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

December 28, 2010 Leave a comment

Don’t Count on It!: Reflections on Investment Illusions, Capitalism, “Mutual” Funds, Indexing, Entrepreneurship, Idealism, and Heroes — John C. Bogle

The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between — William J. Bernstein

I spent the last week or so reading just about everything John Bogle ever published. And man, is that guy cynical about the investing world! The title of his newest book, Don’t Count on It! is a mantra, almost self-help guru-ish in its repeated invocation, to be dubious about anyone or anything in investing. The book is a sort of “greatest hits” of speeches and excerpts from Bogle’s career. In this, it ebbs and flows—his personal reflections on building the Vanguard funds can be engrossing. But at 603 pages, one wonders about the editing—the book is frustratingly redundant, often repeating whole passages.

Bogle believes investing today is populated with products that overcharge and under-deliver; the system is overrun with marketing and lacks stewardship; and virtually no one can outperform the markets over time. So the best thing to do is get market-like returns via ultra-low cost index funds.

Well, that’s certainly a populist view. And a lot of his proclamations (getting rid of quarterly results for public companies, earnings restatements, etc.) go too far. But there’s much gold to be mined in Bogle’s views too. It’s a jungle out there for novice investors: The proliferation of products, not knowing who to trust…it’s daunting and folks do get burned. Heck, stock brokers at this point don’t even have a fiduciary duty to serve their clients’ best interests! And it’s at least plausible to argue expenses at many plain-vanilla type mutual funds could be lower. Vanguard, if anything, is simply spectacular at providing the public well-constructed index funds at low cost. (For years, my boss Ken Fisher has railed publically about the shortcomings of mutual funds and the like for many of the same reasons Bogle does.)

But there’s a rising tide in the industry countering all this: fee-based separate account management. (Full disclosure: That’s what we folks at MarketMinder do.) Registered investment advisers manage clients’ accounts separately (by far a more efficient thing than pooled mutual funds), have fiduciary duty to serve their clients’ best interests, take compensation as a percentage of assets managed (so there’s a big incentive to do well and right by the client), and can in fact long term beat the markets net of fees. I know this because I work for such a place. This simple framework, to my mind, solves most of the stewardship and cost problems Bogle rails against.

If you can’t (or don’t want to) find a manager you believe will consistently do those things, indexing can be fine enough. Just one problem: you still must decide on asset allocation (a trickier business than it often seems) and have the guts to stick with the strategy. A passive all-equity strategy went down just as much as the market in 2008. In other words, it’s still YOU who must be disciplined and sit tight when the world feels like it might be ending—that might be the toughest thing of all in this business. I, for one, witnessed many die-hard passive investors lose their gumption, sell out, and miss the big rally of 2009—doubly damaging. So, behaviorally, passive investing has its problems.

Actually, the indexers inadvertently prove one of the most important lessons for active portfolio managers and stock investors generally: At a minimum you want a strategy that captures the baseline long-term return of equities. To do that, you have to be in stocks. Most get this backwards: people fear losses way too much (now is a classic era for that). The simple reality is that, over time, stocks run circles around the hesitant. You can’t ease into stocks figuring there will eventually be a lower point to get in. That might feel intuitive after a decade of flat returns, but in practice it fails more than it works. This has been proven statistically over and over, but the investing community consistently turns a deaf ear to it.

Which brings us to Mr. Bernstein. There’s sort of a mutual admiration society between Bogle and Bernstein. You can’t read their work interchangeably, but most of it’s in the same ballpark. They cite each other often as influences. Bernstein’s latest, The Investor’s Manifesto, is really an update from his past books, The Four Pillars of Investing and The Intelligent Asset Allocator.

Bogle righteously emphasizes simplicity in a world of rising complexity. Bernstein says his Manifesto is the simplified version of his views, but a layperson will be befuddled after a few chapters. He seems to mistake brevity (and the book is brief) for complexity of concepts. Statistical explanations of how equity risk premiums are supposed to work, why (to Bernstein’s view) small cap stocks are better than large, and so on, will vex neophytes. Mr. Bernstein seems to sense this—which is probably why he argues it’s so difficult to outperform the market, so few can do it, and most are best served passively investing in index funds, a la Bogle.

But there’s some worthwhile wisdom in there too. Bernstein is one of the few to (rightly) favor being a student of market history and, as such, see that “the more you study market history, the fewer black swans you see.” Absolutely correct. And Bernstein interestingly discusses the “narrative” of a company. He advocates knowing the fundamental macro forces really driving share price—a story of the stock that explains why you hold it—instead of toying with the statistical gerrymandering that is valuation and financial statement analysis these days. Bernstein says investors tend to go for the sexy story, the sexy stock (Apple, anyone?), but often miss the companies that are less popular but really drive the economy—your heavy Industrials, Materials, commercial banks, and so on.

Bogle and Bernstein recognize that most folks planning for retirement (or are in it) need a lot of stocks to fight the effects of fees and inflation and achieve any decent return. Yet, they recommend a lot of bonds. This conventional wisdom has always been tough to justify when really scrutinized. It’s about as close as investing gets to a physical law (to my mind) that the long-term return on stocks is better than bonds. So, by definition, the more of a lower returning asset you hold, the lower your total expected return. Period. Yes, stocks are more volatile—a feature of the higher expected returns. But if your time horizon is long (which it is for most folks even in retirement), that can be ok. A good adviser, even if they don’t call every market environment rightly, should be able to help you navigate those times of rough volatility—not allowing you to get too high when stocks soar, but also not allowing you to panic when they fall a lot.

