Intellect with Blinders
September 30, 2007
Market Summary – 3rd Quarter, 2007
Former Federal Reserve Chairman Alan Greenspan has been making the rounds plugging his book. This comes at a time when criticism of his tenure has arisen in light of the subprime mortgage mess. Greenspan was certainly not alone in failing to recognize the potential problems. When asked about this in a recent interview on CNBC with Maria Bartiromo, Greenspan admitted, “you would think I would be acutely aware, but there were no such data at the time.”
Said Greenspan, “I saw some estimates of the proportion of total mortgage originations (subprime) as 20%. I said ‘That’s nonsense. There is no such possibility. They couldn’t be that large.’ But indeed they were.”
It isn’t what Mr. Greenspan did or didn’t do about the potential risks in the subprime market that is so striking, but his explanation. He did not have any data, so there was no reason to perceive the potential for problems down the road. For all he knew, the market for subprime mortgages was miniscule, even though real world examples (like a flood of new mortgage brokers, record-setting home sales and a deluge of advertisements) should have been a clue that something else was happening. Did the Fed Chairman have blinders on?
We aren’t blaming Greenspan for the subprime mess that blew up this year. Rather, his explanation is symbolic of a broader problem – financial “geniuses” who are great at crunching numbers, but lack the power of observation.
The rush of MBAs and doctoral graduates to the financial services industry in recent decades has also led to the development of an array of investment concepts designed to outsmart the market using quantitative models. Many, in their own way, are said to have created a “new paradigm,” one that essentially rewrites much of what we know about the markets. Yet our recent history includes a litany of such ideas that ended up on the trash heap. Take a look at this partial rundown of the most flagrant examples:
New Paradigms Lost – A brief history of genius that turned into failure
Michael Milken promotes junk bonds as a debt strategy that fully accounts for potential risks of making loans to less-than-credit-worthy companies. Yet in 1989, defaults soar and the junk bond market collapses, taking with it the savings and loan business. While junk bonds (properly managed) are a critical part of today’s debt market, the risks are now in a more appropriate light.
Nobel laureates invent Long Term Capital Management, professing that their computer modeling can seize upon nominal market opportunities and generate huge profits, particularly when leverage is used. But along came shocks like the Russian debt crisis, and the Federal Reserve had to arrange a bailout to prevent a significant financial market breakdown. Long Term Capital Management is, of course, long gone, along with its investors’ money.
The late 1990s
Technology IPOs flourish, few of them backed by real earnings, but some claim a “new paradigm” is at work in the markets. Technology is changing our world, it is claimed, and it is changing how we judge investments, making “quaint” concepts like price/earnings ratios an old way of thinking. Of course, by early 2000, the technology boom goes bust as investors return to the realization that companies with no profits make bad investments.
Historically, low interest rates help fuel a housing boom, but so does the creation of new forms of adjustable-rate mortgages that make home ownership a possibility for people who could not qualify under the old rules. Unfortunately, the lower rates are only temporary. As rates adjust upwards, many overextended homeowners face foreclosure. That means investors who bought securities backed by those loans are suddenly forced to write off their investment. A run on the market confounds black box managers (like hedge funds), completely throwing off their models because market activity was “unprecedented,” and not something they could model.
The credit mess triggered by the subprime meltdown is just the latest example. In short, mortgage lenders felt they had a formula in place to offset the risk of loaning large sums to homeowners (and housing market speculators) in over their heads.
Taken to the next step, these loans were securitized and packaged into creative debt products that apparently did not properly reflect the real risk that existed in the underlying mortgages. These securities were marketed to witting, and probably many unwitting institutions for their portfolios.
Then the bottom fell out and it became impossible to place a value on many of these securities. And the latest new paradigm was exposed.
We don’t want to dismiss the value of new thinking and new ideas. But we do question the hubris of those who believe they can rewrite the basic tenets of investing through their product creations or black box ingenuity.
