Category Archives: Investing

Following Bunk Moreland on Gold, Monetary Policy

There is something about monetary policy that drives significant portions of the investing populace insane. As a guess, it’s possible that the physical act of printing dollar bills, and the virtual act of money creation in the banking sector, is enough like magic to tap into the medieval part of the brain to generate the “BERNANKE’S IN LEAGUE WITH LUCIFER!” reaction so common from those compelled to comment on any story involving aggregate liquidity.

People done digging dog face in the banana patch. I can safely write sentences like that because half of this post’s readers have already closed their web browsers and have started composing 2500 word responses to paragraph one. They will marvel at how I can be flip about an issue that is clearly at the core of our democracy. My answer is: I don’t care. Yet.

The simple fact is that for the next week and next month, the value of global currencies will be largely determined by cross-border asset flows. Political news from Southern Europe will be offset by ECB transfers to maintain bank liquidity levels. As with the yen and the yuan, these are policy questions not theological ones. The veracity of MMT theory or the “hocus pocus” of fiat currency will not enter into it. The believers being fully invested already and any notion of intrinsic value being tossed out the window already, gold will rise or fall based on sentiment and technicals. Again, I don’t care. Yet.

Bunk on Money

The forces of hipsterdom have decreed that any discussion of The Wire as the greatest show in broadcast history are cliche. Nonetheless, I am still following the advice inherent in Bunk Moreland’s  Season 5 admonition to McNultey with respect to monetary theory, “That will teach you to give a fuck when it ain’t your turn to give a fuck”. Until bond yields move in some inexplicable degree in one direction, or any signs of a 70s wage/price spiral pop up, monetary theory will have little or no effect on my investing decision making. If either of those things do happen, however, Mosler is going to make some money off me, along with a giant host of other published experts.

Fidelity and Predicting Currency Values

In the mid to late 1990s the consensus economic view was that the US dollar was significantly over-valued, by between 20% and 40% depending on the year and measuring device. At the time, Fidelity Investments built a decent-sized team of macro specialists looking to “add alpha” to the company’s then-famously index hugging portfolios by predicting changes in global currency values. The team was disbanded in five years not due to lack of effort or expertise, but because global currencies trade with complete disregard to economic fundamentals for years at a time. These were all experts in the field, remember, and although I never saw CVs, since we’re talking Fidelity there’s a 98% chance that all of them came from extra-fancy Ivy League schools. They were not, in other words, retail investors attempting to benefit from reading a couple books from the non-fiction bin at Barnes and Noble published by the Smith and Wesson Literary Fund. For me, the primary lesson from this parable is that currencies are not predictable.

Knowing What You Don’t Know

Knowing that you don’t know is among the most important aspects of investing, for both professional and non-pro investors. The most financially dangerous response to an information vacuum is to reach desperately for a framework that makes things intelligible. It is particularly dangerous to grab at one that just happens to fit your personal politically ideology. (Your most vicious associates will brand you an economist if you do this too often).

Take it for what its worth, but my advice would be to watch and consider. Read Cullen Roche on MMT. Watch the exchanges between Senator Paul and the Fed Chairman. Look for signs and accept those that are contradictory to your current understanding. Don’t, in other words, paint yourself into an ideological cul-de-sac that may cost you a lot of money to climb out of. It is time to learn, but there will be plenty of opportunity to become a believer when its time to give a fuck.

The Rules: Interloper Adjusts to Investing as an Outsider

Fifteen years ago if a retail investor, even a giant one, needed to know a PE ratio they had to call their broker. In essence, this was the value proposition of the brokerage industry – they were the ones with the information investors needed, and charged accordingly. In many ways the advice business remains structured around this outdated concept despite its obsolescence, and Josh Brown has gone to great pains to explain why this is so.

The ubiquity of online data and opinion has completely reshaped investor requirements. The base facts are completely commoditized and what is now necessary is prioritization and context, someone to advise on which data points matter most at any given time. This thought formed the underpinning of most of the initiatives at my previous position – I spent less time attempting to reinvent the financial wheel and more in organizing available facts into plausible narratives. Importantly, I was doing this for everybody, which entailed that at any given time there were five or six often-contradictory scenarios to maintain. If I were just doing this for my PA, I could pick the most plausible projection and just follow that.

