rather just a big bear market.

But what exactly is so radical about believing markets will be right more often than individuals or elites? Or, said differently, why is it that now—despite centuries of evidence to the contrary—are we supposed to take the view that regulation and oversight does any better job of preventing a 2008 than anything else?

One of the reasons Kaletsky is so fun is he can get under your skin. He says stuff like, “Marx was right.” And, “2008 proves capitalism is full of internal contradictions that will ultimately fuel its demise!” And, “Free market zealots are as or more dangerous than Marxists!” And so, according to him, without the Feds in 2008 we’d all be sunk.

Thus comes the toughest part of the book to digest: Kaletsky simultaneously excoriates the US government for its performance in 2008, while arguing for more government intervention. Kaletsky even says—rightly—that the panic wasn’t necessary at all, but was caused by the government itself. And it’s one of the only sources I’ve read that understands the perversity of Fair Value Accounting (FAS 157). And, dare I say it, may actually be harder on Henry Paulson than is warranted.

But where MarketMinder has argued it was inconsistent and wrong-headed governance that caused the panic, Kaletsky says Paulson’s folly was because of market fundamentalism. That is, he, like the entire Bush administration, had a preference for believing the market could sort things out for itself, and should have done much more, much sooner to stave off panic. This view gets even weirder when we listen to Mr. Kaletsky argue—compellingly—that the housing crisis in a purely economic sense wasn’t nearly as big as people believe (which is true). So, if the housing bust wasn’t so big, and the panic didn’t need to happen…why not just zap FAS 157 and be done with it? Why is the answer more government?

The foundation for skepticism of government isn’t to be critical of policymakers and then say “next time we’ll do it right.” It’s about being skeptical of any singular or elite body being able to make a correct decision at all. Governmental entities like the Fed are necessary and evolve over time, but in specific situations we can’t look to them to solve our problems—no amount of regulation will ever serve that function; there is no silver bullet for bear markets and recessions.

To see this, let’s do a quick thought experiment. Let’s say, as Mr. Kaletsky does, that it would be prudent for governments to step in when oil prices get too high for fear of derailing the global economy. Ok. So, what is the right price level to step in? Versus which currency? Should the price be normalized for currencies? Why? Should that level now be indexed to inflation going forward? Then what? When do you stop intervening? Who decides all this? How? And when a government does get it right, is it flexible enough to keep it right? The world changes very, very fast—government does not. Most everyone has experienced our plodding bureaucracy on some level. There’s simply no way any of that works as a “best practice” for governance. Its treacherous, dangerous thinking.

All that aside, Kaletsky’s economic analysis is learned and cogent and even longstanding experts will learn something from his work. His views on how inflation really works (and why it’s not happening now), and about the best ways to view sovereign debt are perspectives many alarmists need right now.

A view near to my heart, Kaletsky sees capital markets and economies as adaptive, dynamic, and evolutionary, and that upheavals can actually make them stronger. Further, he argues the only budding branch of economics that has a chance of truly upending classical economics is the study of complexity theory and self-organizing systems. This is provocative stuff, and possibly right. As I said in my own book, 20/20 Money, complex systems theory could potentially develop one day into a framework that integrates both the foibles of men and the macro economic forces they are often governed by without the baseline metaphors of equilibrium, rationality, or efficiency. But we have yet to get there.

Michael Meade pioneered the therapeutic psychological idea that instead of running from conflict we should live with the tension of two opposing things and then watch the “third thing” emerge—spontaneously. That third thing is the answer we seek. Mr. Kaletsky has put socialism and capitalism in tension in hugely ambitious fashion, and found a third thing that might not be right, but is very interesting and worth our while to hear him out anyhow.

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

Fisher Investments Analyst’s Book Review: Squam Lake and Senseless Panic

August 4, 2010 Leave a comment
Let’s get this part out of the way: Don’t read the Squam Lake Report. The book is the muddled product of 15 experts recommending financial reform. It’s mercifully short, but reads like overly collaborative documents do—I shudder to think of the endless word massaging and negotiation writing this thing by committee must have required. The result is an overly formal and tepid work with few novel or particularly lucid insights not already covered elsewhere. And to Fisher Investments MarketMinder’s view, this group fundamentally misunderstands the causes and consequences of the panic. Skip it.