In the end, indexing can be a viable and low-cost way to get a well-diversified portfolio. But it doesn’t relieve individual investors of decision-making responsibility—no getting around it. For those who don’t want the onus, seek the help of a good advisor. Contrary to today’s cynicism, there are in fact many fine and responsible stewards who can help build your wealth over time.

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

Fisher Investments Analyst’s Book Review: Overhaul and Crash Course

November 26, 2010 Leave a comment

Crash Course: The American Automobile Industry’s Road from Glory to Disaster by Paul Ingrassia

Overhaul: An Insider’s Account of the Obama Administration’s Emergency Rescue of the Auto Industry by Steven Rattner

Well, Halloween passed, and I couldn’t let it go without doing some reading of the macabre variety. So I read about the history of US autos. There’s enough zombies, witches, and Frankensteins (The Ford Expedition! It’s alllliiiivee!!!) in there to keep you from sleeping for a week.

Of particular, gory interest is the way US autos came to be politicized and unionized through a decades-long decline. It’s not atypical for big industries, closely thought of as national assets to become so. Pundits hemmed and hawed over this in the US the last few years, but on the global scene nationalization and “protection” of jobs via big companies is about as old as the corporation itself. Still, the plight of the US auto industry is truly a unique tale. Make no mistake—these companies should have been bankrupted, totally refashioned, de-pensioned and de-unionized, and generally revamped years ago, and would be far more competitive today if they had. We’re not talking 3 years ago, we’re talking 25 or 30. The ironic part is that while politicization surely contributed to the inexorable decline of US autos—awkwardly and lumberingly and often bizarrely—it also helped these undead zombies stave off true death for a very long time.

The US automakers—between CAFE laws and scores of costs heaped on by the United Auto Workers (UAW)—just don’t have a fighting chance and haven’t for a long time. Foreign automakers totally missed the SUV craze of the ‘90s, and Toyota dealt with braking system fiascos in the last couple years—a misstep means lower earnings for them, not doom. These days, a bad product offering or an economic downturn means utter catastrophe for GM. So when you hear auto execs and politicians saying they need tariffs or better negotiations to buy parts to remain competitive, or when they whine it was the recession and financial crisis that caused their ruin…don’t believe any of it. US automakers’ cost per car manufactured is higher than basically anywhere else because of politicization and the costs of unionization. Toyota makes a lot of cars here too—they just don’t have the same UAW-related costs GM does.

All of this is starkly apparent in Paul Ingrassia’s Crash Course. The book’s bulk centers mostly on the last 10 years and emphasizes the bailouts, but the first few chapters are a sort of “CliffsNotes” to US auto manufacturing history—tightly written and often entertaining. This concise history provides a necessary framework for understanding the bailout. Crash Course argues the seeds of US auto death were planted decades ago and calls the “corporate oligopoly and union monopoly” of US autos a “recipe for disaster.” Indeed. Ingrassia adeptly recreates the feeling that so many still hold: the very fabric of the US economy is tied to GM, Chrysler, and Ford. That view hails from when the US economy was less diverse and manufacturing still king. These days autos aren’t all—not even close—but our attachment to the auto legacy drives them to be heavily politicized.

Crash Course is filled with fun details. To read about Robert McNamara’s start at Ford before he got to the Pentagon, the Corvair debacle and the rise of Ralph Nader as a political persona, important industrial innovations like the catalytic converter, the machismo and hubris of Lee Iacocca—these and many other tidbits we all know but don’t frequently remember are vital to understanding the state of automakers today.

By contrast, Steven Rattner’s Overhaul skips those details and speaks directly to the transactions and politics of the 2009 auto bailouts. Put the two books together, and it’s a ripping good (but often harrowing) tale.

Malcolm Gladwell recently reviewed Overhaul in the New Yorker. He points out that Rattner, the “Car Czar” of the Obama administration, is two things: A finance guy (a dealmaker) and a political wannabe. A third thing: As the Car Czar, he was the Van Helsing to GM’s Dracula. But those two facts explain a lot about Overhaul. As accounts of financial deals go, Overhaul is adequate. But it’s a very “safe” book. It reads like a political memoir of someone who expects to hold office again. To Rattner, Larry Summers and Tim Geithner are really nice guys, Obama is nothing but brilliant and courageous, and no one is much of a bad guy except Rick Wagoner—the former GM CEO whom Rattner deposed and the safest guy to trash. Maybe it’s all true, but don’t we read these “insider” accounts to get insight on how these folks really operate and speak? It’s too much to believe they’re all angels.

Those who’ve written professionally know that editors can sometimes give odd instructions to gussy up the prose (finance writing isn’t generally as exciting as romance novels). One envisions Mr. Rattner’s editor asking for more gritty details folks will relate to. Rattner seems to have complied by recounting the things he and his colleagues ate. Every couple pages we’re told about McDonald’s sandwiches that were scarfed or breakfast burritos consumed in the wee hours. But otherwise, personal detail is scarce. That’s probably because Mr. Rattner published this book in the midst of a personal legal battle, so he sticks to the facts.

All this no doubt defangs the book some, but doesn’t fully nullify it. Big Macs aside, Rattner describes complex capital structures, negotiations with unions and bondholders, and the process of finding a new CEO for GM precisely but in terms non-finance wonks will understand. It’s striking, in fact, how similar Rattner and Ingrassia’s adjectives describing the nonchalance and arrogance of GM management are.

Chrysler is now basically owned by Fiat and the unions, a revamped GM will go public soon, and Ford managed to survive and seems to be okay. A frightful tale. Autos have done pretty well in 2010—at least they’re on the mend—but I’d wager trouble’s in their future again. Maybe the next recession, maybe not. But sometime. Defined benefit pension plans and powerfully influential unions rank among the most ambitious social experiments of the 20th century, but they’re still far overwrought today. Unless US autos can reform those parts, they’ll rank among the undead again.

