The Float

Friday Reading

Food for thought at the end of a short but eventful week...

• Thanks to Barry Ritholtz for posting links to David Rosenberg's Wednesday appearance on CNBC Squawk Box. All three segments Barry included are worthwhile, but the last one packs more raw insight into four minutes than you're likely to see the rest of the year. Check it out. We've long been fans of Rosenberg, who sees things (and says things!) as clearly as anyone we've encountered on the street. Is he always "right"? Of course not. No one is. But he cuts through the Street's daily noise with an understated Canadian straightforwardness that we find thoroughly refreshing.
• As Joseph Ellis showed in Ahead of the Curve, the rate of change in real consumer spending correlates tightly with corporate earnings. Which adds this morning's release of flat real personal consumption expenditures in April to the expanding file labeled "consumer recession."
• Good stuff from Calculated Risk and The Economist on residential real estate prices.
• Here's a short item on behavioral finance from the WSJ's Marketbeat: "If It Feels Bad, It's Probably a Good Trade."
• Here's a very rich post from Yves Smith on oil demand and commodity prices in general. We especially like his invocation of a point made by the FT's John Dizard:

The political reaction to high prices is most likely to lead to legislated changes in commodities markets regulation in the US and elsewhere. I am fairly certain that the changes will take effect after the coming decline in commodities prices.

I say decline because there always is one, and the late-stage political reaction suggests it is coming soon.

Of all lagging indicators, political posturing (even when understandable and non-crazy) is surely one of the laggingest.

Housing and Long-Term Competitiveness

Every day brings new data on the real estate market, most of it discouraging to the realists in the crowd. The latest evidence suggests that commercial real estate is following residential into the tank. All but the most willfully obtuse Pollyannas now acknowledge that the real estate picture is bad...and likely to get worse before it gets better. Of course the universal caveat applies: Local markets will vary.

As we've written repeatedly in this space (most recently three weeks ago in this item), the mad scramble to prop real estate up may or may not be effective, but regardless of its efficacy, its wisdom is doubtful at best.

So we were pleased to see Yves Smith pass along a summary of Nouriel Roubini's recent roundtable on broad financial and economic circumstances. Here's the relevant passage from Smith's post (emphasis added in bold):

One speaker (I cannot recall which one) argued that the push for more affordable housing was to mask the political impact of stagnant wages. "We needed to show some form of economic progress to meet social goals." Yet channeling so much investment capital into housing has certainly not helped, and probably weakened US competitiveness, thus in the end making workers worse off in the long haul.

That last sentence should be distributed immediately to every member of Congress, with helpful bullet-point explanations of the difference between productivity-enhancing and productivity-draining investments.

As always, none of this should obscure the substantial dislocations (i.e., pain) caused by the bursting of the lending and real estate bubbles. But the extent of the pain this time makes an appropriate policy response that much more important--to minimize the pain next time.

Wednesday Reading

Busy day today. But excuses are weak, so we'll get after it a little more seriously tomorrow...

• Interesting item from Calculated Risk on the "double bubble" in real estate commissions (rising prices and more transactions). With both bubbles bursting, we'll see fewer Realtors and lower commissions. The best agents will still make a good living, but with fewer dabblers, the industry will be further professionalized.
• Overheard in the (local discount-ish) grocery store over the weekend: A record number of out-loud, comparison-oriented discussions (three) about the price of goods on the shelves. Looks like those inflation expectations may come unmoored after all.
• When searching for (more or less) coincident economic indicators, we like to look at state and local government revenue streams. Barry Ritholtz posted a short/helpful item on the topic this morning.
• Dan Gross is right: Like so much of what passes for analysis on Wall Street, the notion of favoring one set of sectors over another, or, even more ridiculously, one set of stocks over another, the notion of political portfolios is an idea whose time will never come.
• We're always a little wary of anecdotal evidence, but we fear the plural of these anecdotes--from Chuck Jaffe on investors' knowledge of mutual funds--is data.

DB v. DC in WV

With our blogging vacation behind us, we have some catching up to do around here. One particularly interesting item that appeared over the last week is Janice Revell's story on the choice faced by public school teachers in West Virginia: Stay with the 401(k)-style defined contribution plan that replaced the schools' traditional pension system, or abandon the DC plan in favor of returning to a defined-benefit pension system.

We'd excerpt the story, but we'd end up passing along just about the entire thing, so instead we'll insist that you spend two minutes reading this very revealing piece. Just about every element of the bigger story in the U.S. retirement system is here: underfunded pensions, employers' cost-conscious transition from DB to DC plans, expensive/underperforming insurance-focused products, poor decision-making by participants, and, as a consequence of all of that and more, grossly inadequate outcomes for rank-and-file participants.

