Rumpelstiltskin Economics
Some of the finest alchemy in the world is currently being transacted on Wall Street and in Congress, the Federal Reserve, and the banking system. Some of us thought that turning straw into gold was simply the stuff of fairy tales. Not any longer.
In distant times economists, politicians and capitalists argued that maintaining the purity of the capital markets was an empirical given, especially if trust and transparency were to be respected hallmarks of a free market.
The challenges within the credit markets today are the last gasp of that worthy goal. Today’s failures are the result of a breakdown in trust and transparency. And, evidently, professionalism, morals and competency. It goes beyond the pale to envision nationalizing our capital markets and making the taxpayer responsible (twice) for the poor judgment of speculators and collaborators who brought down the system’s psyche by their wanton greed and disrespect.
I am truly alarmed, in particular, that the bond market (once viewed as a bastion of safety) has turned its IOU’s (promises of repayment) into near-worthless pieces of paper and left you holding the bag. After all, weren’t bonds supposed to be a surrogate/alternative for the high risk equity markets?
When the Fed, or any government, injects itself into the bailout of risk markets they destroy a sense of equilibrium naturally found in uninterrupted markets. Distortions occur in valuing securities (like mortgages or stocks) which leads to longer recovery time and potential negative fallout in the future. This is not the first time an argument has been made for intervention. And yet I would argue, each capital infusion heightens the level of uncertainty in the market, not quell it. In addition, the agencies and officers responsible for the problem are deemed “blameless” because their money is not used to ameliorate the situation. Setting up a model in which business can “tap into” the treasury is deceitful and probably illegal, if not certainly morally bereft.
Shareholders should seek redress from the agents of their disaffection, not from you and me. And, indeed, they are “owed”, but perhaps only an explanation, not a full return of capital, for taking the risk in the first place.
Markets
Hybrid investments, synthetic alternatives, hedge funds and the like are concoctions designed to enrich their originators while promising to deliver returns to their investors. But make no mistake, Wall Street is in the money-making business and the public is their vehicle.
I would argue, as well, that the influence of technology and 24 hour media contributes to a sense that markets cannot be destructive because “we know all there is to know”. This sense of invulnerability permeates the investing public and makes them think that “it can’t happen to me”. Unfortunately, when the market declines, or home values recede, or unemployment happens it’s only representative of the natural evolution of parabolic economic cycles.
I believe, for example, that technology, today, can be a double-edged sword in the financial world because while we now have access to methodologies and alternative strategies that expand the scope of capital gains potential beyond traditional investing, those options also deteriorate the fundamentals of valuation that govern the underpinnings of asset classes. Additionally, the quality of humanism and morality cannot be replicated by black-box methodology or complex financial algorithms.
Finally, the problem with one-size-fits-all solutions is that they do not allow for regional or cultural nuance, or individual preference for risk/reward tolerance.
Wall Street has inflicted real losses in the last 6 months, some of which are financial, others are psychic and very painful.
The risk in financial markets is obviously not restricted to the United States. Bankruptcies are pervasive in many global arenas. The implication of further reverberation inhibits markets from raising capital or expanding their capital gains potential.
Balance sheets are suffering from lack of consumer demand and increased costs of raw materials, including energy. No one believes that the ripple-effect of one depreciating economy can be held at the border, and not felt within.
Borrowers are cash-strapped and the crisis endures. Regulators are either part of the problem or unsure about how to effect a solution.
Strategy
The difficulty of this whole mess is that it erodes investor confidence, the bulwark of any capital market. With portfolio values declining, home values diminishing and earning power falling behind, many investors are overcome by hopelessness and distrust. Goals and aspirations are becoming wiped out just like portfolios.
People have a right to be angry. But let’s realize that cycles are natural. Prudent portfolio methodology might have mitigated the impact of risk-taking by balancing aggression with conservative asset allocation strategies.
No one was complaining when the markets were expanding. Regulators looked the other way as long as the machine was functioning profitably. We all know, however, even from most recent experiences with technology and dot.com equities, that no trend endures indefinitely.
