The Float

The Warning

Frontline's latest--"The Warning," about Brooksley Born, Alan Greenspan, and the anti-regulatory ideology that helped put us where we are--is required, morally imperative viewing.

One revealing/disturbing highlight: "Greenspan didn't believe that fraud was something that needed to be enforced." No. We aren't making that up.

We recommend that you watch it at your earliest opportunity.

UPDATE: The bit about Greenspan's bizarro reluctance to discourage/discover/punish fraud is a real jaw-dropper. But the most affecting segment of "The Warning" is former SEC Chair Arthur Levitt's acknowledgment that Brooksley Born was good and right. Here are Levitt's words, roughly 48 minutes into the show: 

"I've come to know her as one of the most capable, dedicated, intelligent, and committed public servants I've ever come to know. I wish I knew her better in Washington. I could have done much better. I could have made a difference." 

Those words mean a lot, but the genuine emotion--the pain--underlying Levitt's statement can only be sensed by watching him. It's as if he becomes, in those few seconds, the personification of so much national regret. Amazing stuff.

Hussman on Cicularity

John Hussman's most recent weekly comment contains the following insights, with which we happen to agree wholeheartedly:

In recent weeks, the dominant view of investors and analysts has shifted clearly to the expectation that the U.S. economy is in recovery. Appearing to seal the deal for some analysts was the third consecutive increase in the index of leading economic indicators. For that index, interest rate spreads and the S&P 500 Index have been the strongest contributors in recent months, as 10-year yields have shot higher from near 2% at the beginning of the year to about 4% before retreating a bit, and stocks have similarly rebounded from deeply oversold levels. Unfortunately, as I've noted before, there is little information content in mean reversion following extreme moves, and that's what the LEI is picking up here–-to a much greater extent than has typically been the case at the end of recessions. Put another way, the case for an economic recovery is based largely on mean reversion from the early 2009 extremes (not on improvements in jobless claims or other measures to a level that is on par with prior recoveries).

...

Taking the rally in stocks as an indicator of economic recovery (which the LEI largely does), and then taking the presumption of an economic recovery as a reason to buy stocks, all strikes me as circular reasoning.

"Failure of a Fail-Safe Strategy"

Given the meltdown in so many asset classes over the last two years (remember: it was in the Summer of 2007 that the music first stopped without enough chairs), it has become somewhat fashionable to question the benefits of diversification across asset classes.

We've weighed in on this issue here and here, arguing that diversifying across relatively risky asset classes shouldn't be--and never should have been--seen as a means of reducing risk amid crisis conditions.

On Friday, Tom Lauricella filed another entry in the not-so-sure-about-this-asset-allocation-thing genre. As he so often does, Lauricella handles the material well, noting that correlations among risky asset classes had been rising before the recent meltdown. But the most important point about the last 24 months is that cash-equivalents and treasuries held up remarkably well, providing capital preservation and even some appreciation for investors who held them while risky assets cratered.

Lauricella's story opens with a Raymond James broker saying, AA-style, that he's "a recovering asset-allocationist." Near the end of his piece, Lauricella tells us about this broker's new style: more cash, and more flexible mandates for the active managers he hires for clients. We think this makes pretty good sense. As we've argued repeatedly in this space, asset allocation should be inexpensive and index-based; active management should be nimble and relatively unconstrained. In other words, they should be different, and purchased/pursued under different frameworks (not in the big, expensive mash-up of market- and manager-driven returns offered by most mutual funds).

Lauricella closes with this telling sequence about his example broker:

He says he is convinced there is a way to make diversification work. In fact, after the strains of last year, he says, many investments are behaving more like they did before 2008.

Asset allocation, he says, "might well have been injured....But I don't think it's gone forever."

No doubt. Properly understood and executed, asset allocation remains a perfectly intelligent strategy. To paraphrase Churchill's quip about democracy, asset allocation might be the worst thing out there...except all the others that have been tried.

One more note: Be sure to look at the WSJ's interactive graphic on asset-class correlations over the last 15 years. Good stuff.