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

Fisher Investments Analyst’s Book Review: Choice 2-Pack

November 5, 2010 Leave a comment

How We Decide proves Jonah Lehrer ranks among the best active science writers, while Sheena Iyengar’s The Art of Choosing is a sometimes cluttered but broader meditation on the act of choice in our lives.

When you get right down to it, most newfangled studies of behavior are getting at a single thing: choice. How do we choose, and why? If you can figure that out, understanding why we make mistakes and similar questions are easier.

Of course, understanding choice is the $64,000 question of the neuroscientific era (but it’s nothing new—philosophers have grappled with it forever too). We don’t even all agree that we get to choose at all! To this day, some psychologists contend choice is instinctual, unconscious, out of our control.

In my own investing travails, I’ve less asked the question, “How are we irrational?” and instead asked, “How do we choose?” Of course we’re all irrational at times, but why? It’s a question for the individual as well as the crowd. As often argued in this space, the crux of the issue, ultimately, is self knowledge. Psychology (the kind that doesn’t include pill-popping) is at core about exploration and understanding yourself, and that’s the thing leading to greater control and awareness. We too often shun this basic fact because a dominant feature of irrationality is the illusion of control—we believe our reason, our consciousness, can rule the roost. It can’t. Our minds are much larger than just our awareness. From where does love or hate come? Surely not reason. Yet those are as important as any datum and foundational to choice, whether we like it or not.
Enter Jonah Lehrer’s fantastic, and pithy, How We Decide. Like his debut, Proust Was a Neuroscientist, this book is a tour de force of lucid, simple explanations about how our brains work, yet is bursting with ideas and insight. Lehrer is one of the only popular authors to consistently offer deep thinking on contemporary neuroscience, not just reductive conclusions. Anyone interested in the psychology of investing, or popular psychology in general, should read this book.

Lehrer, unlike behavioral economists, doesn’t care about explicit irrationality. That is, he doesn’t have an agenda to disprove classical economics. This frees him to tackle issues of behavior in ways economists mostly don’t. He tells us the subconscious brain also “thinks,” and emotions are in fact a kind of thinking—they are “messages” from the unconscious parts of our brain delivered to our awareness. More, that the neocortex (where reason happens) is one of the weakest and smallest parts of the brain! In fact, the unconscious works faster, and is often more right, than reason (à la Malcom Gladwell’s study of intuition, Blink). To access the vast power of the full brain, there must be room made for the emotional unconscious—to actually listen to, but not necessarily follow, those messages.

In a shrewd move, Lehrer describes the brain’s neocortex (where our “reason” resides) as being the regulator of our brains—to provide a circuit breaker for emotional impulses that might be wrong. It’s less likely our neocortexes were designed for actual forward-thinking reason, though that’s what we generally use them for. This idea of regulation rather than reason is a hugely important perspective for investors. True masters, with reason and experience on their side, understand how to allow all parts of their brains to have their say. Different parts of the brain will disagree with each other; the brain sends mixed signals and is rarely harmonious. Simple awareness of this ought to allow us to override what “feels” right but we know isn’t.

For investors, intuition sometimes serves us well, but more often leads us astray. Why? For one thing, intuition tends to fail because the stock market is a really tricky feedback mechanism—it prices in what people learn and anticipate, so it’s tough for a brain’s lower functions to really home in on anything consistently right. Nevertheless, Lehrer reminds us that over-thinking can lead to as many wrong decisions as relying on the gut alone. But at times, he can be too reductive—it’s not right to say Garry Kasparov makes all his chess judgments based on past experiences. Though it’s certainly true that great chess players use their intuitions, their faster-computing unconscious minds, to quickly pare available moves down to a set of the best choices.

Lehrer finds that the brain can’t handle the complexity and non-intuitive parts of the market, and therefore no one should ever try to beat it. He would’ve done better to examine the psychology of those who have in fact consistently beat markets as opposed to speaking to the lowest common denominator. Still, he offers a handful of worthy insights: Fear of losses (loss aversion), for instance, makes people more willing to accept a measly rate of return directly after they feel losses (like a big bear market). This is why investors often miss the first parts of stock bull markets even though that’s a spot where the biggest gains can be.

Meanwhile, Sheena Iyengar’s Art of Choosing is a broader meditation on the issue of choice in everyday life. Iyengar is adept at weaving current psychological findings into little stories and anecdotes, but often veers too far from topic. Too much time is spent on cultural relativism, issues of equality, and so on, that can be tangential to choice but aren’t explicitly about it. Still, in relief to Lehrer, the book is quite a good complement, offering reinforcement and treading territory Lehrer doesn’t. Perhaps Iyengar’s best contribution is the idea that interpretation of information is as important to choice as anything. Simple perspective can make two people interpret the same event differently. Investors should always keep this in mind, and it is specifically why MarketMinder’s front page links to perspectives from a variety of sources each day—both those we agree with and ones we don’t. You can’t make a good choice if you interpret the situation wrong to begin with.

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

Fisher Investments Analyst’s Book Review: Travel Reading Diary

November 4, 2010 Leave a comment

After a long business trip, a few reading suggestions.

New Yorkers get a bad rap. They aren’t jerks, they just want things to keep moving—quickly. They mind their own business, and when/if you need something or get in their way, they don’t mind telling you about it. Otherwise, they’re as courteous (often more so) as anyone. But in their own way. They’re the most self-interested folks on the earth, but they respect that the many millions around them are self-interested too, all going about their day. So let’s keep it moving; we’ve got things to do, and so do you—NOW. There’s no better place for the epicenter of capitalism.

