Wednesday, December 30, 2009

The Enduring Lessons of the Last Ten Years

As the ‘naughties’ (what a perfectly descriptive name for the 2000-2009 period) come to a somewhat anti-climactic close, it is important for those of us in the investment community to take stock of what new lessons have been learned, what immutable laws have been reinforced, and what changes in policy, strategy and execution need to occur in order to avoid a repeat of the booms and busts of the last decade. The reason I think such an analysis is critical is that I do not believe most investors are cognizant enough of the dangers lurking in the world’s financial markets. Memories are very short and despite suffering through a number of serious market downturns over the last 10 years, I worry that we have already started a snowball rolling that has the potential to cause even more lasting damage than the dot com bubble or the real estate bubble and subsequent financial collapse. Therefore, it may be true that only by understanding the past can we hope to avoid such a fate.

The following list is not meant to be all encompassing. I’m sure each individual investor can come up with additional items and could justifiably disagree with some of my conclusions. Also, you will surely recognize some of these rules and guidelines as often repeated clichés. That is the point. I am not trying to re-invent the wheel or point out things that are not relatively obvious. However, I do believe that people who keep these beautifully simplistic lessons in mind have a much better chance of successfully navigating through persistently treacherous financial waters than those who ignore the past.

  1. Trees cannot grow to the sky: This rule is number one for a reason. No matter how many times this idea is repeated or shown to be true in the market setting, another hot investment invariably comes along that causes people to forget that appreciation has its limits. However silly it may sound at a time of irrational exuberance, the restrictions on unending price increases consist of these pesky little things called fundamentals. For example, since no company can compound revenue growth at 20% indefinitely, fundamentals rarely justify paying exorbitant price to earnings multiples for stocks, regardless of the sell side’s bullish extrapolations. Or, since rents often do not increase by more much than CPI inflation on a yearly basis, real estate price appreciation that is significantly above the inflation rate is not likely to be sustainable. Basically, aside from commodities that are valued mostly based on supply and demand dynamics, most assets need to be valued based on the cash flows they can produce. It really is that simple. Accordingly, when price increases become decoupled from cash flow growth, the ensuing bubble is likely to eventually explode and devastate those who forgot that those annoying fundamentals will invariably win out.

This is a lesson that was reinforced a number of times over the last ten years within a number of disparate asset classes. However, this is the one lesson that is never sufficiently learned. As true as it is that the sun will rise in the east and will set in the west, investors will inevitably be willing to pay far too much for certain assets based on unrealistic assumptions about growth. Therefore, the solution for prudent asset allocators is to find investments in which it is possible to buy at a price less than intrinsic value and get any future growth for free.

  1. Fighting the Fed means you can lose your shirt: All I can say is that I totally underestimated what near zero interest rates, a flood of bank liquidity, and an implicit government backstop of all risky assets would do to the price of everything but the US dollar. In retrospect the valuations of many stocks at the 666 low on the S&P in March reflected a draconian outcome for the US economy that was probably unlikely, especially with the Fed stepping up to the plate. It is now abundantly obvious to me that incredibly low interest rates punish savers and force people to go further out on the risk curve. Even worse, historically low rates apparently can cause lasting distortions when it comes to asset prices. Thus, it was foolish not to expect some rally in stocks. The length of the current rally has been impressive and clearly driven by some extent by the Fed’s money printing. Anybody who was significantly short during the last nine months has suffered mightily at the hands of the Fed’s attempt to reflate all asset classes (but the dollar) simultaneously.

Accordingly, this is a lesson that any and all short sellers should take to heart. When both the Fed and the officials in charge of fiscal policy make known their intentions to throw money at a situation with impunity, it likely to be very profitable to cover and go long risk, regardless of the underlying fundamentals. For investors who shun such speculation, when the Fed gasses up the Helicopter and loads up the money bags, it appears that the best course of action is to take short exposure way down and if valuations are right, add more to existing long positions.