Which brings us to now. Whereas before I would add newly released data to existing spreadsheets tracking trend projections now there is so little truly important data available (i.e. CDS quotes) that attempting to cobble together a spreadsheet is not worth the time and effort. Furthermore, there are none of those quick chats with analysts to tease out the details unpublished in for research reports. (Analysts are constrained – not idiots. They know lots of stuff that can’t, or won’t print). I am, in effect, now an Outsider little different from diligent retail investors and this has changed my investment style completely. I’ve organized the general changes in methodology into three rules, which reflect my own experience and are not meant to be exhaustive:

Outsider Investor Rule 1: You need to have a view. There is no way, as an Outsider, to adequately follow even five or six potential market outlooks with enough depth to make their conclusions worth risking your cash. A flexible economic/market outlook makes the sorting process of new developments a binary operation – fits or does not fit. Investors without a plausible scenario in mind may feel more open-minded, but are also more likely to sell copper miners on a weak durable goods number and buy them back on stronger NFP. Without a view, in other words, new data is not organizable into a usable context for investment decisions.

None of this is to suggest blind adherence to an uncertain set of predictions. The “does not fit” column has to be maintained, if anything more diligently than the “does fit” to prevent losses.

Outsider Rule #2: Secular over Cyclical. Reducing economic sensitivity in a portfolio can drastically reduce portfolio risk and the labor involved in investment decisions. Investors in construction equipment, for instance, will be forced to white knuckle every dubious Chinese economic data report for the foreseeable future, three or four times per month. There are, however, investable trends that will happen, at varying speeds, regardless of the economy. The average age of the developed world population will rise in complete disregard to global industrial production levels. Mobile data transmission will increase by 100% or so for at least the next five years.

Investing in secular trends is not necessarily easier, but it does reduce the number of variables to be considered. Biotechnology companies, as a notable example of a counter-cyclical sector, are beset by competitive and regulatory pressures and are not guaranteed outsized returns. But, the same is true of cyclical companies to some extent and unlike them, the value of biotech stocks do not hop around by three or four percent every morning at 8:30. Orthopedic stocks, as another counter-cyclical case from health care, are inexplicably twitchy but there are few plausible scenarios under which demographic-based end demand will not provide a fertile backdrop. For cyclical sectors, a 1997-like growth hiccough in China would place an open manhole in front of shareholders.

The risk/return trade-off does dictate that investors following rule #2 to the letter are limiting potential returns generated by a global economic recovery. All portfolios should have some economic growth exposure, but the amount should be roughly inversely correlated to how much time is available for research and general obsessing over existing holdings.

Outsider Investor Rule #3: Know Your Limitations. The proliferation of ETFs has proven an effective tool to avoid specific company risk through diversification. In the end however, time-constrained Outsiders must consistently be aware that they do not have time to fully understand the whys and wherefores of their portfolio performance. Unexpected things, bad things, will happen that we never see coming. Conversely, we are likely to trail the index for significant periods of time because we “missed” something. Outsider psychological well being, I think, is dependent more on the acceptance of this fact than any other. To fight it is to open the door to a “headless chicken” investment style that is more likely to buy a yacht for your broker than yourself.

In Wall Street, Gekko reinforces the stereotypically aggressive, chest-thumping characteristics of finance by having Bud read “Art of War”. The book still comes comes up, although references are usually limited to the “manly men” strategies on how to destroy opponents. For Outsider investors, however, the best advice comes at the beginning:

 It is said that if you know your enemies and know yourself, you will not be imperiled in a hundred battles; if you do not know your enemies but do know yourself, you will win one and lose one; if you do not know your enemies nor yourself, you will be imperiled in every single battle.

Or, to paraphrase another timeless classic: The first rule of Outsider is to recognize that you’re an Outsider.


Personal note: I’m getting very close to a new position, just awaiting a contract. Its an amazing initiative and, for those few people worried about it, should mean more available Interloper writing rather than less, although under my real name. If anyone’s seen an “Idiot’s Guide to Un-anonymizing Yourself” I’d appreciate it if they could point it out.

Interloper: End of Chapter One

True to the pervasive obsessiveness of financial industry employees, I wrote a list of topics to cover with Interloper at the outset. This list, which was surprisingly unchanged as the months progressed, has now been covered.  Alarmingly, as a result of this, the last posts began to exhibit the two temptations that, in the beginning, I swore I would never succumb to – beating on near-dead rhetorical horses (the industry in playing on your imperfect psychology) and attempting to wring pearls of wisdom out of the work of others (notably Epicurean Dealmaker for some reason).

