Worth Reading

Worth ReadingToday I offer four fantastic articles for your careful examination, perhaps over the week-end. All are worth your time and attention. 

I’ve seen complexity fail over multiple investment cycles in these types of portfolios, but as Keynes told us, “Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally.” Somehow simplicity has become the exception while complexity is now the rule.

I believe that meeting long-term spending needs for institutional portfolios and controlling risk can be accomplished through simplicity.  That’s not to say that it’s easy, just less complex.  A complicated portfolio relies on the hope of being smarter than your investing peers and the markets while taking on added risks.  We all know hope is not an investment strategy.

Confessions of an Institutional Investor (via Josh Brown)

The world of investing is infinitely complex. It feels like we need complex strategies to generate returns. The problem is that as Adams says complicated systems are more likely to lead to “opportunities for failure.” We cannot control what the markets do. We can however control our own actions. For the vast majority of investors a simple system that we can follow over time will in all likelihood lead to better outcomes.

Simplify your investing to avoid ‘opportunities for failure’ (from Tadas Viskanta)

How many people here think that this bull market, wonderful as it is, is built on a foundation of robust and impressive macroeconomic growth and policy choices that are laying a foundation for impressive growth in the years that lie ahead? And how many think that it’s [built on the Federal Reserve’s] printing press? I prefer to play in markets that are priced attractively, priced to offer strong, long-term returns, not ones that are expensive.

Where should you put your money now? From Rob Arnott and others (via Fortune)

Modern day investment management resembles, sadly, another old profession – and I’m not thinking of the oldest one, although there may be parallels there as well. Rather, I’m thinking of ancient alchemy with its near constant promises to turn lead into gold, just as investment managers repeatedly offer to transform low returns into high returns. This raises the question as to why investors/people keep falling for the stories offered up by investment managers/alchemists.

No Silver Bullets in Investing (just old snake oil in new bottles) (from the wonderful James Montier)


Old Always

We humans are optimistic by nature and self-interested by necessity.

So when the markets and the economy stay relatively uncooperative for more than a dozen years, no matter how foreseeable in terms of the “long cycle,” people scrambling about to claim that this time is different is entirely to be expected, especially when it’s in their interest to do so.  Russ Koesterich, the iShares Global Chief Investment Strategist, is the latest to jump on the “new normal” bandwagon.

[I]t is very hard to envision the world going back to the way it was anytime soon. For investors this means that investment process and philosophy need to be geared to the current environment, rather than the way the world was.  In my next post on this topic, I’ll outline 3 strategies for doing just that. 

How much do you want to bet that these three strategies require the use of iShares?

I’m with James Montier and the Reinhart/Rogoff team.  The “new normal” is effective marketing, but reality is the old always.  Since March of 2000 we have been suffering through a secular bear market.  These periods, which average about 17 years in length, are characterized by sharp volatility in both directions (cyclical bull and bear markets within the secular bear) but little overall progress.

Source: Crestmont Research 

The current situation is especially precarious because of the way that the Fed has propped up both equity and fixed income markets, making it achingly difficult to ascertain value.  During these secular bear market periods, one’s first priority should be — must be — to preserve capital.  Thus hedges matter. Risk matters.

The markets have performed exceptionally well this year, at least to this point.  I don’t pretend to know how long that may continue. The Keynes adage about the market being able to remain irrational longer than you can remain solvent is always apt.  For those who have been prudent and taken some care to be cautious, this year has been very challenging.  Cyclical bull markets within secular bears are both tempting and frustrating.  It is extremely hard to withstand the psychological pressure to make a dramatic move during such periods.  But withstand it you should.

My position here isn’t new and it isn’t unique.  But it’s worth reiterating with some regularity.  It’s hard to be patient when the markets are difficult and the “natives are restless” (both professional and client “natives”).  The urge to take action — perhaps dramatic action — can be overwhelming.

Resist the temptation.  Stay the course (once you have gotten on the right course).  Play the course that you’re on — not the course you wish you were on.

O-L-D   A-L-W-A-Y-S.


Update (10.17.12):  I just received a question via email that I think deserves comment here. 

I have a question regarding the historic measuring of bear and bull markets. My question is how does one determine the end of the current secular bear?

Unfortunately, one can only determine the end of secular bulls and bears with any degree of certainty in retrospect.  The key measurables relate to valuation, but we can never be sure how high or how low valuations will (can) get.  I keep reminding myself of what Keynes said – the markets can stay irrational longer than you can remain solvent.  I looked at the valuation data most recently here.

CFA Conference: James Montier

So my biases are clear and fully disclosed, I should point out that I am a big fan of James Montier and his work, including his books and his “white papers” both when he was at SocGen and now that he is at GMO.  Since I also try to be a deep value investor whose work is informed by behavioral finance, we share the same general approach.  And since I met him this afternoon for the first and found him both friendly and engaging, I am obviously inclined to be an appreciative audience.  James said that he was a bit nervous about his speech — The Flaws of Finance — because it is a new one, but he needn’t have been. My rough notes follow (with no guaranty of accuracy or comprehensiveness).

The focus:  bad models. bad policies, bad incentives and bad behavior.