Now the question facing all investors is whether or not the Fed’s actions will continue to stimulate price appreciation in various asset classes. My guess is that the corollary to the above rule is also true: when the Fed is eventually forced to take away the punch bowl, it is the longs who are bound to suffer while the shorts prosper. Therefore, it may be prudent for long-biased investors to take some profits if and when the Fed finally starts to consider hiking interest rates and shutting down the money spigot.

  1. Ignore the warnings of The Oracle of Omaha at your own peril: I am just about finished with Alice Schroeder’s epic biography of Warren Buffett entitled The Snowball. The book serves as a fabulous reminder that investors should heed the advice of their elders. At the annual Sun Valley meeting in 1999 Buffett notoriously warned the crowd that technology stocks and the equity markets appeared overvalued and that stocks were poised to deliver mediocre returns in the coming years. What happened? You might recall that the tech bubble burst and many people, especially retail investors, experienced severe wealth diminution. Then, over the next few years Buffett wrote about and spoke of derivatives as weapons of mass destruction and indicated that he believed some kind of crash would come as a result of their proliferation. If you can’t see the prescience imbedded in those statements I suggest that you review what happened to AIG and what that company’s near demise did the global financial markets.

Recently, Buffett has made “all in” bets on America after his October 2008 op-ed piece in the NY Times and his enormous purchase of Burlington Northern Railroad (BNI) in 2009. What he hasn’t said directly about some of his recent moves (but has discussed in other contexts) is that these investments are actually hedges against inflation. In an inflationary scenario the best assets to own are solid businesses that have the ability to raise prices and those that will benefit from spikes in the prices of commodities (railroads for example). The Oracle is telling people to be positioned for coming inflation. After the number of things he has gotten right over the past 10 years it would be absolutely foolish to dismiss his words this time.

  1. While being early may look and feel a lot like being wrong, investors must stick to their convictions: John Paulson knows this better than anyone and the tremendous profits he made shorting the housing market serve as an example of the need for investors to stick to their guns. I saw Paulson speak in New York earlier this year and the insight into his thought process during the 2006-2008 period was invaluable. From what I recall, Paulson was early in making bets against the RMBS market and actually closed out some shorts at a loss. However, he then discovered the magic of credit default swaps as a way to profit if the housing market tanked and by staying with his investment thesis was able to make billions of dollars for his fund and himself in 2007. It would have been easy to have gotten scared out of these contrarian positions, especially when people like Ben Bernanke were swearing that a widespread housing crisis in the US was just about impossible (isn’t it amazing this guy kept his job AND got re-nominated for another four years?). Fortunately for Paulson, he had done the necessary in-depth research and understood the dynamics and risks inherent in the RMBS market better than central bankers, policy makers, investment banks and institutional investors.

What current investors need to remember is that markets are absolutely not efficient all the time and the herd can potentially be wrong for an extended period. Thus, as long as you can stay solvent longer than the market remains irrational (a big if for firms that employ a lot of leverage), you can make fistfuls of money when your thesis plays out, even if you are a bit early.

  1. Risk is not the same as volatility: The distinction between risk and volatility is crucial and investors must always be on the lookout for opportunities that arise from a general lack of understanding of the difference. Risk should always be defined as the potential for permanent capital impairment. Specifically, risk implies a drop in the value of an asset. In contrast, measures of volatility are derived from fluctuations in prices and have nothing to do with a change in intrinsic value of an asset. For reasons that have to do with behavioral and structural biases, investors continue to confuse these concepts and subsequently sell assets whose price has dropped but whose value has remained intact. Situations in which selling is based solely on declines in prices are the best times to be a value investor because companies with solid balance sheets and distinct competitive advantages can fall out of favor when sentiment turns against them. This creates an opportunity for knowledgeable investors who focus on the measurement of intrinsic value to back up the truck and load up on shares of their favorite companies. Accordingly, volatility is the friend of a value investor while risk is something that needs to be guarded against. If we have learned anything in recent years it is that it’s imperative to spend time attempting to evaluate the cash flows a company will generate as opposed to a completely useless metric such as a stock’s beta.
  2. Never forget that politicians’ main objective is to get reelected: What this very sobering lesson implies is that there is almost never the political will to make tough choices that will lead to short term suffering even if current sacrifices are likely to lead to future prosperity. As a group, lawmakers seem to be consistently unwilling to risk their political aspirations for the good of the country or to hold to true to their beliefs. This is especially true in elections years like 2010. However, as a result of the exorbitant cost of running a political campaign, even in non-election years our elected officials are forced to continue to raise money and become even further indebted to special interests and powerful lobbyists.