The urge to write combined with a lack of anything new to say is a time-honored recipe for masturbatory crap, so its definitely time for a hiatus. There are also practical reasons for this – I still need to find employment to take some pressure off Mrs. Interloper, who desperately needs a vacation.  Writing blog posts and hitting F5 every 90 seconds is not conducive to a sustained effort in that regard.

At the risk of going all Altucher on the people nice enough to read this, I want to also explicate a strange emotional risk that also informs the decision to take a few weeks off from blogging. I couldn’t, first of all, be happier with the way things turned out for Interloper and the five-or-so people most deserving of gratitude for this know who they are. Having readers focus on your opinions, and occasionally agree with them, has been incredibly rewarding. At the same time it also gives birth, for me at least, to an unhealthy ambition for further recognition – what was an initial, highly gratifying surprise morphs into a weird existential need. Twice during the past two weeks (and this is truly embarrassing) I’ve been on the verge of picking a fight with another blogger only to discover, with a modicum of introspection, that the root cause for the impulse was a desire for attention. Acting on this would have disqualified me from ever calling out anyone else’s behavior as infantile which, as it happens, is one of my favorite things in life.

End of therapy session. I’m not done; I just need time to make a new list. Hopefully the few very nice emailers asking what was up with the lack of writing now have some idea.

To end Interloper: chapter 1, I’ve re-framed the issues covered to date into three broad industry/investing tenets as follows:

Cui bono: Whenever you’re confused about anything involving the finance industry, look to how it benefits the investment banking department. If, for example, analysts from three large BDs all raise ratings and targets on the same stock that hasn’t moved in 5 years, first assess the potential for an M&A transaction or secondary offering.

Don’t trust your gut: The industry knows your brain better than you do, how to appeal to its less rational, emotional elements. Going with a gut feeling and winning is undoubtedly exhilarating and you’ll want to do it again. This is, however, the same thought process that built Vegas. The corollary is to be very careful when you see what you want, or expected to see. Try and practice thinking like other, successful investors with a different style, if only as a test drive.

The finance industry has its own interests, not yours, first: View every research report and every speaker on business television with the same skepticism you’d bring to Super Bowl commercials. This is not inherently cynical – good products need advertising almost as much as bad products. But don’t expect full disclosure.




End of chapter 1

Epicurean Dealmaker Explains Banking’s Role in Asset Bubbles Without Trying

This blog has no consistent mission statement or goal and hopefully will stay that way, outlining both the problems with the finance industry and the inconsistencies with anti-finance arguments. At the same time, it became apparent during the first month of writing that there existed a large body of content in a gray area consisting of things everyone within finance believes are unarguably true, but even reporters that have been covering the industry for 20 years do not. As an example, the fact that the industry is designed as structure to generate transactions, with all of the media appearances and research reports functioning as a Marketing Department roughly analogous to that at Frito-Lay, remains hidden from most investors and commentators.

That is all to preface a terrific post by The Epicurean Dealmaker (TED) over the weekend which, in 500 words, blithely defenestrates a well-intentioned academic study attempting to link CEO pay to risky management decisions. TED’s point is that CEO pay is largely irrelevant to the discussion. The real question is how much commission revenue was generated by department heads, a number that frequently exceeds CEO annual pay, and whether this formed a catalyst for risk-ignoring behavior. In my experience, it definitely does.

I want to extend the argument a bit further to propose that investment bank revenue is a net position of between 10-20 smaller “bubbles”, for lack of a better term, composed of each component of Capital Markets. Each sub-department of an investment bank – Equity Trading, Equity Sales, Investment Banking, Bond Trading, Structured Products, Prime Brokerage, Prop Desks etc –  forms one of these components.

To backtrack briefly, one of my former global investment bank employers used Revenue per Employee as the primary measuring stick for departmental budgeting, and at first this seemed a remarkably unsophisticated, blunt tool. Over time, however, it became apparent that the system had one extremely profitable outcome – it got human assets into areas with rising revenues and profits extremely quickly. (The other interesting side effect is that by not distinguishing by salary – an admin counted against you equally to a higher-salary skilled person – it kept the number of support staff to a minimum.). At any given time, staff and budget were being removed from departments with declining revenue and added to those with rising activity.