Portfolio returns have a built-in relevant range, I believe. No portfolio can exceed “maximum valuation’ or fall below “negative valuation”. This means that historical norms are guidelines for understanding the realm of portfolio probability potential. When tech stocks rose, then fell in the 1990’s, it was not the demise of technology as a fundamental tenet of secular growth. Rather it was a reversion to mean valuation and an expression of the excesses of speculation which preceded. In the 1980’s home values did the same thing, rising then falling, but eventually returned to a bull market status in subsequent decades.
Every asset class has a time, place, and quantifiable limit to its expansion. How do we know when and how much? I have tried, for example, by creating a proprietary tool to help answer these questions quantitatively, equating relationships between stocks sectors, regions, and macro events.
Conclusion
History helps determine the magnitude and amplitude of investment cycles, such that we might explain performance in terms of quotients and relative strength within these cycles. Whereas cycles are not limited by psychology or methodology, we can quantify their movements to determine optimal entry or exit strategies. Without attaching a value judgment to a stock or sector, we can measure the location of a financial security and its duration within its cycle. One never wants to stay too long at the party, so we use excess valuation as a trigger to sell securities or to rebalance the portfolio.
Simply knowing the course you are on and its location is better than not knowing at all, and wishing you had known. Reducing risk is sometimes a matter of having a science (methodology) and sticking to it.
As investors, we can choose either to be aggressive or risk averse. Those who understand the volatility involved with high risk investing accept those parameters. Those who choose a more conservative approach are less willing to be subject to the whims of market contingencies. In either case, though, returns are directly related to the type of risk one might be willing to take. And since “return” is generally what most investors are about, it is necessary to accept some risk in order to achieve the desired performance.
We can, however, modify risk, and enhance returns, through prudent asset allocation methodology, diversification, and statistical quotients that allow us to balance internal portfolio relationships to the overall market’s probabilities. In other words, we try to do more with less overall exposure to volatility.
In the context of today’s market, the lowering tide has taken down all boats in the harbor. But the equilibrium point is not “equal” for all asset classes. Out of the current mess, I believe a new secular bull in alternative energy, biopharmaceuticals, agriculture, environmental pollution control, infrastructure and technology (including telecommunications) will be the next areas of global opportunity, without borders and irrespective of market capitalization.
But I do caution that changing the discussion, the mindset of greed, and the culture will not be easy. A generation of techno-savvy investors hold strongly to the belief of a “new paradigm”. Consulting computers for solutions, and 24 hour business media for direction, they have lost a certain ability to authenticate their ideas with street-wise common sense.
I would argue, however, that machines infect the investment process by relying sometimes too much upon alchemy and synthetic solutions. The process is corrupt, not the objectives. Thus far, no one has sought to slow down the speeding train, or be the hero standing in front of it.
Market dysfunction sometimes creates a self-fulfilling prophecy. As we all might agree, no other system can replace what we have, but the one we have needs fixing and a better moral compass. I am confident that infusing our science with humanism is the correct first step towards dispelling the fairy tale whim of 2008.
Asset Allocation:
Equity 30%/Fixed Income 45%/Cash 25%
Monday, September 29, 2008
Friday, September 12, 2008
Market Commentary for the week of September 15, 2008
An Editorial:
I worry, sometimes, about the influence, or lack thereof, of morality in the drama of equity investment and speculation. It seems that in the thirty years I’ve been involved in the securities markets there has evolved a “new way” of analyzing credit, balance sheets, and fundamentals.
Each generation brings its own biases and experience to bear upon its collective professional ethos, but somehow we’ve deviated so far afield that speculation and aggressiveness have become this decade’s norm, while patience has been shunned aside.
New powers and statistics have been synthesized to justify a new alchemy of synthetic derivatives whose primary purpose, it seems to me, is to generate revenue for the issuing body first and returns for the client second. I am wary of the reputation this new “science” brings to my profession and the aftershock of cross-currents it creates in its wake. During a crisis in the markets like the kind we are now experiencing there is no historical paradigm for evaluating the valuations of these instruments, nor the depth of the carnage, should it occur.
Clearly, we are walking through new territory, which is what makes these crises so scary to the first-time, and long-time, investor.
I don’t have a direct solution for these afflictions, nor do I have enough space in this column to vet the details. But I do know that the unprecedented nature of these catastrophes (dot.com, real estate, commodities, etc.) is self imposed and not the effect of natural market continuums. They are brought about by generational shifts in morality that dictate speed versus carefulness, action versus inaction, greed versus compassion.