Revell is right to wonder about taxpayers' potential costs in all this. But the teachers' interests represent the other side of this troublesome coin: American workers who need--but generally aren't getting--the best possible retirement savings programs.

Source

Janice Revell, "Take this 401(k) and shove it," Money, May 20, 2008

This Week

Since launching The Float in March, 2007, we've posted at least one item every day the NYSE has been open for trading. We don't expect or deserve any particular prizes for that, but the streak has become a bit oppressive. Bottom line: We need to recharge our blogging batteries, and for various reasons related to what we're doing as a firm at the moment, this week turns out to be a good time to take a break. So that's what we're going to do.

We'll be back on the 27th, refreshed and ready to get after it once again.

We appreciate your readership and we look forward to re-engaging after Memorial Day.

Friday Reading

A few items for the road...

• The Economist's Buttonwood summarizes the potential consequences of elevated crude oil prices. More on oil: David Gaffen at MarketBeat. 
• Two interesting items via Calculated Risk: Fed Governor Mishkin on preemptive bubble-popping and a warning on festering problems in the HELOC market.
• Two interesting items from Barry Ritholtz: Merrill's strange new rating rules and a hugely important observation on the employment situation from Merrill's David Rosenberg.
• What if politics on the sub-continent was less about a nuclear standoff between India and Pakistan and more about...food prices?
• Behavioral finance? Here's a useful missive from John Mauldin on "investors behaving badly" (originally written a few years ago, with updates to reflect recent events).

Learning from Bill Miller

In yesterday's reading list, we included a recent New York Times piece on Legg Mason's Bill Miller, the renowned fund manager whose flagship fund beat the S&P 500 for 15 consecutive years, from 1991 through 2005.

The story's premise--that Miller has been chastened a bit by his fund's recent underperformance--is fascinating enough as a study in manager psychology. More interesting (to us, anyway!) is the fact Geraldine Fabrikant's piece features a few arguments that we've made repeatedly in this space.

First, there's the big picture phenomenon of reversion to the mean. In relatively efficient markets, it's just enormously difficult to sustain significant departures from the performance of a fund's underlying asset class. Many efficient-market absolutists will suggest that Miller's successful run may well have been little more than coin-flipping luck. With so many managers in the field, they might say, a small number of coin-flippers will come up heads 15 times in a row. We think there is such a thing as investment skill, often more temperamental than technical. But we fully acknowledge that luck is part of the game as well, and we suspect Miller was both good and lucky for many years. There's no reason to suspect he's any less skilled now than he was five years ago, but his randomized draws from the bag full of luck has clearly turned against him.

Second, there are the intertwined problems of asset bloat and market impact. Here's Fabrikant:

SOME longtime market experts think that fund size is the most daunting challenge he faces. Regardless of periodic ups and downs, he may simply be managing too much money to continue to produce outsized gains, they say.

"The number of investment opportunities just shrinks radically" when a fund swells, says John C. Bogle, the founder of the Vanguard Group, the mutual fund powerhouse, who describes himself as a fan of Mr. Miller. "The bigger you get, the fewer the number of stocks you can hold with a meaningful position."

Indeed, Mr. Miller holds a relatively concentrated portfolio, and the bad news has kept coming for some of his major picks. Last week, after Microsoft's proposed buyout of Yahoo fell apart, Yahoo's stock plunged 11.5 percent last week. Legg Mason holds a 6.7 percent stake in Yahoo. Countrywide Financial, another big holding, has been slammed by the mortgage crisis and errant lending. Its stock has fallen 87.9 percent over the last 12 months. And Mr. Miller amassed a sizable position in Bear Stearns, the investment bank gone to the grave.

We remember one of Miller's annual letters in which he freely acknowledged the constraints of running a portfolio that was at once enormous and highly concentrated. (He was aware of the problem then, but, in Fabrikant's telling, seems to dismiss it as a cause of his recent underperformance.) Because asset bloat is a structural problem, there's not much he can do about it, unless he diversifies his holdings. Which he and his team appear to be considering:

At Legg Mason, Mr. Miller has been stress-testing his investment theses -- the way he and his colleagues picks stocks -- and is considering a move away from concentrating his bets on dozens rather than hundreds of stocks.

"The question we are asking ourselves is: Should we think more broadly now about probability, about high-impact events and protecting against them by having broader exposure to the market?" he says.

Which leads us to the third point: Chasing "hot" managers is not a particularly wise game, at least not after they're both hot and pretty much universally recognized as such. Paying managers to pick positions and manage risk actively isn't inherently unwise, but it should be done with great care, and such services should be delivered in products and programs that have a relatively high probability of delivering what investors are paying for. There can be no guarantees, of course, but piling into enormous funds with a relatively high likelihood of mean-reversion strikes us as an approach that makes a difficult game that much harder.