It is very rare for all departments within Capital Markets do be doing well at the same time, and this is the primary source of bonus time animosity and a vicious form of political skullduggery that would make the Tea Party look like, umm , a tea party. . The multi-gazillionaire Masters of the Universe bond traders of the late 80s were the miserable also-rans of the mid-90s. The Structured Product departments that were a major driver of profits starting ten years ago are doubtless shrinking rapidly as I type along with the death of the CDO market. The profitability of the investment bank operations overall, and thus CEO pay, is the net position of the success or decline of each department.

TED more or less covered this, only written better.  The part I want to emphasize though, is the way in which all of this structurally encourages asset bubbles. Because, if CEO pay is based on the net profits from all departments, the commission revenue from each separate department is clearly not. Remember that finance generates revenue primarily through the number and size of transactions, not successful investments or the course of markets. The key point here is that nothing generates transactions like asset bubbles. The more money that comes in, the more commission is generated, the more staff get allocated, the more product/ideas get generated, the more money all of those staff make in bonus.  The big money attracts big talent, people eminently able to invent new ways to exploit the trend.

Importantly, this hypothetical department is generally not exposed to a potential bubble’s inevitable collapse, outside of lower commission revenue and staff cuts, so they will wring every ounce out of that bubble they possibly can. After all, market tops are notoriously hard to call and Soros himself has noted, through his Theory of Reflexivity, that all bubbles go on much longer than anyone thinks possible.  We’ll jump off that bridge when we get to it – the legal department can take care of the lawsuits down the road. The department head, who might have made $10s of millions over the course of the rally, could likely care less about getting fired after all is said and done if it makes management happy.

So TED is entirely right – the place to look for excessively risky decisions is not the CEO, who is responsible for overall profits and cleaning up any mess than results from excess bubble stoking, but the individual commission-incentivized departments generating the highest profits.  Risk Management is essentially the process of standing on the tracks in front of the money train which is, to say the least, a politically unenviable position in any organization. For regulators, always fighting the last war, by the time they even start sorting out the whos and whys and where all the money went, the bubble has moved to a new department. Current candidates for this phenomenon include the lending operations under ETFs and funky methods for I-bankers to raise capital for banks ahead of Basel III deadlines.

I suspect that, although the process described above is Fisher-Price elemental for any finance employee with rudimentary observational skills, it will come as a surprise to many outsiders as an example of the Interloper “gray area”.  The interesting question for me is, given the literally thousands of reporters and commentators on the financial industry, why this remains so.


Mister, I Don’t Sell to Fish

Charlie Munger’s reticence to speak publicly is a grave disappointment because he’s proven adept with wonderfully entertaining and enlightening anecdotes like this:

I think the reason why we got into such idiocy in investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, “My God, they’re purple and green. Do fish really take these lures?” And he said, “Mister, I don’t sell to fish.”

The metaphor of investing opportunities as fishing lures works better than its more popular “market as casino” counterpart on a number of levels, most notably with respect to the initial confusion regarding who the fish really are.  The fishing lure salesman is only concerned with whether his product works to the extent that it affects repeat business and investment banks are no different. For the salesman, he would rather his product perform well, but would be perfectly happy with a world where everyone bought tackle, went fishing and nobody caught anything. The corollary for investment banks is that a world in which everyone keeps trading even though they all lose money would be perfectly fine and massively profitable.

In the real world, selling lures that don’t attract fish and selling trade ideas that always lose money would be, at best, a short-term operation. Both cases, however, imply the same subtle manipulation of its clients. The fishing lures are purple to attract fisherman, not fish and “actionable ideas” are designed to attract investors, not necessarily investment returns.  Anyone attempting to deny the finance industry’s success at this should just check the performance of the average IPO, even (and maybe especially) the massively over-subscribed ones.

The extent to which investment banks are exposed to the performance of the products they sell is massively misunderstood. This is highlighted by a commenter responding to the Interloper post “Why Anyone Not at Their Desks by 7:30 is a Nobody” who, objecting (understandably) to the aggressive tone of the piece writes:

You people work all these hours and you and your clients still can’t beat the markets

It’s a completely fair and verifiable observation. Understanding the answer is contingent on the realization that, for the investment bank, the success or failure of trade ideas and research reports is primarily determined by how much trade and commission it generated, not how much the asset appreciated. This is how target prices keep getting published when they are so often wrong. In other words, it is a matter of how many fishing lures were sold, not how may small mouth bass were caught in the end.