Anyway, I had the privilege of spending a week recently in Manhattan meeting with clients, and, between two long flights and a little downtime, got some reading done.

The Pleasures and Sorrows of Work—Alain de Botton

I assumed I’d hate this book, but didn’t. It’s a philosophical discourse on work. But it’s not overly abstract or conceptual—Mr. de Botton scrutinizes the workplace via real offices, warehouses, and people. Thus, it’s often more like journalism—and about half of the story is told through pictures.

De Botton doesn’t just deride modern work, as many in his position (intellectual outsider) might. He spends quite a lot of time on the aesthetics of business—the sheer grandeur of a giant warehouse, the elegant complexity of a logistical center, the creative genius behind today’s robotics, the grit and stamina of those who do repetitive tasks all day yet with high quality results. He could tell us what to think of these things but doesn’t, preferring to appreciate and analyze—a clever move because didactics here would only produce disdain from working readers. But he does also take time, in quite lively and well crafted prose, to highlight work’s inherent absurdities. (Just what, exactly, does an accountant actually do in that tiny cubicle all day? Moving numbers from one side of the ledger to the other? Has anything, you know, existentially, really changed?) He’s still a philosopher, after all.

Ultimately, the effect is to raise the idea of work and industry in our consciousness; to really see these mundane things (the biggest and often most transparent parts of our lives) in a new way. The effect is well worth the while. A favorite passage on the problems of socialism upon the author touring a cookie factory:

Their self-indulgence has consistently appalled a share of their most high-minded and morally ambitious members, who have railed against consumerism and instead honored beauty and nature, art and fellowship. But the premises of a biscuit company are a fruitful place to recall that there has always been an insurmountable problem facing those countries that ignore the efficient production of chocolate biscuits and sternly dissuade their ablest citizens from spending their lives on the development of innovative marketing promotions: they have been poor, so poor as to be unable to guarantee political stability or take care of their most vulnerable citizens, whom they have lost to famines and epidemics. It is the high-minded countries that have let their members starve, whereas the self-centered and the childish ones have, off the back of the doughnuts and six thousand varieties of ice cream, had the resources to invest in maternity wards and cranial scanning machines.

So, this guy is pro-capitalist, right?

Good to Great and Why the Mighty Fall: And Why Some Companies Never Give In—Jim Collins

I often get asked for good books by which to judge great companies to invest in. There are none, really. Great companies are, of course, the foundation to great stock investments, but there is so much more than just that for investors to contend with. Markets and company performance often enough are different things in the short and medium term. Great investors must understand capital markets as much as they do the companies.

That said, if you want to witness the ethos of what great companies do, there are few better studies than Jim Collins’ Good to Great. This is a book about how disciplined, usually humble, determined companies focus on their core competencies and become the best in their fields. Collins at times comes off a bit like a bombastic business book guru, but the substance is there. His more recent, How the Mighty Fall—about how companies fail and how some regain greatness—is a lesser achievement but still along the same lines as Good to Great.

Theatre—David Mamet

Most will know Mamet from his screenwriting for movies like Glengarry Glen Ross. Oh, there is so much more. This is Mamet’s book on the actual craft of theatre—acting, directing, and so on. But it carries lessons every business manager should heed.

Mamet, to my view, ranks among the best living playwrights. This is, principally, because he’s been among the few who do not condescend to audiences with petty political rhetoric or piteous social messaging. He is a meticulous student of human motivation, its frailties, and the masks we wear to cover them (which is opposite of, say, the constant social/moral haranguing that is a Jonathan Franzen novel). Mamet is free of moralizing—here is human interaction, as it is, writ large, starkly. And often with a dose of comedy to boot.

Thus, he is one of the few fiction writers today that has much to teach us about human behavior in a non-didactic, non-tedious way. As Mamet says, art is, at core, entertainment. A few favorite quotes:

Drama is about lies. Drama is about repression. And that which is repressed is liberated—at the conclusion of the play—the power of repression is vanquished, and the hero (the audience’s surrogate) is made more whole. Drama is about finding previously unsuspected meaning in chaos, about discovering the truth that had previously been obscured by lies, and about our persistence in accepting lies.

The theater is, essentially, a deconstruction of the repressive mechanism, which is to say, of the intellect and its pretensions…Those who can accomplish this trick are known as artists; those who cannot may find for themselves another name, and indeed, they do, presenting themselves as professors and critics…

Both, in their own way, seem germane to stock investing.

Clutch—Paul Sullivan; Choke—Sian Beilock

I recently choked. Public speaking’s been a part of my job for years now, and I always wondered (and dreaded) when the day would come that I just sort of…forgot what I was saying mid-sentence. It finally happened a few weeks ago—I was talking, talking, talking…and then…nothing. In front of the whole audience. A trifle embarrassing.

I lived to tell the tale, but I figured now was the time to do some reading on current studies in the field of performance under pressure. After all, an investor is, in some sense, always under such pressure to perform, to make the right decisions. And the stakes are usually high.

Both of these are fine enough books—Clutch deals with the principles of performance under pressure via anecdote and qualitative study, mostly.Choke is a hardcore synthesis of modern, science-based psychology.  On both counts, though, it’s striking how little there really is to say about this topic. Neither book does much better than tell us to do things like “focus,” prepare/practice adequately and try to replicate pressure-filled situations, and don’t over-think things. One hopes most regular performers already intuitively knew most of these things.

In the end, this just isn’t the territory for science or logic, and no empiricist is going to explain the fortitude of Michael Jordan down to some root principles. But it’s surprising how much reticence there is to speak of determination, courage, and their role in performance. As if those aren’t topics fit for serious intellectual discourse any longer, and thus not applicable for study of grace under pressure.