Source

Tom Lauricella, "Failure of a Fail-Safe Strategy Sends Investors Scrambling," Wall Street Journal, July 10, 2009

From the Contrarian Files

From time to time a headline strikes us as an especially fraught suggestion that the investing herd is buying or selling en masse, often quite late in whatever the latest game might be. In Monday's Wall Street Journal, Shefali Anand came up with a classic of the genre: "A Taste for Risk--Again." Here's how the story opens:

It's amazing the difference a rally can make in investors' appetite for risk.

A few months ago, mutual-fund investors were yanking money out of stocks and high-quality corporate-bond funds and parking it in safer places, like money-market funds and U.S. Treasurys. Lately, however, as stock and bond markets have rebounded, mutual-fund investors have had a split personality.

They're back to buying relatively safe investments like high-quality corporate bonds. But they're also pouring money into the riskiest investments. They're lukewarm toward U.S. stocks but plunging into high-octane vehicles like emerging-market companies, commodities and junk bonds--making these among the 10 best-selling mutual-fund categories this year.

Unfortunately, the story doesn't deliver enough compelling data to get our contrarian hackles all the way up, but it's one of those things that gives us pause.

And here's another ingredient in our current caution. In the chart below, you'll see how the 20-day moving average of the S&P 500 (the red line) provided support on two key occasions during the rally off the market's March lows (especially on April 20^th/21^st and throughout mid-May). Then on June 15^th the S&P closed right on the 20-day, broke below it on the 16^th, and bumped its head on it at the start of July. In addition, the 20-day has rolled over.

In the relatively short term, we don't make much of moving average crossovers, but we've certainly noticed that the 20-day is now moving lower for the first time since the middle of March.

None of this is to say that the rally can't or won't re-ignite. But the Summer's burden of proof may have shifted from the bears back to the bulls.

Source

Shefali Anand, "A Taste for Risk--Again," Wall Street Journal, July 6, 2009

Fun With Headlines

From the hope springs eternal file, a few headlines in today's "Before the Bell" missive from Reuters:

• "Oil firms above $60 on U.S. refinery fires, Nigeria"
• "Japan GDP sinks at record pace"
• "Deere quarterly net falls 38 percent"
• "Toll Brothers' homebuilding revenue dives 51 percent"
• "Hewlett-Packard outlook disappoints"

and...

• "Stock futures point to higher open on economic optimism"

Toles on the Second Derivative

Catching up with the irrepressible, irreplaceable Tom Toles...

May 7^th

May 11^th

Dueling Realities

We're disinclined to attribute single-day trends in the capital markets to anything in particular, but it does appear that today's reports out of India and Lowe's have boosted traders' enthusiasm.

Here's a bit from the Lowe's announcement, quoting CEO Robert Niblock (emphasis added in bold):

"The economic pressures on consumers remain intense, and bigger ticket projects continue to be postponed as wary home improvement consumers watch the economic climate and housing market dynamics very closely," Niblock added. "But, as spring arrived, we saw relative strength in smaller, outdoor projects."

Niblock clearly understands the "intense" pressures on consumers, but traders might want to contrast middling concepts like "relative strength in smaller, outdoor projects" with this CNBC report on rising credit card defaults: "Credit Card Defaults Reach Record Highs in April." Here's a summary via Calculated Risk:

	April	March
Citigroup	10.21%	9.66%
Wells Fargo	10.03%	9.68%
JPMorgan Chase	8.07%	7.13%
Discover Financial Services	8.26%	7.39%

Hard to muster a lot of "second-derivative" enthusiasm off of numbers like these.

Brett Arends' 12 Rules

Back on May 1^st, the WSJ's Brett Arends spun out "12 Rules for Investing in the Next Bull Market," most of which are insightful and helpful. We generally like Arends' work and this piece is no exception. Though we're quibblers by nature, this is pretty strong stuff and it deserves your consideration. Here are a few of Arends' rules followed by our comments:

2. Avoid big moves.
If you buy or sell heavily in one shot you're taking a needless risk. And waiting for the right moment to make your move is futile. You probably won't catch the bottom or the peak anyway. If a market trend has much further to run, then what's the rush? And if it doesn't...what's the rush?