For the purposes of explaining the point, I have presented a more cynical depiction than actually exists in practice. The market is involved here, and fishing lures that work best in the river are much more likely to generate the highest sales and profits. Over time, trial and error by fisher, um people, and investors will mitigate the negative effects of the vendors’ partial conflicts of interest. In the financial world, however, we still have experienced investors trampling over each other to participate in deals like the Groupon IPO where history clearly indicated that the chances of short-term success were low, falling for projected growth and profitability levels that were very much analogous to the florescent purple paint on Munger’s lures.

European Debt Issues Test Investors’ Twitter-shrunk Attention Spans

How would you feel about your property value if there were a growing fire destroying an entire block of houses two miles away? Sure, it’s a little smoky when the wind blows the wrong way but you just slapped on a fresh coat of paint. Someone’s going to put the fire out, right?

The European sovereign debt/banking crisis is the fire for US investors at the moment and investors’ attempts to change focus to more positive thoughts – the ADP report this morning is the latest example –  have been continually thwarted by events.  Traders are increasingly banging their heads on the desk after another series of “false break-outs” as Italian bond yields play hopscotch with the 7% level. As the 2011 S&P 500 non-performance clearly showed, we’re stuck.

The thing is, we’re not good at this anymore. Trained by immediate, excessive news flow our collective attention spans have shrunk to the time it takes to read 140 characters. Large research reports? Forget it – if its important FT Alphaville, Felix Salmon or Megan McArdle will summarize it for us into a neat 500 word post. Next.  KardashianNFLPlayoffsADPKimJongIlIranNuclearWeaponsObamaSucksRatigan’sNewBookGorillaLooseatMall. Beer. Eat. Nap. Jon Stewart. Sleep. New day – new story, please. Oh, and if someone could just fix Europe for me overnight, so I can go back to safely piling money into the market on new economic data and attractive technical set-ups, that would be terrific.

The starting date is arguable but the origins of current developed market debt problems are at least 20 years old – 1982 and 1994 are the two most-cited start dates – which implies that expecting a quick solution is unreasonable, whether our modern attention spans can handle it or not. Even if the ECB kicks the can down the road by printing (the most likely eventual outcome from all I’ve read), there is still the issue of Basel III-related forced bank recapitalization, as Unicredit was nice enough to remind us of yesterday.

The “Wall of Worry” remains a helpful metaphor and it is entirely possible that the global economy “muddles through” the host of hurdles before it. It is also likely, however, that the investor contrarian reflex to buy dips, or whenever sentiment is poor, will be a perilously unproductive one if its primary basis is boredom with yesterday’s negative news. In order to understand complicated credit issues that are a) almost unfathomably enormous if we include the shadow assets and b) decades in the making, we will probably need to learn more, maybe finish a few of those large research reports, and act less. Waiting for a bottom, when the fire is either truly out or at least shrinking towards embers, may take considerably more discipline than the era of the Great Moderation has trained us for.

Consultants, Fear and Portfolio Manager Incentives

In the late 90s, I lived in a big house with four other guys, only one of whom was in finance. One, I’ll call him Rob, was in business consulting. Rob was a recent graduate of one of the world’s top engineering schools, not CalTech or MIT, but always mentioned among them. As a Microwave Engineer he had perfect timing, this being the late 90s during the great information highway build out. His company flew him all over the country and charged $500 an hour for his work plus expenses, the latter including funds to fly home every weekend which, if he didn’t use, he kept (got a nice set of golf clubs for working one weekend).

His biggest project during the period was a TMT company that had been falling behind technologically and wanted advice as to future investment and restructuring. Rob, bulldog that he was, worked 14 hours per day analyzing, interviewing and studying the competition for, if memory serves, about 10 weeks. His conclusion was that the company was unlikely to catch-up in terms of novel technology and profitability would be much better served by “sticking to their knitting” or historical core competency.