Thinking beyond the box
The quantitative analysts (“Quants” for short) have been all the rage in recent decades. We know now that many of the top scientific and mathematical brains that might have used their abilities to design better cars, faster computers or safer jetliners in the past have been drawn instead to the big money world of Wall Street. The purpose – to put their scientific acumen to work coming up with “systems” to beat the house – that is – outperform the market on a regular, dependable basis.
Real estate on Wall Street, in Greenwich, Connecticut, overseas in London and in many other parts of the world are filled with these “engineers” staring at multiple screens at once, plugging data into computer models as a way to make money. It has nothing to do with investing in the traditional sense. Generally speaking, these are data-driven investment strategies that are based on reams of market statistics crunched to fit into a mathematical model. Note – while these engineers are living in luxury, how are their clients doing?
The turbulence of this past summer was notable, because a great number of “quant” investors found their models
weren’t working. There was “unprecedented” or unexpected reaction in the markets that did not match the models they had created. Positions lost money even though everything in the model said the strategy should have worked.
The names of the hardest-hit institutions come right out of Wall Street’s Hall of Fame:
Goldman Sachs needed $3 billion ($2 billion of its own money and another $1 billion it raised from outside investors) to bail out one of its hedge funds Bear Stearns had to fold two hedge funds invested in mortgage-backed securities, after pledging $3.2 billion in bailout loans Merrill Lynch has announced that it will write down $4.5 billion due to losses sustained in derivative securities and subprime mortgages.
According to Barron’s “…Citigroup and UBS [they] would take write-downs of $5.9 billion and $3.4 billion, respectively, to atone for having lent neither wisely nor well.”
Hedge funds and other types of alternative investments exacerbate the problem by using leverage to try to maximize the gain made on their programmed trades. But as the numbers on average hedge fund returns show, leveraging does not necessarily result in a HUGE payoff. In other words, the potential gains on at least some of these quantitative strategies are so limited that they only create value when they are leveraged, in order to multiply the impact.
Of course, leverage adds another level of risk. If the market moves in the wrong direction, the fund can pay a significant price that far exceeds what would have been the case had leverage not been part of the strategy. The examples listed above show just how risky the strategy can be.
Legendary investor Warren Buffet (one of the great market observers of our time) was quoted as saying “whenever a really bright person who has lots of money goes broke, it’s because of leverage. It is almost impossible to go broke without borrowed money being in the equation.”
The failure of a “left-brained” approach
The examples we’ve discussed here are investments driven by left-brain thinkers – people with a linear view of the world. If “A” occurs, then “B” is the result. There is no questioning, they believe it is the way it always has been, and the way it always must be. But as the events of this past summer proved, it didn’t always have to be. As a result, hedge funds, designed to have the potential to profit regardless of market conditions, failed to keep pace with the stock market through recent, volatile times.
The fact that these people are whizzes at math and models cannot be denied. But can they really bring scientific certainty to the investment markets? Whether it is structuring a hedge fund strategy, developing a “foolproof” asset allocation model or a “Monte Carlo” retirement planning tool, the goal of these financial engineers seems to be to eliminate uncertainty.
But those who think market uncertainty – unexpected twists and turns – can be avoided in the world of investing have been fooled time and again. We’ve demonstrated just some of the most recent examples.
As Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Alan Greenspan and the whiz kids (from junk bonds to Long Term Capital to Enron to Countrywide) proved Twain right. Undoubtedly, more of the same foolishness will come in the future.
A more recent author, Daniel Pink, says in his book “A Whole New Mind – Why Right-Brainers Will Rule the Future,” makes the case that an important change is coming. Pink claims that after a period of time where people with a certain kind of mind (left brain), including computer programmers and number-crunching MBAs, ruled the world, the future belongs to big picture (right brain) thinkers.
Says Pink, “We are moving from an economy and society built on the logical, linear, computer-like capabilities of the Information Age to an economy and society built on the inventive, empathetic, big picture capabilities of what’s rising in its place, the Conceptual Age.” According to Pink, right-brain thinking will supplant left-brain approaches in driving the direction of the world.