The unconventional nature of what is today called “alternative investments” is, by itself, unsettling because I don’t see the problem with traditional equity investments or non-leveraged debt. As much as we might try to reinvent the wheel, the challenge should be to perfect the wheel we already have.
I believe the criticism for these problems should be directed at the elders of our financial systems, not the young or inexperienced. Those who are charged with the oversight of rules, regulations, and policy should know better, particularly those who have the benefit of time and wisdom from prior experience.
Failing to act when you know that the consequences of that inaction might be harmful to the capital markets, or, even worse, participating in questionable transactions without fully understanding the ramifications is simply unjustifiable behavior, in my view.
As custodians of the public’s money, and trust, we must do a better job of balancing risk and maintaining a high level of consistency to our science.
Respectfully,
Scotty C. George
I worry, sometimes, about the influence, or lack thereof, of morality in the drama of equity investment and speculation. It seems that in the thirty years I’ve been involved in the securities markets there has evolved a “new way” of analyzing credit, balance sheets, and fundamentals.
Each generation brings its own biases and experience to bear upon its collective professional ethos, but somehow we’ve deviated so far afield that speculation and aggressiveness have become this decade’s norm, while patience has been shunned aside.
New powers and statistics have been synthesized to justify a new alchemy of synthetic derivatives whose primary purpose, it seems to me, is to generate revenue for the issuing body first and returns for the client second. I am wary of the reputation this new “science” brings to my profession and the aftershock of cross-currents it creates in its wake. During a crisis in the markets like the kind we are now experiencing there is no historical paradigm for evaluating the valuations of these instruments, nor the depth of the carnage, should it occur.
Clearly, we are walking through new territory, which is what makes these crises so scary to the first-time, and long-time, investor.
I don’t have a direct solution for these afflictions, nor do I have enough space in this column to vet the details. But I do know that the unprecedented nature of these catastrophes (dot.com, real estate, commodities, etc.) is self imposed and not the effect of natural market continuums. They are brought about by generational shifts in morality that dictate speed versus carefulness, action versus inaction, greed versus compassion.
The unconventional nature of what is today called “alternative investments” is, by itself, unsettling because I don’t see the problem with traditional equity investments or non-leveraged debt. As much as we might try to reinvent the wheel, the challenge should be to perfect the wheel we already have.
I believe the criticism for these problems should be directed at the elders of our financial systems, not the young or inexperienced. Those who are charged with the oversight of rules, regulations, and policy should know better, particularly those who have the benefit of time and wisdom from prior experience.
Failing to act when you know that the consequences of that inaction might be harmful to the capital markets, or, even worse, participating in questionable transactions without fully understanding the ramifications is simply unjustifiable behavior, in my view.
As custodians of the public’s money, and trust, we must do a better job of balancing risk and maintaining a high level of consistency to our science.
Respectfully,
Scotty C. George
Monday, September 8, 2008
Market Commentary for the week of September 8, 2008
Sometimes, euphemisms can be a clever way of delivering bad news if done with such gravitas that the listener thinks he’s hearing something important. Last week the market sunk dramatically, not fooled by reports that global productivity kicked up a notch. In my book, productivity is a catch-phrase for “you’re fired”. To be sure, unemployment spiked to a 5 year high last week.
I may catch flack from other economists and political scientists, some younger than me, who buy into the technological revolution and the advances made in manufacturing and business services by computers, structured work forces, and human resources management.
But let’s face facts. Getting people to produce more (output) while their contemporaries are being laid-off or while cost-cutting (wages) reduces overhead is the most inefficient way of boosting inventories, or profits, without having the company succumb to pressures later on to ameliorate its inefficiencies.
When is “profit” a dirty word?
Wall Street analysts know this. If, in fact, earnings are the barometer of a company’s health, then creating earnings off the backs of fewer laborers without increasing sales volume or piquing demand is a recipe for disaster in the capital markets.
Can fewer workers and cost controls produce greater efficiency? Absolutely. But the current data doesn’t support the enthusiasm about productivity increases as it should, definitionally. Labor rolls and wages are decreasing, and have been for at least half a decade.
Unit labor costs, while declining, have not shown a commensurate decline in inflation or prices. Therefore, fewer workers are working, but paying more for the goods they produce, in real currency terms.