The way Rob described it, the process for these things was for him to take his giant binder of full color charts and graphs, the fruits of his expertise and hundreds of hours of effort, and present it to a partner at his firm. The partner, in turn, would present the conclusions to corporate management. After this meeting took place, the partner’s reaction was something along the lines of “ This is excellent work, but I can’t tell them this. There would be no more business in it for us”.  In the end, the partner took three graphs from the binder, and built the rest of his presentation to management out of in-house material outlining the future riches available through mass investment in the wonders of new technology.

Thankfully, I have only had passing contact with management consultants; usually they were calling me for insight after winning a new contract (for free – this pissed me off no end). I have no idea if this story is an outlier or if it is indicative of a bubble environment that has changed since.  I have had, on the other hand, extensive experience with pension consultants. Some, I’ll mention Northern Trust here, are actually very good. Others show all the hallmarks of Rob’s old partner.

In discussing pension consultants, the key is to recognize that the incentives for pension managers are, with few exceptions, very, very different than for the average investor. Investors are afraid to lose money; pension managers are terrified of underperforming the benchmark. Underperforming the benchmark gets you fired. Following the benchmark lower during a bad year is not notable. Beating the index by a wide margin is usually considered a very bad thing, indicative of risk (they still focus on standard deviation, although will provide 90 pages of other stuff) that could, the following year, result in underperformance of the benchmark. Which will get you fired.

The levels of complexity built into the simple “don’t trail the benchmark, ” rules are unbelievable. There are 25, slightly different terms for index hugging – Information Ratio, Tracking Error, Style Drift* – that turn common sense into particle physics. The creation of “appropriate” benchmarks is, of course, the sole purview of Nobel Prize winners. This isn’t the Paleolithic era – you can’t use 60-30-10! If it weren’t crazy complicated, why would you need a consultant? Of course you need to know about the complicated private real estate transactions the endowments are doing and, for a fee, we can tell you how to do it yourself!

Business and pension consultants make a fuckton of money playing on their clients’ fears of being fired. Consulting companies have armies of brilliant, well paid dudes and lady dudes like my friend Rob who constantly derive new insights for the partners to manipulate into pitches for new business. But in almost every case I’ve seen, consultants are hired to tell managers and management things they already know, the hope being that the shiny new report will give them the backing they need to do things they already know they need to do. The (usually inevitable) failure to implement the strategy results in a new round of consultancy. And so it goes, round and round, proving again that fear trumps intelligence whenever big sums of money are involved.


*”Style Drift” is an awesome, all-purpose weapon for messing with the heads of PMs. If, for example, I were looking to get my way on any question regarding a value versus growth fund, I would just move utility, bank and pipeline stocks between value and growth benchmarks. I’d have good reasons, too – see Appendix 9 for methodology.

Interloper’s Best Reads of 2011

Attempting to drink from the financial information fire hydrant is more or less a necessity for investors at this point, despite the numerous counter-productive side effects the practice entails.  One of the larger issues involved is one of prioritization in that the daily onslaught of noise-ridden details makes an assessment of yesterday’s opinion difficult. Wave after wave of advice and opinion keep coming at us, paradoxically leaving no time to learn anything from it. To paraphrase the great John Wooden, we are confusing activity with achievement.

In highlighting my favorite blog posts from 2011, I want to focus on those with persistent benefit rather than outline successful trading ideas or strategies that may or may not be useful in the next twelve months. (I will, for future reference, point out that Richard Bernstein again justified my ongoing adulation – see HERE.) The danger as always is to select articles because they reaffirm what I already believe, which would make this post merely an excellent example of confirmation bias. I hope I have avoided this pitfall, but look for readers to call me out.

Psy-Fi: The Proper Etiquette for Market Panics.    The consistently-awesome Psy-Fi Blog more or less lays out exactly why investors do what they do, why its wrong, and how to fix it.  In a market environment where returns are generated almost solely by arbing the market’s emotional overshoots, it is difficult to think of a more productive blog to read than this one. Thee were numerous candidates for applause among Psy-Fi content in 2011 but this one stood out for its “man bites dog” argument surrounding volatility. The key bit:

all the sensible indicators like whether economies are actually doing well or badly and whether companies are more or less profitable don’t always matter very much when markets go mad. Often it really does seem to be a matter of psychology rather than financial fundamentals.