The takeaway from this perverse situation and overwhelming desire to be reelected at any cost is that investors can count on legislators and the White House to kick the can as far down the road as possible and even create laws that exacerbate the problem in the long run but serve as a potential quick fix. The perfect example of this behavior was the passing of the Medicare part D legislation, a program that Paul Krugman argues created an $9.4 trillion unfunded liability over the next 75 years. Such giveaways are a nice way to get reelected, may help boost the stock market temporarily, but could end of bankrupting future generations of Americans. Therefore, long term oriented investors must be prepared to deal with the lasting secular trends that result from knee-jerk reactions to cyclical events.

  1. Relying on so-called experts—central bankers, economists, and financial pundits—can lead investors down a slippery slope: If you turn on CNBC you have the wonderful luxury of being able to hear the opinions of hundreds of people who work with the markets on a day to day basis. Since these folks spend all of their time living and breathing financial markets, they should know best, right? Well, it turns out that experts are often wrong; not necessarily because they are bad people or are fools, but because accurately predicting the future is incredibly difficult. Accordingly, investors should remember that any prognostication, no matter who it comes from, needs to be taken with a grain of salt and that person’s particular incentives and biases must be taken into account as well. In the end people need to make up their own minds based on the facts in front of them and the extensive research they have performed. Making investments by relying on the advice of strangers or as a result of minimal time invested in understanding underlying valuations and fundamentals is not much better than random speculation. As the past ten years have shown, such behavior is a fantastic way to lose money.
  2. When a market dynamic does not make sense fundamentally, that probably means the trend will not last: I think this is one of the most important takeaways from the numerous bubbles we have witnesses in the past decade. If you can’t understand the rational for specific trend or the fundamentals fly in the face of that trend, you have to believe that a severe reversal or correction is inevitable. On great example I remember of one such situation occurred in early 2008 with Martin Marietta Materials (MLM). With the stock trading well above $100 a share I continued to read sell side analyst reports touting the strength of the company’s aggregate reserves and resilient revenue stream. Unfortunately, at the time the US economy was going into the tank AND there was a huge supply of aggregates coming online over the next year. Not very bullish fundamentals for a company whose stock price depended on the price of aggregates. Predictably, the subsequent free fall in the US economy caused demand to decline dramatically at the same time the company had ramped up production. Despite the bullish predictions of sell side analysts the stock proceeded to go from close to $120 in September 2008 to just over $60 in November. Now, I have nothing against the company and have no opinion about the current stock price. But, at the time the gravity defying price of the stock did not make any sense based on the very obvious headwinds facing the company.

So, when you see zombie companies like Fannie, Freddie and AIG trading way up one day or notice their prices consistently climbing higher, keep in mind that if the reason for such activity completely confounds you, it is unlikely to be based on sustainable fundamentals.