Instead, pick up the equally pithy but vastly wiser Senseless Panic, by William M. Isaac. As former FDIC chairman and close collaborator with Paul Volcker through some truly rough financial times like the Penn Square/Continental Illinois banking crises of the early ‘80s, and the S&L crisis of the late ‘80s, this guy is a regulatory veteran with real world experience to give us important perspective about today.

It’s a great thing to see the 2008 crisis contrasted with these events—something that’s been almost wholly neglected until now. The situations weren’t the same, but the basic lessons about public policy vis-à-vis banking are vital. Basic lessons about getting broad participation from banks for emergency programs, dealing with moral hazard, being decisive and transparent for the markets, showing the “bazooka” of commitment to backstop vital institutions, recognizing the interconnection of banks, and much else, were all experienced here…less than a generation separated from 2008. Back then, at least, they staved off a true panic.

The first part of Isaac’s book is a memoir of his career as FDIC chair, which is surprisingly lively and light—he turns out to be quite a gifted communicator. This is a very readable book. His anecdotes about the Butcher banks of Tennessee, for instance, hold great lessons about how banking stress tests work, and are entertaining without being overly wordy or bogged in detail.

And it’s from this authoritative viewpoint of experience that Isaac launches the second part of the book, which unequivocally states: This panic didn’t have to happen. It’s a breath of fresh air to read Isaac make some basic empirical observations about the subprime mortgage market and its magnitude (it was far too small to create a global recession and market panic), and ask the basic question: So how did a manageable situation like this turn into such a disaster? Answer: The devastating mark-to-market accounting rule and inept response from our government. Simply, this is the best breakdown of FAS 157 published so far.

There’s only a little to be critical of in this book. I couldn’t shake a sense of “apologia” in the same vein of Henry Paulson or Alan Greenspan’s memoirs. Much of the first half of Isaac’s book reads almost like a justification for his decisions 30 years ago. This is understandable because free markets proponents (such as these fellows) would normally feel ambivalence about public policy in the first place. But it’s tedious to continually justify one’s existence.

Isaac is most upset because in 2008 the Feds didn’t get out in front of the problem and instead handled it in a cobbled, hodgepodge fashion. This, truly, is the best advice for a public official—to be consistent and transparent. But at times this lesson becomes overwrought. The hope is for regulators in these positions to realize their powerful, but often limited, ability to truly anticipate and contain all financial ills. Unfortunately, too often such folks are addled with the political disease of believing they are capable of more than is realistic.

For example, Isaac describes the need to enact reforms and policies that detect and/or fix future ills before they happen. That is, instead of being reactive, they ought to be more proactive. Some of this good: Filling the FDIC insurance coffers in good times rather than imposing higher fees in bad times (as happened in ‘08 and ‘09) is a fine enough thing. But, Isaac simply isn’t skeptical enough of his own powers, or those of who might serve in the future. There’s far too much talk of “there’s a proper way to do this” and “we can make sure a panic never happens again” via sound public policy. This is hubris. So long as we continue to have free markets, there will be more panics. There’s only so much any elite group can anticipate and appropriately act upon. And, every situation will be unique and require context to make the best decisions—no rigid playbook will work. So, it’s disappointing to hear Isaac support notions of a Systemic Risk Counsel (SRC)—a regulatory body designed expressly to monitor risks in the system and recommend circuit breakers for them in the future. (Which is now a reality, by the way, thanks to the new financial reform bill.)

Oh! If only it were that simple. The fact is some of our best, most learned financial minds simply botched this episode. The lesson is not to further strive toward a quixotic utopia of regulation to prevent future breakdowns. Regulation should evolve with the quick-moving capital markets, but sound regulation realizes its limitations—it is by definition reactive and will remain so as long as capitalism remains dynamic. That means recognizing the fantasy of making rules that prevent all future ills. We boom and bust. This lesson is particularly poignant now that we can view the US financial reform, which mostly ended up a jumble of politicized goo that proved wholly unable to produce solutions to the true problems of the era.

In some fashion, though, this is quibbling. Isaac has produced one of the best analyses about the 2008 crisis, and we’d do well to heed the lessons of his well-articulated experience. As the regulators begin to interpret and act upon the new reform bill over the next many years, let’s hope they keep his work in mind.

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

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