However, a nice piece of research by Dion Harmon and colleagues entitled Predicting Economic Crises Using Measures of Collective Panics attempts to do exactly what it says on the label. Now, generally economists have studied volatility, the rate of change of stock price movements, as a way of investigating behaviour during market crashes. However, volatility doesn’t appear to predict crashes:

“Studies find that, on average, volatility increases following price declines, but do not show higher volatility is followed by price declines.”


The implications of the conclusion, essentially that volatility is a lagging indicator, are wide reaching, not least because we can now forget about the Vix as a predictor of anything.  If the study is accurate, the phrase “I’m not buying until the Vix goes below 30” will become a historical artifact.


Felix Salmon:  The growing crisis of institutional legitimacy . Reuters’ most visible online voice details a longer term issue that scares the bejeebers out of me:

on this side of the pond we have Rick Perry — harbinger and prime example of the way in which mistrust in federal institutions has moved from the fringe to the mainstream. Indeed, what we see with Perry is far more than mistrust — he actually denies most federal institutions their existential legitimacy, and has written a book explaining at length how everything from Social Security to federal bank regulation is in fact unconstitutional.

When Perry accuses Ben Bernanke of treachery and treason, his violent rhetoric (“we would treat him pretty ugly down in Texas”) is scary in itself. But we shouldn’t let that obscure Perry’s substantive message — that neither Bernanke nor the Fed really deserve to exist, to control the US money supply, and to work towards a dual mandate of price stability and full employment.

No matter what your political affiliation or financial caste, a complete breakdown in institutional trust will not be welcome. It should also be noted that anti-institution pressure is coming from both ends of the political spectrum – OWS hates big banks, Ron Paul wants to get rid of the Fed. It is certainly not my contention that every institution that currently exists should be maintained, but this urge this urge to tear everything down, as an extension of the ongoing infantilization of public discourse, is a process that can run out of control. (I attempted to cover the technology aspect of this, and the echoes of the violent Protestant Reformation HERE. Warning: its among my most disjointed performances).


Interfluidity: Why is finance so complex?: Some essays are so good they represent an intellectual punch to the face, necessitating the equivalent of a “standing eight count” of ponderation.  One of the undercurrents of Interloper to date has been an effort to illustrate the ways in which the industry subtly misleads its clients, with the intention that more transparency will allow for more investor wealth creation. Waldman turn this on its head by suggesting that hiding risk from investors is one of the primary, and overall economically

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Cop Logic for 2012

The book where I first read the phrase “Cop Logic” is lost to memory, but the concept stuck. A modern form of Occam’s Razor,  the process of cop logic states that when uncovering the violent death of a housewife in her home, and finding out that the ne’er do well husband is missing, it doesn’t make any sense to think up any scenarios beyond the husband’s guilt until he is found and questioned. Process must still be followed, but experience dictates a 95% probability the husband did it, and its best not to get distracted until that possibility is investigated.

I want to thank mining and energy analysts for so clearly supporting the application of cop logic to investing for 2012. For eight years, analysts in the resource sector have, correctly for much of the period, touted Chinese industrial demand for the “tree grows to the sky” supercycle in their sector. Over the past two weeks, however, Chinese demand as a catalyst for investment has all but disappeared in favor of potential supply disruption – geopolitical concerns in Libya and Iran for oil, labor disruptions in South America for copper. To see this as a bad sign we only have to remember what happens on Criminal Minds when the defendant is forced by new information to change their alibi.

Cop logic clearly implies slower global economic growth for 2012. It is entirely probable that the European Union may be saved by ECB intervention, but I would not hazard a guess on this either way. What is evident, however, is that even if the Eurozone is preserved, massive austerity for southern Europe will be a precondition for the rescue effort. For investors there appears only two potential outcomes – a horrendous structural implosion or a preservation strategy for the current system that all-but guarantees painful economic reforms and deep recessions for Italy, Spain, and other member nations.  Cop logic says rising GDP growth for Europe as a whole is simply not in the cards without divine intervention.

Trade data, while notoriously inaccurate*, indicate that the Eurozone and the U.S. are roughly equal in size as destinations for Chinese exports.  A significant decline in European economic activity clearly implies a headwind for 2012 Chinese economic growth. Economists will correctly point out that China’s economy is less export-driven than most believe, much more sensitive to infrastructure and real estate development. Unfortunately, as professor Chovanec details HERE, the Chinese real estate bubble us currently imploding, taking the balance sheets of a number of regional governments with it.