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

Fisher Investments Analyst’s Book Review: The Misbehavior of Markets

October 1, 2010 Leave a comment

If you could stop every atom in its position and direction, and if your mind could comprehend all the actions thus suspended, then if you were really, really good at algebra you could write the formula for all the future; and although nobody can be so clever to do it, the formula must exist just as if one could. - Tom Stoppard, Arcadia

One of our editors at MarketMinder, Jason Dorrier, read this quote and said: “Now make every one of those atoms into a human being and you’ve got a market. Predict that will you?” Indeed. The Stoppard quote describes the credo of the misguided masses of finance: The fetishistic seeking after math-based formulae to explain stock markets.

Simply, markets aren’t metaphors. They’re markets! Markets can be compared to, but aren’t weather systems, evolution, physics, math, or anything other than markets. As a philosopher might say, they are “as such,” a category unto themselves. We must take markets on their own terms, not on the terms of some obtuse metaphorical vehicle.

Of all the many things I’ve been privileged to learn from Ken Fisher, it’s been to study markets, not theories about them, not mathematical constructs, psychological theories, or otherwise. Focus on what stocks do—allow the results to drive your explanation; do not shoehorn your interpretation of reality to fit your preferred theory. If they don’t match, trust what actually happened and adjust your theory.

To a mathematician, markets are math; to a psychologist, markets are neuroscience. But math is not a thing, it’s a logical description of things. Psychology is not the mind, it is an—often poor—explanation of the mind. These are useful ways to think about markets, but ultimately they’re not markets.

It’s against this backdrop we encounter Benoit Mandelbrot’s Misbehavior of Markets. He’s the founder of fractal theory—a now well-established sect of mathematics. In a nutshell, it’s the idea that small and jagged instances can give rise to larger, predictable, smoother patterns. (Click here for more about it.)

Mandelbrot is the archetypal wizard for the Modern: the white-haired, disheveled mathematician as today’s Merlin. I was lucky enough to see him speak earlier this year, and though widely acclaimed as a maverick of the academy, in person he seems a diminutive, gracious man.

Of course, as one of the mathematical titans of the time, Mandelbrot sees markets as math-based. The Misbehavior of Markets explains how markets behave like his fractal theory. This produces both unique insights and a handful of misconceptions but is ultimately a worthy addition to financial theory. We should note that Mandelbrot openly and honestly says he doesn’t know how to make money with these ideas, he’s instead reporting what he’s observed. (Ah, the freedom of the academic life!)

Mandelbrot might seem the forerunner to now famous market gurus like Nassim Nicholas Taleb (of Black Swan fame). This is one of the first accounts of the now-vogue ideology that markets are actually riskier than most believe, and that the so-called “fat tail” or “Black Swan” events are much more frequent than current financial theory can account for. Indeed, the last few years have been a veritable tidal wave of backlash against the bell curve (or, more formally, Gaussian distribution) and random walk (or, Brownian motion) theories of stock markets—averages don’t matter, reality is very wild, with unlikely events the norm. The sum of all this is, essentially, a critique on risk as most financiers see it.

On that basis, Mandelbrot is indeed the father of Taleb-ian thinking. True, finance inappropriately defines risk as some smooth, average volatility, which is fine for statistical analysis but captures nothing of the true, visceral, emotional, and ultimately very spiky (like a fractal’s edge) range of features risk manifests in us, and therefore markets. Financial risk measures (“beta” and the like) are really another kind of broad, reductionist calculation (though not without its usefulness), but not an appropriate way of viewing the actual, ontological, thing that is risk.

But Mandelbrot often mixes the short with the long term, sometimes to good and sometimes to ill effect. He never seems to note that a long-term investor doesn’t actually care about things like the 1987 crash or the more recent “flash” crash in May—a long-term investor may or may not even realize it happened, but a trader—on that single day—could be ruined. It’s this inability to differentiate between short/long that disallows Mandelbrot to preach one of the most important lessons of investing: That yes, stocks can be highly volatile, but they actually go up over time despite the seeming perpetual world tribulation. To miss that lesson is to miss the point of investing entirely. It’s tragic that he doesn’t offer that lesson for the investing masses, and somewhat puzzling considering his mathematics is based on the idea that the small instances can roll up into larger patterns.

Yet, Mandelbrot also offers a novel observation: That we should not think about markets in terms of our experience of time. Rather, we should think of markets as having their own sense of time. This is remarkable, and correct. Most investors I meet think about stock returns on their time—“I have five years till I retire and want XX return”, or, I want to buy a boat in seven years and need XX% return by then”. And so on. But the market doesn’t care; it does it’s own thing on its own time. This is a vital lesson.

And here is where comparisons between he and folks like Taleb end. Taleb believes in pure stochasticity (random chance), and even views stocks’ long-term returns as “random drift.” Mandelbrot does not: He is a firm believer in patterns and that fundamentals ultimately rule stock returns—and the power of probability in forecasting future prices.

He’s right, but Mandelbrot goes too far. Finance theorists have long held that stocks are not auto-correlated, which means that past returns don’t influence future returns. Mandelbrot disagrees, proclaiming that “long dependence” has a profound effect on future prices. Effectively, that all past prices have an effect on the probability of a stock to move one way or the other. This actually might be true for very short-term observations of stock moves. But, if so, it’s only true in a non-practical, theoretical sense. The math of fractals could predict probabilities—slightly, and I mean really slightly—better than 50/50. But with transaction costs and the rise of hedge funds with high frequency trading to arbitrage most such possibilities away, this is all but an impossibility in the real world. Or, said differently, if the idea of market long dependence were true, Mandelbrot would be a trillionaire by now. He acknowledges this indirectly by admitting anticipation is unique to markets, and at the heart of how they work. Again, an uncommon insight, and a correct one, but somewhat lost among murkier premises.