No quibbles here. This is exactly right. 

6. Be truly diversified.
That means investing across a spread of different asset classes and strategies. As investors discovered last year, "large cap value" and "mid cap blend" funds don't offer diversification. They're just marketing gimmicks.

Though it's true that correlations rose sharply among risky asset classes during the last 20 months, we aren't willing to concede this point. There are ways to slice the market too narrowly, but historically there have been--and, we think, will be again--material differences in the risk/return profiles of various classes of equities. Tilting strategic portfolios in one direction or another by weighting assets classes isn't just a marketing gimmick. Or, to be more precise, it isn't necessarily, or always a marketing gimmick.

10. Be patient.
Investment opportunities are like buses. If you missed one, you don't have to chase it. Relax. If history is any guide, others will be along shortly.

Yes.

11. Don't sit on the sidelines completely until it's too late.
You'll probably end up splurging at the last moment. If you are afraid to invest, do it early, little, and often.

Yes.

12. And above all: Price matters.
After all, an investment is just a claim check on future cash flows, whether it be a company's profits, a bond's coupons or an annuity's income stream. By definition, shares in a solvent company are twice as good at half the price...and vice versa. It's amazing how many people get suckered into thinking it's the other way around.

And yes.

But then there's this morning's Arends column, in which he taps some recent research suggesting that near-term economic prospects have almost nothing to do with stocks' long-term returns, which in turn makes the notion of "price" a little less concrete that most investors--and certainly less concrete than most fundamental analysts--would like to believe. Here's an excerpt:

The stock market jumped 6% last week on growing hopes of an imminent economic recovery. It has risen 39% from the March lows on similar hopes. Of course, it had previously fallen nearly 60% on fears of a slump.

All these moves have one thing in common: Millions of investors have acted on the belief that share values are closely related to what will happen in the economy in the next few months and years. But are they right?

Not according to Ben Inker, director of asset allocation at contrarian fund company Grantham Mayo Van Otterloo & Co. In a recent and fascinating note ("Valuing Equities in an Economic Crisis, or How I Learned to Stop Worrying about the Economy and Love the Stock Market"), Mr. Inker persuasively argues that the next moves in the economy shouldn't actually matter too much to investors at all.

Why? Two reasons.

First, because most of the value of shares really depends on the cash they will generate many years, even decades, ahead. The next few years are only a minuscule part of the equation. "Since stocks do not have an expiration date and dividends grow over time," Mr. Inker argues, "the duration of stocks is extremely long. If we assume that half of the return from stocks in a given year comes from the dividends and half from the growth in dividends, most of the value of stocks comes from cash flows in the distant future."

(The second reason is that short-term deviations from long-term trends in economic growth are typically resolved back toward those long-term trends within a few years.)