Cop logic also has implications for Q4 corporate capex although here there may be a silver lining. As Oracle’s recent results indicate, global CFOs responded to the potential for a European economic disaster by suspending capital expenditure. This only makes sense – investing in expansion is risky enough with a strong global backdrop. Earnings season for Q4 is likely to uncover a significant drop in corporate spending across the globe, which will affect revenues for large swaths of the S&P 500, most notably in technology, media and industrials. However, this trend could be temporary and stock sell-offs in these sectors could provide buying opportunities as conditions stabilize.

The sell-side bias towards optimism makes it easy to predict a wholesale attempt at obfuscation for 2012, giving us page after page of reasons why companies are likely to “side-step” a global economic slowdown. As we can see above, the process has already started for resource stocks as the bullish rationale adapts to a new economic reality. We will be given ample reason to invest further in cyclical stocks despite the fact that slower global growth almost by definition ends the possibility of relative outperformance. For this reason, cop logic will be instrumental for investors this year.


*It is one thing that Apple products are considered imports from China – they are assembled there – although the profit stays in Cupertino. But the calculation of the value of exports is archaic. Boxes of, for instance, Windows 7.0 OS disks, are valued at something like $20 per pound at the shipyard.

Asset Price Deconstructionism: How Big is a Balloon?

French philosopher Jacque Derrida caused a plague revolution in literary circles that continues to inaffect academic circles to this day. Termed Deconstructionism, the theory proposed that in literature, and by extension painting and sculpture, there was no such thing as objective value. In short, the worth of a work of art could not be separated from the reader. If the audience determined that the poetry of William Blake, for example, had no relevance to their experience, then it was worthless no matter what anyone else thought. To the extent that deconstructionism led to a reassessment of the dominance of Dead White Males in history, it was entirely healthy. Its wholesale adoption in college English departments, on the other hand, is an ongoing disgrace. I have no problem believing that current IQ testing is inaccurate and unfair for inner city kids because of the context of the questions, but the second this thought leads to Hamlet being crap because a high school student “doesn’t get it”, I have to tap out.

A similar process of Deconstructionism is occurring in asset markets as most conceptions of objective equity and debt values are being tossed out the window.  The valuation of investment assets is, of course, a matter of debate. However, for the sake of argument let’s accept that most valuation techniques are variations on the primary theme that a “hard value” can be determined by the present value of future cash flows. This is a blog post and I’m not getting paid, so we’ll keep the discussion of correct discount rate simple, assuming  a blend of government rates.

This underlying assumption of this classical valuation technique was that the discount/interest rates were only peripherally related – the economy, as reflected by the discount rate, went a long way in determining the relative value of the cash flow stream of the investable asset. This is the relationship that’s been completely thrown on its head.  The Fed and the ECB are determining rate policy in response to credit, not economic conditions, arguably with the sole intention of boosting asset values. History will judge whether this is a good idea or not, but it is clear that rate policy is now largely disconnected from current economic activity. This in turn implies that the validity of current rate policy is arbitrary in the same way that Deconstructionists believe that the value of Shakespeare is arbitrary – dependent on the reaction of the audience or markets.

The preponderance of technical analysis in the current market is an important contributor to this phenomenon. Technicians eschew fundamental analysis in favor of careful measurement of short-term investor behavior. With reference to Graham’s belief that the market was (to paraphrase) “a voting machine in the short term and a weighing machine in the long term”, technicians are fully concentrated on the former. This is not to criticize technicians, far from it – during the past three years ignoring technicals has been a sure path to investor bankruptcy. But, the fact that the vast majority of current trading activity is determined by an investment philosophy that completely fades any concept of intrinsic or objective value, furthers the argument of this post – that the market is operating without the net of accurate asset price valuation.

To attempt to determine the “correct” value of an investable asset in the current market is to ask “how big is a balloon?”,  dependent on how much central bank air will be pumped into it.  The market today, in light of the ECB’s LTRO program is nuts – being in uncharted waters, I wouldn’t predict market disaster as any more probable than any other scenario. At some point though, equity and debt markets will have to settle into some form of homeostasis where future values are in some way predictable. Until then, we are just gambling on coin tosses and hoping for the best, living in a world where The Di Vinci Code can be considered our highest artistic achievement if enough people agree.


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