And that is the way this book goes. By now, there are better, sharper analyses on these topics. But we must credit Mandelbrot as among the first to really present such ideas to the wider public. His fractal theory doesn’t explain markets, but turns out to be a sometimes effective mechanism to help contemplate them.

Another favorite Stoppard quote:

Skill without imagination is craftsmanship and gives us many useful objects such as wickerwork picnic baskets. Imagination without skill gives us modern art.

In today’s world, where mathematician is Merlin, Mandelbrot’s book focuses his prodigious—and imaginative—intellect on markets to provide some worthy insights. But be wary, math, at its core, is often the Modern Art of stock market interpretation.

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

Fisher Investments Analyst’s Book Review: The Shallows and Cogintive Surplus

September 29, 2010 Leave a comment

When society gets anxious, it tends to infest all corners of culture. Today’s age of perceived plight has turned its gaze toward technology. So, wonder of wonders, a recent batch of books reveals our nervousness, anxiousness—tensile jitteriness—about technology. This should be all the more striking compared to our decade-ago view of tech as economic savior.

Nicholas Carr’s book, The Shallows: What the Internet Is Doing to Our Brains, is getting a lot of attention. The book is about how the mind works in the internet age and asks the question: Is our technology making us smarter or dumber? He believes we’re getting dumber. Clay Shirky disagrees. His latest book, Cognitive Surplus: Creativity and Generosity in a Connected Age, argues technology and the information age are a source of goodness almost beyond our ability to comprehend.

Paradoxically, Carr’s book is often wrong but worth reading; Shirky’s is often right but should be skipped. We’ll tackle this review from two perspectives—the books themselves, and what they mean for investors.

I. Technology and Our Brains

This year, I had a mild career change. I went from being an analyst to managing some of them. A few months into it, my boss asked me how it was going. I said, “It’s changing my brain.” He looked at me sideways. But I meant it—I’ve had to think differently. Instead of contemplating just me and my work, I had a bunch of folks to consider, constantly. I’d get requests and interruptions all day such that I’ve had to learn to change focus on a dime, continually. At first, I worried this would affect my ability to think deeply and write for long stretches. Turns out, those things didn’t go away at all (these book reviews seem to be getting longer and longer!). Plus, I now have a new set of skills and new perspective.

Carr’s book, The Shallows, deals with this topic in earnest. He believes information bombardment from the net, email, smartphones, Twitter, text messages, and so on makes us less capable of deep, linear, focused thought and more prone to attention diffusion and interruption. Carr spends many pages making one point: Human brains are malleable, and so what we “feed” them dictates a lot of their wiring and thus how we think.

This ends up both right and wrong. True, the internet age will change our brains, but our neural abilities are so powerful this doesn’t have to be a bad thing and certainly doesn’t have to make us “shallower.” Through history, intellectuals have lamented mass paperback publishing, comic books, radio, television—saying they’d all ruin society and our ability to think deeply. They didn’t. Why? Carr goes to great lengths to prove that the brain is the finest computer of all time, but oddly doesn’t recognize our brains might have the ability to switch gears. Perhaps sometimes our attention is diffused on conversation, emails, and the like. And maybe other times, we can still sit quietly and read.

Carr cites a study that ostensibly proves a person’s brain changes materially with “just one hour of internet use a day.” From this, he concludes that if one hour does all that, think of what a whole day in front of the screen will do! One would expect interaction with any new medium to require a lot of energy and new neural activity before it becomes habitual. But that doesn’t mean the magnitude of new neural activity would necessarily continue unabated in each subsequent hour—or crowd out older, learned modes of thinking. Rather, and in keeping with Carr’s insistence on the primacy of neural plasticity, the marginal brain change would diminish over time. You only have to learn to ride a bike once and then riding is easy, making room for additional new learning and allowing the peaceful coexistence of all previous modes of thought.

More, Carr argues that solitary, silent reading and writing were the substrate for some kind of individuality that was imperative for the development of society. This is sheer nonsense and can be dismissed simply by examining the life of Socrates, who never wrote or read, but spoke and listened. This reflects Carr’s confusion on the important difference between the ability to think and how that thought is transferred. Transfer mechanisms, like books and language, influence thought, but are not thoughts themselves. (Steven Pinker has proven this over and again in his studies of language.) Further, our fabulous brains make room for many different transfer mechanisms (as discussed above)—the evolution of which have only furthered and deepened thought.

On one level, The Shallows is a sterling introduction to contemporary neural science—from studies on instinct and plasticity to the chemistry of memory. Carr is extremely well researched and authoritative here. (He even cites—and seems to have actually read!—David Bueller’s hugely turgid Adapting Minds, a seminal critique of evolutionary psychology.) But The Shallows is ultimately less than the sum of its parts—a grouping of well-written, thought-provoking pieces that never really prove the case. By contrast, Clay Shirky’s Cognitive Surplus is often generally right to argue that increasing information and technology is a good thing for society, but does so in tedious and tautological fashion. Shirky has a few important points:

  • There will always be folks lamenting the new opening of information and that always ends up wrong.
  • Though we feel busier and more anxious about it than ever, we actually have more time than ever and are more productive than ever. This is the “cognitive surplus.”

But we didn’t need a whole book to get to these points. Most of the text is a quagmire of tautology like, “the needs of the group and the needs of the individual should be balanced” for an online community. (Who needed to be told this, and what does it really have to do with the book’s topic?)