  • If you give CAPM and VAR to monkeys, they’re going to create a financial crisis.  Indeed, I think they just did.
  • Remember that models are abstractions and don’t represent reality — they have clear weaknesses (low beta outperforms high beta).
  • CAPM assumes risk is volatility and ignores liquidity and leverage (and that’s nuts).
  • VAR — like a vest that is 95% bulletproof (fails when you need it).
  • Bad models and bad assumptions tend to replace common sense.
  • Graham — the more abstruse the maths, the more uncertain the results (“complexity to impress”).
  • Derman and Wilmott (2008): The Modelers’ Hippocratic Oath.
  • VAR — like asking children to grade their own schoolwork.
  • Bad policies generate bad incentives.
  • Experts tend to have the tendency of giving us “permission” to turn our brains off.
  • Anchoring — give someone a number — any number — and s/he thinks it means something (even when it doesn’t).
  • Narrow framing — risk means much more than volatility.
  • Bad policies encourage bad behavior.
  • Asymmetric policy to problems — cut rates; environment of low rates encourages investors to reach for yield (a cardinal sin of investing — following Keynes’s law, that demand creates its own supply); Buffett — “Never ask a barber if you need a haircut.”
  • Commission-based loan originators’ loans failed 30% more often than salary-based loan originators; incentives create asymmetric responses.
  • With a simple game, the higher the incentive, the worse people played.
  • We tend to neglect risk.
  • Leverage can’t make a bad investment good but can make a good investment bad.

Problems: Five impediments to recognizing predictable surprises:

  • Over-optimism (hope is not a strategy).
  • The illusion of control (Kahneman’s “planning fallacy”).
  • Self-serving bias (confirmation bias).
  • Myopia (lunch is not a long-range plan).
  • Inattentional blindness (we don’t see what we don’t expect to see).

A Manifesto for Change

  • The Modelers’ Oath (no points for elegance).
  • More realistic models.
  • More practical experience.
  • Less complex math.
  • Aim for robustness, not optimality.
  • Define risk as the permanent impairment of capital.
  • Be skeptical of alleged innovation (it’s usually simply out for leverage).
  • Know the limits of your models (and don’t exploit them).
  • Focus on the long-term.
  • Study history, especially financial history.
  • Don’t get bogged down in details (complexity).
  • Look for predictable surprises (start with Minsky’s models).
  • Central banks should lean against the wind.
  • The markets are *not* efficient (science advances one funeral at a time).
  • Capital adequacy should be contra-cyclical/
  • Guard against regulatory capture and industry-based self-serving bias.
  • Lessons from the 2008-09 crisis (not equity-based risk, but expensive equity-based risk — that has sown the seeds of our next crisis as we are now preaching “buy more government bonds”).

Investing is simple but not easy.

  • James (and GMO) uses simple models, but it is hard to stick to them.
  • The accounts they have the most confidence in are the accounts they are most likely to be fired on.
  • Buy when the consensus is selling and vice versa (be contrarian).
  • Chasing what is popular is a great business model but an unethical one.
  • Sadly, regulators are no less susceptible to behavioral bias than anyone else (the bias blind-spot).

Worth Reading

 Two of my favorite writers on markets and investing have new pieces out that are well worth your time. Howard Marks is the chairman of OakTree Capital Management and has put out a terrific book recently that collects his investment commentaries over the years. The book is The Most Important Thing: Uncommon Sense for the Thoughtful Investor.  In his most recent piece, Marks looks at history and why “this time” usually isn’t different (despite what firms like Goldman and Citigroup are saying).  Some highlights:

  • “The tendency of investors to overlook or forget the past is noteworthy.  So is their habit of succumbing to emotion and swallowing tall (but potentially lucrative) tales.  In particular, people tend to forget the cyclical nature of things, extrapolate past trends to excess, and ignore the likelihood of regression to the mean.”
  • “Common sense isn’t common.  The crowd is invariably wrong at the extremes.  In the investing world, everything that’s intuitively obvious is questionable and everything that’s important is counter-intuitive.  And investors prove repeatedly that they can be less logical than Yogi.”

His conclusion is pretty positive for stocks on account of current P/E levels.  He also focuses a good bit of attention on two articles that you might want to read for yourself:

James Montier of GMO has written a new article examining the sustainability (or not) of record high corporate profit margins. He argues that if you want to understand where the market is headed you need to have some grip on whether and for how long the current (very high) profit margins can be sustained.  Montier concludes:

To us, the macro profits equation is a simple but powerful tool for understanding the drivers of profits, and helps us assess their sustainability.  It is a useful organizing framework for thinking about the possibility of a structural break in profit margins.  When we look at the drivers of today’s high profit margins, we find fiscal deficits behind the high profit margins of many countries.  There is nothing “wrong” with this per se, but it does suggest that moves toward fiscal retrenchment will bring margins back toward more normal levels.  It seems unlikely that “this time is different” when it comes to mean reversion in margins: what goes up must come down.

One can readily infer from Montier’s profit margin expectations that he is not nearly as positive on stocks as Marks is. For what it’s worth, I agree with Marks generally but not specifically because (like Montier) I see good valuation as including more than simple P/E (Barry Ritholtz adds some helpful insight here).