Source

Geraldine Fabrikant, "Humbler, After a Streak of Magic," New York Times, May 11, 2008

One Great Ad

You may have seen the spot, but if you haven't, or if you like it as much as we do, and therefore want to see it again, we recommend the "Love Sweet Love" ad from Barclays Global Investors' iShares unit, a clever spin on the Hal David/Burt Bacharach tune. You can see it here. Because they're so perfectly apt, we've transcribed the lyrics here:

What the world needs now, is clarity, a little tax-efficiency, and much more transparency. What the world needs now, is fresh ideas, more complete advice, and shelter from all the nonsense. They're the only things that there's just too little of.

There's plenty not to like about the financial services industry's advertising efforts. This one, however, is worth celebrating.

Wednesday Reading

That wasn't particularly bullish action this afternoon...

• How 'bout the bizarro world of BLS inflation data? Barry Ritholtz has a reality check.
• Here's Reuters' Emily Kaiser interrogating the data on gasoline prices in particular.
• Foreclosures: Climbing, and fast.
• Yves Smith has some fun (if that's the word for it) with several charts on housing and credit markets.
• Interesting NYT piece on Bill Miller's recent struggles at Legg Mason. Note the accompanying chart for a classic case of reversion to the mean.

Cash Levels and Active Management

In yesterday's reading list, we mentioned a Jonathan Burton story on varying levels of cash in mutual funds. Burton mentions a few funds that have maintained relatively high levels of cash in recent weeks, noting that some of these funds have performed well even as the equity markets have rebounded off their January and March lows.

Here are a couple relevant excerpts:

The volatile stock market and the weak economy have derailed many mutual-fund managers, but without the ability to bet against stocks, some are playing defense the only way they can -- by holding more cash.

In recent months that's been a smart move. Cash is king when stocks head south. A sizeable allotment to short-term Treasury bills and other cash-equivalent vehicles can dodge the worst blows of a down market and absorb its unpredictable shocks. Moreover, money on the sidelines lets a cost-conscious manager scoop up bargains as they appear.

...

Yet this seemingly safe route is not without its own risk. Cash is trash when stocks rebound. Clinging to cash at those times creates a drag that can transform a leading fund into a laggard. Since no one knows when markets will turn, and given the constant pressure -- from both their shareholders and their bosses -- to outdo a benchmark index, most fund managers stay as close to fully invested as possible; the average diversified U.S. stock fund keeps only about 4% of its assets in cash, according to Morningstar.

Financial advisers in particular look askance at funds with outsized cash positions. Advisers set and adjust portfolio allocations between stocks, bonds, cash and other investments based on a client's risk profile. A cash-rich fund can upset those plans, says Dan Moisand, an investment manager at Spraker Fitzgerald Tamayo & Moisand LLC in Melbourne, Fla.

"If you're hiring managers to buy and sell stocks, that's what they should be doing," he says. "We should be making the cash decisions, because we're closer to the client."

Now, this leads to an interesting and important discussion.

In one sense, Dan Moisand is entirely right: Advisors are closer to their clients, and they should make the big asset allocation decisions. But there's another sense in which we think Moisand is on the wrong track.

When clients want active management (i.e., the explicit pursuit of alpha through some combination of outperformance in strong markets and capital preservation in weak ones), we think they should get it in a framework that's meaningfully different from the typical mash-up of active and passive exposure delivered by conventional long-only funds.

One of the key differences between tracking-error minimizers and true active managers is that the latter are less constrained than the former, in particular in the sense that their investment mandates do not require them to be (more or less) fully invested in all market conditions. After all, money management is risk management, and managing risk can be done in one of two ways: (1) strategic asset allocation and radical diversification or (2) active hedging of one sort or another (using options, short positions, cash levels, &c.). Both methods are perfectly legitimate. But they're different! And they need to be understood, pursued, and sold differently.

Burton's certainly right that large cash positions can weigh on performance during strong market episodes. But the essence of successful money management is in delivering market-beating returns for the same level of risk or market-like returns for a lower level of risk.

If advisors are frustrated with fund managers who maintain high cash levels (or whose cash levels vary somewhat unpredictably), they should look elsewhere for pure asset-class exposure, in particular to the inexpensive ETFs and index funds designed to provide exactly that.

If they want active managers, and are willing pay for same, they should know that varying levels of exposure to risky assets is part of what any self- and investor-respecting money manager should deliver.

Source

Jonathan Burton, "Kings of Cash," MarketWatch, May 11, 2008