II. Technology and the Investor

I increasingly hear questions from clients about how to choose information sources, which ones to trust, and how to generally deal with the bombardment of information that hits us every day. One thing is certain: Just the mass influx of information causes heightened anxiety—it can be like drinking from a fire hose. Serious investors need to consider how technology and the availability of information affects their decisions.

Fifty years ago, with paper, pencil, and newspaper stock quotes, you could make a stock price chart and calculate a few things like P/E ratios. If you had the time and a big enough research budget—you could cleverly use all this to act on things others weren’t seeing or hadn’t thought of. (Have you ever actually graphed a stock price by hand? It takes forever.) Today, you can get every stock price or metric (any piece of data you can think up, really) free on the internet and crunch it any which way you like—in milliseconds. Where once all of this was only possible for an elite few, today all you need is a computer, the internet, basic knowledge of statistics, and spreadsheet software like Excel.

A good bit of investing used to be about how fast and comprehensively we gathered information, but today it’s more about the quality of our thought and analysis and how well we sort out the noise. The human brain still ultimately pulls the decision-making trigger and our brains haven’t much altered—we can only digest, think through, and understand so much, and rational thought is still influenced by subjective emotions. Said differently, more information hasn’t led to better investor returns. We live in a world where successful market forecasting is more than ever about interpretation…and less about finding that one “magic bullet” no one else has yet found.

Look no further than right now. We at MarketMinder have been truly breathtaken at how quickly folks have decided recent slower economic data automatically means double-dip recession. Fifty years ago, an average US investor couldn’t get a hold of, say, a breakdown of Japanese GDP without spending huge time and resources (and probably hiring a translator). And even if they could, it would likely lag weeks or months after it was reported. Today, a full breakdown of global GDP is available online, basically instantly, to everyone and for almost every country. So, the issue is how to interpret the GDP reports. Our analysis says this is a very typical deceleration of growth after what’s been a swift first stage of recovery. Recoveries—and expansions, generally—aren’t straight, smooth lines up. Others disagree. Whoever’s right, there’s no secret or hidden piece of data that tells the tale.

Thus, effectively sorting and interpreting, not just data gathering and computing, is more important than ever before. Or, as James Hillman has said, the “hungering for eternal experience makes one a consumer of profane events.” Determining what is truly holy to markets (what moves them) and what is profane (noise) is the crux of forecasting today.

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

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.

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.

Fisher Investments Analyst’s Book Review: 13 Bankers

July 23, 2010 Leave a comment


With the “sweeping” financial reform bill effectively a done deal, I’m not sure who’s supposed to be happy about it—those wanting to address the underpinnings of the financial crisis got next to nothing, some increased transparency, banks got punished (and possibly put at a disadvantage to foreign banks, all of which ultimately hurts average folks who actually do banking), and we got a smattering of new oversight boards. Who got the satisfaction? This turned out to be a feckless bill full of “stuff” that makes it look like the politicians did “something.” Which means on balance this bloated bill will create some winners and losers and a general disincentive toward financial activity, but the world will go on.

Part of capitalism’s adaptive ability to create prosperity includes scraping out the bad (which can be violent, à la 2008). Now, we’re emerging from that destructive phase, and the new financial regulation had nothing to do with that recovery. After such dislocations, debate rages on the balance between markets and government. But the foundation of governmental skepticism—as old as the US—is to realize the dangers of a government with good intentions. The sheer nature of concentrated power corrupts, diverts, and distorts into eviler things. It’s quite telling of this bill’s plight to read long-standing Democratic economist and public servant Arthur Levitt excoriate the thing with malice in the Wall Street Journal.

Enter Simon Johnson and James Kwak’s 13 Bankers. A handful of clients have mentioned this book, noting its emphasis on the interconnectedness of Wall Street to the Beltway. On this topic, Bankers is a blitz of finger-wagging at both politicos and CEOs. But its premises, and the sum of its argument, simply don’t hold water.

Bad Banking Attitude

MarketMinder’s written extensively that today is an era of anger and pessimism. As such, we get books like Bankers operating from the baseline notion that banks are predatory and aggressive, and left to their own devices will suck the blood from anything they can. Moreover, if not regulated properly, banks will effectively, and consistently, commit suicide (via overleveraging or excessive risk-taking). All this acts as great populist rhetoric, but is untrue.

Maybe we can agree many high financiers aren’t cuddly teddy bears, some compensation incentives are perverse, and the potential for systematic problems exists without government oversight. But on balance, private banking has provided one of the greatest social functions in all human history—acting as a vital intermediary directing capital to more productive places. (That is, unless we don’t want a mechanism allowing us to fund entrepreneurship or buy cars, houses, college educations, and so on.)

By the last chapter, the fangs really come out. To Johnson and Kwak’s minds, banks essentially exist to “ensnare” (their word) fees from the unwitting public. This is more a rhetorical trick than reality. Banking costs for the average person have come down a lot over the years—from brokerage trading costs to checking fees. (Of course, that’ll change now that new regulation is coming to pass: “…banks are preparing new fees on basic banking services as they try to replace revenue lost to regulatory rules…” Talk about the Law of Unintended Consequences!)

And anyway, when did it become a crime to charge a fee for services rendered? Maybe we should refer to charges for all goods and services as “fees.” How can McDonald’s take such a fat (pun intended) fee for providing high calorie food? Why, I’ll bet they’re skimming 3 to 5% right of the top of each transaction! And what about the fees involved in purchasing the authors’ book? I would have thought, out of the kindness of their hearts, Messrs. Johnson and Kwak would at least give us the wholesale price. But I digress. The only way this makes a lick of sense is if you believe (as many of the intelligentsia do) that banks ought to be purely bodies serving the public welfare. In which case, profits are illegal.

What Deregulation?