Thus, the markets fell dramatically last week because earnings projections weakened in the face of rising costs. Broad indices worldwide contracted because in spite of all the “gains” in output, the economic data is moving in the opposite direction.
Consumer demand is stagnating significantly. Industrial producers, as well as consumer cyclicals, basic materials and technology companies are finding shallower markets to sell into.
Hold on a little longer.
The decline in global demand/consumption is taking its toll on the equities markets. Most strategists just simply chose to take money off the table last week, rather than to sit with depreciating assets. Declining issues outnumbered advances significantly.
Investors are paying the toll for this uncertainty. The bear persists and is dragging all sectors in its wake. The prevailing attitude amongst clients is to hunker down against the headwind and not to play the risk game for the time being.
Because the decline transcends regional/national boundaries, the concept of global bailout through commercial exchange has also been put to rest. Exports are limited by low demand and the vectors are not strong enough to support one region pulling all the others along for the ride.
I have said that we must weather through weeks like the one we just had. I hope that impatience doesn’t grow as quickly as, say, inflation.
I may catch flack from other economists and political scientists, some younger than me, who buy into the technological revolution and the advances made in manufacturing and business services by computers, structured work forces, and human resources management.
But let’s face facts. Getting people to produce more (output) while their contemporaries are being laid-off or while cost-cutting (wages) reduces overhead is the most inefficient way of boosting inventories, or profits, without having the company succumb to pressures later on to ameliorate its inefficiencies.
When is “profit” a dirty word?
Wall Street analysts know this. If, in fact, earnings are the barometer of a company’s health, then creating earnings off the backs of fewer laborers without increasing sales volume or piquing demand is a recipe for disaster in the capital markets.
Can fewer workers and cost controls produce greater efficiency? Absolutely. But the current data doesn’t support the enthusiasm about productivity increases as it should, definitionally. Labor rolls and wages are decreasing, and have been for at least half a decade.
Unit labor costs, while declining, have not shown a commensurate decline in inflation or prices. Therefore, fewer workers are working, but paying more for the goods they produce, in real currency terms.
Thus, the markets fell dramatically last week because earnings projections weakened in the face of rising costs. Broad indices worldwide contracted because in spite of all the “gains” in output, the economic data is moving in the opposite direction.
Consumer demand is stagnating significantly. Industrial producers, as well as consumer cyclicals, basic materials and technology companies are finding shallower markets to sell into.
Hold on a little longer.
The decline in global demand/consumption is taking its toll on the equities markets. Most strategists just simply chose to take money off the table last week, rather than to sit with depreciating assets. Declining issues outnumbered advances significantly.
Investors are paying the toll for this uncertainty. The bear persists and is dragging all sectors in its wake. The prevailing attitude amongst clients is to hunker down against the headwind and not to play the risk game for the time being.
Because the decline transcends regional/national boundaries, the concept of global bailout through commercial exchange has also been put to rest. Exports are limited by low demand and the vectors are not strong enough to support one region pulling all the others along for the ride.
I have said that we must weather through weeks like the one we just had. I hope that impatience doesn’t grow as quickly as, say, inflation.
Tuesday, September 2, 2008
Market Commentary for the week of September 2, 2008
October (?)
Although not the official end of the quarter, the Labor Day holiday in America is nevertheless a psychological hurdle, as if the end of Summer has come to pass, irrespective of the calendar. To that end, the markets seemed to be positioning themselves last week as if to rearrange like the end of a quarter. Indeed, three day holidays in a bear market are not a comfortable time to be “long”.
I find it always helpful to step back and look at the big picture rather than the “rearranging” for psychological comfort.
It looks, still, as if a global bear market is firmly established, even though some sectors show indications of intermediate bottoming and upwards acceleration (Financials, Telecoms). For the bear to end, we need closure on the root causes of price creep and inflation, and a longer period of downside deceleration within the bear. In other words, too few equities are showing signs of stabilizing and too few global baskets are in a condition of upside momentum.
Rather, nearly three-quarters of measurable financial instruments within my database are in a bear phase that initiated in 2007, and show no signs currently of having reached their nadir.