"This sort of analysis is a useful antidote to stock market moods," writes Arends. Maybe. But the other way of looking at Inker's research is that all we really have in the short run is "stock market moods." Which means you either trade on the technicals (with some attention to short-term expectations of the fundamentals, as in a Keynesian beauty contest) or, like Joshua in War Games, refuse to play the short-term trading game in the first place.*

~~~~~~~~~~~~~~~~
* It's one of the great lines in movie history: The rogue computer program "Joshua," having realized that "global thermonuclear war" produces no winners, declares that "the only winning move is not to play."

Sources

Brett Arends, "12 Rules for Investing in the Next Bull Market," Wall Street Journal, May 1, 2009

Brett Arends, "How to Value Stocks? Ignore Economic News," Wall Street Journal, May 11, 2009

Ben Inker, "Valuing Equities in an Economic Crisis," Grantham Mayo Van Otterloo & Co., April 6, 2009 (registration required)

From the Contrarian Files

We still can't feel as sanguine about our near- and medium-term economic prospects as traders (and the few remaining investors) appear to these days, but there's a powerful logic to "don't fight the tape"--let alone the Fed. Whatever the market's near-term prospects, when one takes a longer, multi-year view, this strikes us as a probabilistically attractive time to acquire equities.*

Two items caught our attention along these lines: Rob Arnott's much-discussed Index Universe piece on the relative performance of stocks and bonds in recent years. (We mentioned Arnott's research earlier this month.) As we argued in March, true bottoms tend to be marked by mass indifference, even revulsion toward stocks. In turn, one would expect that indifference to manifest itself in grinding, low-volume trading. But intelligent, sensible efforts like Arnott's can flash revulsion as well, not of the rash, emotional sort, but a kind of mean-reverting phenomenon in which the data Arnott cites, backward-looking by definition, are unlikely to repeat themselves. Take a look at Brett Arends' excellent coverage of this issue in Tuesday's Wall Street Journal:

"Starting any time we choose from 1979 through 2008," Mr Arnott writes, "the investor in 20-year Treasuries (consistently rolling to the nearest 20-year bond and reinvesting income) beats the S&P 500 investor." He argues the figures are even true going back to the late 1960s.

Mr. Arnott's article has generated quite a stir in the investment world, where he has, in theory, turned a lot of received wisdom on its head.

But American mutual fund investors, responding to last year's turmoil, are already voting this way with their wallets. So far this year they've withdrawn $45 billion from mutual funds that invest in the stock market, and put $68 billion into bond funds, reports the Investment Company Institute.

Should you follow suit? Not so fast.

Obviously bonds, especially Treasurys, held up well during last year's crisis. And they can make an important part of a portfolio, especially at the right price. But anyone hoping for a repeat of the last thirty years is probably dreaming.

The second item that leaped off the screen at us was yesterday's Journal story on financial advisers forsaking traditional buy-and-hold strategies rooted in asset allocation and Modern Portfolio Theory. We manage money in two styles, one traditional and strategic, the other (mildly) alternative and tactical. But we've been doing that since before the crisis, and when we see media coverage of rank-and-file advisors (and, implicitly, their clients) throwing up their hands in disgust at the supposed failure of traditional methods of portfolio construction, we can't help but think that this is a great time to have (or acquire) an inexpensive, diversified portfolio of global asset classes. To return, in other words, to the methods many people (professionals included!) can no longer abide. That's our kind of revulsion.

~~~~~~~~~~~~~~~~
* Which, as always, implies no particular guesses about the short-term direction of the market.

Sources

Rob Arnott, "Bonds: Why Bother?" Index Universe, April 27, 2009

Brett Arends, "Bonds' 30-year Hot Streak Begins to Cool," Wall Street Journal, April 28, 2009

Anne Tergesen and Jane J. Kim, "Advisers Ditch 'Buy and Hold' for New Tactics," Wall Street Journal, April 29, 2009

Hussman on Bear-Market Rallies

Here's some good stuff from the always-worth-reading John Hussman:

Bear market rallies from oversold conditions are not predictable, in the sense that a market that has endured a steep selloff can easily continue lower another 10%-15% or more. Still, there has historically been some tendency –- on average –- for the market to rally off of deeply oversold conditions. The problem is that those generally positive averages mask an enormous amount of variation, so the actual return/risk ratio isn't nearly as attractive as one might imagine.

With the warning that the following figures do mask a very large amount of risk and variation, the charts below present the average percentage returns of the S&P 500 in the weeks following points when the index was at least 10%, 15%, 20%, 22%, and 25% below its 50-week smoothing. The 22% category is included because the sample size quickly becomes very small beyond that point. I've included two charts – one including data from 1940 through 2007, and the second including data from 2008. Note that the inclusion of 2008 makes an enormous difference, because the market simply failed to advance despite very deep compression -– a reminder about the risk and variation within these averages.

Oversold bounces: Average cumulative S&P 500 % returns 1940-2007 based on starting % below 50-week smoothing (time scale measured in weeks):

That's some serious mean-reversion.

Read the whole thing. And while you're in Hussman's 'hood, read this from Bill Hester on the significance of trading volume in bull markets and bear rallies.