Many have used this recession as a platform for rebuking capitalism, calling the last ~30 years (ostensibly starting with Reagan/Thatcher) the “Great Moderation” that led to the big panic—an era highlighted by few crises and high economic growth, allowing for deregulation that allowed predatory banks to kill the system. This is ridiculous. First, go back 30 years or more. What about the 70s was so idyllic that we should return to those years? Why is that viewed as an ideal? The 70s were a perfect example of what you get with government “guiding” markets.

Also, the last 30 years have been the most prosperous on human record globally, but also included much turbulence along the way—the Cold War, two Gulf Wars, 9/11, theS&L crisis, a massive tech bubble, most of South America defaulting, the Russian Ruble crisis, the Asian debt contagion, the market crash of 1987, Japan’s decades-long malaise…and much, much more. Also, Superman died for about a year in the early ‘90s (which broke my heart). It was a turbulent time. And today is no different; there was no Great Moderation, just a very prosperous time that I’m not convinced has ended and/or can’t accelerate from here.

Yet, the “Era of Deregulation” has now been accepted as gospel, as if it were an official thing. I want to see a study—some real, non-anecdotal evidence that we’re less regulated today than 30 years ago. Because for every dissolution of Glass-Steagall, there are 10 Sarbanes-Oxleys. This world is vastly more regulated today than bygone days. I think the confusion lies in a mix up between actual regulation (i.e., rules) and an era of privatization. Indeed, the last 30 years have been a global era of privatization—a tremendous thing, not just for stocks, but for society.

We had a bear market/recession with Financials as the hub, which is more damaging than having it, say, start in Technology because Financials are the epicenter of commerce and the engine oil of capitalism. But that doesn’t mean this was the end of finance, or that a bad 2008 for stocks means the 30 years of unprecedented economic stability and wealth were nothing but a “leading up” period. We’re going to have more bear markets on the way to higher highs and ever more prosperity.

US-Centric, and Concentrated Power

What Johnson and Kwak’s perspective reveals is an over-focus on the US. This is the sin of much investment and economic analysis. If this really was a 30-year period leading up to the worst bear and recession since the Depression, with the US as culprit, then how is it that the US is currently a recovery leader for the developed world and that the supposedly safer—and more regulated—Europe is ailing most now? The narrative simply doesn’t hold.

How then can the authors argue that more regulation is the key to a safer system? They start with US forefathers Hamilton and Jefferson. Theirs was a heated debate, seen largely in the Federalist Papers. Hamilton was amenable to banking and financial markets generally, while Jefferson was skeptical and supported tighter restraints. Hamilton saw the vast benefits of free flowing capital, and Jefferson feared consolidated economic power, particularly its influence on politicians. Through the latter part of the 18th and early19th century, the US was an emerging market. Much of its charge toward global economic leadership during the Industrial Revolution can be traced to market liberalization à la Hamilton, many of its 19th century travails to Jefferson’s antagonistic view of banking (I’m talking to you, Jacksonian-era politicians).

This is the strongest part of the book and the authors are quite creative in framing the discussion this way. Big banks are the center of today’s heated debate, and the US has a long history of (generally) successful trust-busting. Or, at least without hamstringing the economy fully. (Whether the government needed to break up companies in the early 20th century is debatable. The Titans probably would have declined of their own volition. After all, what killed big rail companies wasn’t rail competition, it was competition from newer industries like autos and aircraft. What brought Microsoft back to earth? Google and Apple, not antitrust hawks.)

Either way, now isn’t the same as then. To see that, resume thinking globally. It’s true the big US banks are highly consolidated (even more now than before the crisis—thanks largely to the government!) and enjoy a great deal of influence on the Beltway. But they aren’t the only game in town anymore. An average person can do business with banks across the world. HSBC, Barclays, and others are all over. Heck, my firm uses the brokerage services of a handful of foreign banks too. Thinking US-centric makes it seem likeGoldman Sachs rules the world and controls all liquidity. But in fact, especially in places like Europe and Asia, the biggest banks have much more government scrutiny and intervention, yet they fared no better in the crisis.

All this context leads to a near total misinterpretation of how and why 2008 happened. Johnson and Kwak view it as the aforementioned 30-year process, whereas the true causes stemmed from government itself—dreadful regulation and guidelines in the form of Sarbanes Oxley and FAS 157, mixed with inconsistent government response to spark the panic. (Again, MarketMinder has featured much commentary on this, so we’ll abstain here.)

But it should give us pause when the authors say the government-conducted banking stress tests turned the tide in the panic. (Huh? The tests were done in April/May ‘09—markets had rallied hard for two months by then.) Johnson and Kwak also claim that each time the government intervened with a new program or policy, panic waned a little, until panic finally ceased. The opposite is true—as Bernanke and Paulson haphazardly hopped from bank to bank, panic heated up in late 2008. And TARP didn’t stem jitters a wit.

In the end, much of this rolls up into the fantasy of exerting complete control over a complex system like the global economy. It would be so nice to prevent cyclical downturns, but we can’t and shouldn’t seek to. Government should play a role in establishing property rights, transparency, and enforceable rules of the game. The goal of regulation isn’t to prevent crises (those are a part of capitalism), but to increasingly deal with them effectively as they happen. If you preemptively dampen crises, you dampen potential prosperity—which actually makes us all worse off in the long run.

Few see this now, but my view is the end result of the last +30 years was a Golden Age founded on burgeoning financial innovations that moved into the mainstream, sparking some of the most profound wealth creation of all time. Capitalism’s engine always gets a bit overheated and must cycle back. And we’re getting through it now. But today’s world is a better one than decades ago, and tomorrow’s will be better than today’s.

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