This is not to suggest that the end might be elusive or far away. I would argue that the magnitude and amplitude of the current bear indicate that we are closer to the end than the beginning of the contraction. Think about it. If the origin of the bear was immediately after the zenith in stock relative strength quotients in July of 2007, then today we find ourselves in the midst of a mess, to be sure, but farther from its original starting point and maximum potential for negative direction.
Calm down.
Is this comforting? Not really. Because like the long car-journey with kids in the backseat asking “are we there yet?”, it’s not going to be comfortable until we reach the end of the journey. And unfortunately, quantitative science can only identify the inflection point of a turnaround after it has been achieved. Whereas we can predict a range of time and values around which the reversal might occur (when relative strength empties to its maximum), the actual values are expressed only as a range of possible quotients. The caution therefore is that one should never play at the margins when stocks are at their greatest strength (“it’ll never end”) or when despair seems its greatest (“I won’t buy any stocks here”).
One must follow the prevailing trend and play within it to maximize profit potential.
You know the score.
So much of this boils down to common sense, anyway. Computer models and scientific methodology are only as good as the information given them, and the efficiency of their ability to produce results.
Sometimes, capital gains is not the only result sought, because later on imbalances might occur. That is why different methodologies or mutual funds appear “hot” for certain time frames.
But ultimately, I believe the key to market analysis is consistency through all phases of economic travails. Nobody can forecast the exact entry or exit inflection points of ownership of financial securities (real estate, gold, equities, bonds, etc.). Therefore, intuition and balance should be considered desirable objectives.
There are enough negative influences today to dissuade anyone from taking a chance on the market. I, instead, prefer to focus upon the search for potential positive outcomes.
The final quarter might be scary, if you let it be, or fertile soil for the next leg upwards.
Although not the official end of the quarter, the Labor Day holiday in America is nevertheless a psychological hurdle, as if the end of Summer has come to pass, irrespective of the calendar. To that end, the markets seemed to be positioning themselves last week as if to rearrange like the end of a quarter. Indeed, three day holidays in a bear market are not a comfortable time to be “long”.
I find it always helpful to step back and look at the big picture rather than the “rearranging” for psychological comfort.
It looks, still, as if a global bear market is firmly established, even though some sectors show indications of intermediate bottoming and upwards acceleration (Financials, Telecoms). For the bear to end, we need closure on the root causes of price creep and inflation, and a longer period of downside deceleration within the bear. In other words, too few equities are showing signs of stabilizing and too few global baskets are in a condition of upside momentum.
Rather, nearly three-quarters of measurable financial instruments within my database are in a bear phase that initiated in 2007, and show no signs currently of having reached their nadir.
This is not to suggest that the end might be elusive or far away. I would argue that the magnitude and amplitude of the current bear indicate that we are closer to the end than the beginning of the contraction. Think about it. If the origin of the bear was immediately after the zenith in stock relative strength quotients in July of 2007, then today we find ourselves in the midst of a mess, to be sure, but farther from its original starting point and maximum potential for negative direction.
Calm down.
Is this comforting? Not really. Because like the long car-journey with kids in the backseat asking “are we there yet?”, it’s not going to be comfortable until we reach the end of the journey. And unfortunately, quantitative science can only identify the inflection point of a turnaround after it has been achieved. Whereas we can predict a range of time and values around which the reversal might occur (when relative strength empties to its maximum), the actual values are expressed only as a range of possible quotients. The caution therefore is that one should never play at the margins when stocks are at their greatest strength (“it’ll never end”) or when despair seems its greatest (“I won’t buy any stocks here”).
One must follow the prevailing trend and play within it to maximize profit potential.
You know the score.
So much of this boils down to common sense, anyway. Computer models and scientific methodology are only as good as the information given them, and the efficiency of their ability to produce results.
Sometimes, capital gains is not the only result sought, because later on imbalances might occur. That is why different methodologies or mutual funds appear “hot” for certain time frames.
But ultimately, I believe the key to market analysis is consistency through all phases of economic travails. Nobody can forecast the exact entry or exit inflection points of ownership of financial securities (real estate, gold, equities, bonds, etc.). Therefore, intuition and balance should be considered desirable objectives.
There are enough negative influences today to dissuade anyone from taking a chance on the market. I, instead, prefer to focus upon the search for potential positive outcomes.
The final quarter might be scary, if you let it be, or fertile soil for the next leg upwards.
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