  1. Sexy financial and economic models often fail to capture the idiosyncrasies of actual functioning markets: Honestly, I don’t think I can do this topic sufficient justice. If you need a refresher on why intricate models have failed so badly, check our Nassim Taleb’s recent testimony in front of Congress. Let’s just say that cute models look great on paper but when irrational people get involved, they often fail to predict how markets will react. You would think that the world would have figured this out when LTCM blew up and almost dragged all the banks down along with it. The sad thing is that companies continue to use flawed models like Value at Risk (VaR) to assess risk. Shouldn’t we have realized the models’ limits when David Viniar of Goldman Sachs admitted that the company was seeing 25 standard deviation events several days in a row? No, the world was not experiencing some tectonic shift that caused asset prices to do things that should happen once every 100,000 years. The models were just wrong and continuing to rely on them is only going to enhance the risk of an extreme tail event that would even make a black swan blush.
  2. When it becomes impossible to distinguish economic theory from religious theology, economists are likely to become blinded by their own beliefs: Why did so few economists see the financial crisis coming? Maybe they were too busy calling each other names to see the unsustainable debt levels and financial company excesses building up in plain sight. While the financial crisis has allowed the behavioral economists to gain deserved popularity, it is an indictment of the entire economics community that so many people who dismissed the rational actor fallacy were marginalized by the mainstream. Now, in spite of compelling conclusions about the way irrational people impact markets, somehow many neo-classical economists continue to hide behind their theories in a curious attempt to try to explain away the recent financial crisis.

Now on to the disciples of John Maynard Keynes. Could it be that the neo-Keynesians are so wedded to the belief that unlimited fiscal stimulus and deficit spending are the only paths back to sustained prosperity that they have lost sight of the risks of such profligacy? What if the Keynesian response to the recession was the correct reaction but the magnitude of the fiscal policy was far too strong and will eventually lead to some very unpleasant outcomes? With Keynes no longer alive but still deified by his followers, could the true believers even see it if they had it all wrong?

In my view, the constant bickering between the saltwater and freshwater economists and complete inability to see the to the other side of the argument (not to mention the absolute dismissal of the Austrian school’s tenets) seems more like an entrenched religious battle in which each side believes only one methodology can be right. Unfortunately, unlike arguments about the existence of god, market outcomes are not necessarily binary and the nuanced truth could lie in between economic theories. Thus, people who are willing to defend their position in the face of mountains of contrary evidence are likely to be so biased that they cannot be trusted to assess the state of the economy.

Even more concerning is this article in the Huffington Post that argues that the Fed effectively controls, monitors and censors what is published in economic journals. That’s the last thing the US needs: formerly autonomous and free thinking economists being controlled by the banking oligarchs who have a definite inflationary and Wall Street bias. We have already seen where that has gotten us and it is not pretty.

The conclusion that needs to be drawn about those who belong to what appears to be a very closed-minded and divided economic establishment in the US is that many have been compromised and may not be the most reliable evaluators of the past, present or future global economy.

  1. Leverage is miraculous on the way up and a killer on the way down: My favorite analogy regarding the risks of too much leverage comes from none other than Warren Buffett. Buffett likens carrying too much debt to driving a car with a dagger attached to the steering wheel pointed at your heart. Everything is fine until you hit a bump and that dagger goes right into your chest. Of course if you are lucky and there are no bumps for a while you can make an incredible return on your equity. However, eventually that bump in the road is going to come and smart companies and households never put themselves in a position to allow that bump to be life threatening. Further, there is some compelling data that suggests that financial bubbles are almost always driven by too much leverage. The good news is that by in large companies have solidified their balance sheets over the last two years and households are finally starting to deleverage a bit. Thus, at least in the private sector and among consumers, the dagger is slowly being pushed further away.

However, I do worry that there is one particular institution that has ignored the above lesson and has taken on far too much leverage. Who is that you ask? Why the US government of course. One risk is that something unexpected happens, the government is forced to print even more money, the deficit spirals out of control, and in the end the quality of life for all Americans is impacted. We are already fighting two wars, have thrown trillions into the financial markets, have huge Social Security and Medicare obligations and on top of all that have passed stimulus legislation in an attempt to prevent a depression. Therefore, we can ill afford any unexpected expenditures. Even now it is hard to imagine how the US will live up to all of its obligations. Let’s just hope that the economy improves, tax revenues come back, and our foreign creditors are somewhat appeased before we hit that next inevitable bump. If not, both equity and bond markets could be devastated by the fallout.