There’s no substitute for observation
When you stare at eight computer screens at a time, it is easy to miss what is (or may be) going on in the real world. Our own experience tells us that the power of observation can make a real difference, particularly in the world of investing.
Technology is a wonderful thing, and it is certainly a marvel to think how much information is available to the average investor these days compared to what was the case even just a few years ago. There is no substitute for good information but sometimes there can be too much of a good thing. Without experience, judgment and the power of observation, it is easy to get caught up in all of the “knowledge” that can be had by watching a steady diet of cable business news and staying glued to a computer. Just ask anybody who became a day trader during the stock market bubble of the late 1990s.
Observation is most important. All of the technology in the world does not substitute for the fact that businesses, governments and countries need to be judged on their own merits, including many factors that go beyond mounds of data that can be generated by a computer.
A close observer of world affairs could also recognize that by printing more money, the U.S. is steadily draining away the value of the dollar. This creates a more attractive environment for companies owning tangible assets that maintain value over time – like gold, oil, copper, beryllium and other commodities. We have been able to turn this observation into profit.
Buy low – sell high
It may not be cutting edge, but it remains the simplest logic of the investment markets – one that does not always calculate in the world of the black boxes. More than anything, an investor needs to observe ways to identify true value in an investment. Despite all of our fastest technology and the greatest thinking of today’s best and brightest, a simple truism in the world of stocks is that if a company does not generate profits, its owners (stockholders) won’t either. In case you have doubts, check with anybody who owned stock in Enron or Pets.com.
A few observations worth noting
There has been plenty of speculation in the markets this year, ranging from “everything’s great!” in late June and early July to “disaster looms!” in late August. Generally, we know the media loves to make hay out of bad news and speculation that things could only get worse. And as bad as the subprime mess and the housing recession have been, the rest of the economy in the U.S. has held up well. What’s more, the global economic environment appears to be even healthier.
Here are three observations that have not received much play in the media, but tell us a lot about the opportunities for investors who don’t want to rely on exotic, left-brain driven instruments to make money (these are based on insights provided by 13D Research, Inc.):
Observation #1 – Corporations are flush
All of the talk prior to the summer’s market dive was about how much capital was floating around. Merger activity was rampant and companies were looking for ways to spend their cash. That hasn’t changed. Corporate cash as a percentage of corporate balance sheet assets is at post-war high (that’s World War II, by the way), while debt as a percentage of corporate balance sheet assets is at a post-war low. That means a number of companies are in very solid financial shape (and in a position to go on the hunt for acquisitions or invest more capital in their growth, and maybe even pay out dividends to shareholders!).
Observation #2 – Consumers still have buying power
Speculation is that consumer spending will be weak, posing a threat to the economy. But according to the Federal Reserve, consumer assets are five times consumer liabilities. Household balance sheets are stronger and more liquid than at any time since 1945 (when the Federal Reserve first began tracking this data). A record $6.47 trillion resided in money market funds and savings deposits in the first quarter. For some perspective, that is 50% higher than where that figure stood at the same time in 2001.
Observation #3 – There is vast growth on the global economic front
During the past five years, the U.S. has contributed just 13% of global economic growth. 55% has come from Asia, about half of that from China and India alone. Global savings and investment rates now total $11 trillion, a record, and up more than 50% in the past five years. We observe opportunities in U.S. multinational companies that generate significant earnings from overseas business.
From our standpoint, the real world, and finding value in it, is still what matters. If there is no perceived risk in it, it is not the world of investing we know. But if the value is real, then there is a better opportunity for gain with more limited downside.
We won’t be so bold as to predict only good times ahead, but each of these facts is compelling to anybody who wonders whether the economic environment can support opportunities in the years to come. It is good, old-fashioned observation that plays a role in helping us determine specific stocks that offer good potential for our portfolios…
And we’re proud to say it is a very whole-brained approach to the markets.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.