  1. Wall Street wins whether the economy prospers or fails and whether markets go up or down: This may sound like populist propaganda, but it is hard to argue that this is not precisely how the last few years played out. Yes, Lehman and Bear are gone and Merrill Lynch is now a part of Ken Lewis’s failed empire. There have clearly been a few losers in the aftermath of the dramatic financial crisis. But, in aggregate, Wall Street has not only survived, but has also prospered immensely at the expense of American taxpayers and businesses. Expected record bonuses this year are only icing on the cake. When many Americans spent this Christmas wondering if they were going to lose their jobs or whether they will be able to feed their families, I’m sure many on Wall Street enjoyed a very comfortable holiday. If this seems unjust given the fact that without government assistance many firms might not exist anymore, that’s because it unequivocally is.

At the center of all of this (but not alone) is Goldman Sachs. First, Matt Taibbi documented the success of Goldman in up and down markets in his July 2009 piece. Then, just before Christmas Gretchen Morgenson alerted the masses to what the investment community already knew: Goldman consistently bet against the same clients it was selling dodgy assets to. Don’t forget that despite unemployment rising above 10% Goldman somehow managed to only lose money on trading on one singular day in the 3rd quarter of this year. If a baseball player batted .900 or higher for 3 straight months he would quickly be crowned the greatest hitter who has ever played the game. But when Goldman accomplishes a similar feat in what used to be a zero sum game, we don’t even blink anymore.

What all of this means is that through their political connections and too big to fail status, Wall Street firms are just about guaranteed to receive favorable treatment relative to the rest of us no matter how well or how poorly the economy is doing. Thus, investors who short these firms are at the mercy of the actions of a Fed and Treasury that do very little to protect against moral hazard. In fact, at a certain point, regardless of the dubious activities such as high frequency trading and so called trade huddles, it almost makes sense for investors to give in any say, “if you can’t beat ‘em, join ‘em.” Well, I said almost.

  1. The most dangerous words in investing are “this time is different” but this economic cycle in the US may really and truly be different than the recent ones: The book by Carmen Reinhart and Ken Rogoff entitled This Time is Different is on my seemingly endless reading list but I have yet to get to it. But, from the reviews and commentary I have read, the authors do a great job analyzing past boom and bust cycles and disproving the notion that individual situations are different and thus certain countries can avoid experiencing the devastating and enduring impacts of financial crises. The title of the book is obviously ironic in that the authors show that there are common factors that cause financial debacles. Surprisingly, people make the same mistakes over and over again under the false premise that their own personal or country-specific circumstances will allow for a different outcome than others have experienced. Inevitably, such beliefs end in tears.

What does this have to do with the current economic and fiscal situation the US finds itself in? Everything. First off, the duo provides lessons about governments accumulating too much debt and pinpoints what leads to sovereign defaults. Second, if the US is following the same path as Japan (as the authors assert) in terms of dealing with the insolvent banking system, why should we expect a different outcome? These are just two of the topics addressed in the book that give investors a way to understand the risks associated with investing in government debt and bank stocks, for example.

In the end, my real worry is that the title of the book has a double meaning. While financial crises and the associated lasting effects on economies may be similar, I am concerned that many policy makers are viewing this downturn as if it were a typical inventory recession that can be cured by low interest rates and some targeted government stimulus. I fear that it may be that this recession is actually different from ones like the post-September 11th slump. Accordingly, if Reinhart and Rogoff are right and this financial crisis is going to play out like others have around the globe, the template suggests that the US’s experience this time may be dramatically different from other recent domestic recessions. What that could mean for investors is a long slog of mediocre GDP growth and substandard returns on equities as the powers that be prolong making the tough choices needed to purge the system of debt and get back to fiscal sanity.

(Picture courtesy of