Wednesday, December 31, 2008

Lies, Damn Lies, and Statistics

On Tuesday we learned from the S&P/Case-Shiller Index report that housing prices had declined by 2.2% in the month of October. That was greater than "analysts" had forecast. Hmmmm....

What do you suppose happened to the price of my home in October? Or yours?
I have no idea, because like the overwhelming majority of homes in the country, mine didn't sell last month. It wasn't offered for sale, and I had no intention of selling it. Like most people, I bought my home because I needed a place to live, and it suited my needs and my budget. Some day I'll sell it, and I hope and expect that I'll get a fair price. But why do we need monthly price statistics on something with very low turnover? How does anyone know what the price of my home was in November, or October, or last year? The same is true for art, or wine, or antiques.

We get a myriad of statistics every day. Durable Goods Orders. Producer Price Index. Continuing Unemployment Claims. Merchandise Trade Deficit. Non-Farm Payroll Employment. Sometimes, the reports come from government bureaus, which use them for planning and tracking. But sometimes, they're created by individuals and organizations for publicity purposes (see The Challenger Report of Announced Layoffs) or simply to make a profit. Over a long period, many of the better statistics can help us to understand long-term factors in the economy. But in the short term, they're mostly useless.

However, the media, in its effort to cover the stock market like a sporting event, thrives on statistics. CNBC frequently shows an onscreen bug with the countdown to a report's release (37 minutes to December Retail Sales!). And often a market's move is ascribed to some random event: "Stocks dropped today after traders were disappointed by an unexpectedly large fall in the Empire State Manufacturing Index."

The only statistic that really matters is the one that you see on your stock monitor-- the current quote. A stock, or a barrel of oil, (or your home, for that matter) is worth what someone will pay for it right now. Don't get hung up on statistical analysis; the market price tells you everything you need to know. And if it's an asset that rarely trades and doesn't have a current quote (like your home) don't pay much attention to some theoretical price.

Sunday, December 21, 2008

Beware the unknown unknowns

There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.

Donald Rumsfeld, 2/12/2002

A successful investor needs to not only be intelligent and insightful, but also pragmatic. Know what you don't know. But one also needs to allow for events and outcomes that simply can't be anticipated-- the "unknown unknowns."

I thought about this when I read an article in today's Chicago Tribune . It was a "year ahead" piece on the economy and financial markets, with opinions from various experts. Professor Erik Hurst, of the University of Chicago business school, on housing prices:

Housing prices will fall another 15percent to 20 percent in the next couple of years, he predicts. "We've got a long way to go."

His study of market data stretching back decades gives him 100 percent confidence in his prediction, he said. "A big increase in price movements is followed by big declines. Take it to the bank."

Hmmmm.... "100% confidence"? based on his study "stretching back decades"?

I can only hope that he was severely misquoted. If not, I think he's an idiot. Let's think about this. First, what's his data set? "Stretching back decades" could mean as little as 20 or 30 years. But let's assume that he has gone back 190 years (otherwise he would have said centuries, no?). I know that Schiller and others have looked at housing prices back to the 1800s, but how good is that data? Do you really think that they have good records for a broad range of housing transactions dating back that far? Sure, there may be history for some houses on Beacon Hill dating back to the 1600s. But what about the sod huts in Nebraska in the 1870s?
I'd be willing to bet that many home sales went unrecorded or otherwise lack good records at least as recently as the 1930s. And many of the meticulous details that we have today, dutifully reported on CNBC like sports scores, date back to the 1970s or '80s.

But even if we have good data back to the early 1800s, Prof. Hearst is telling us about a study of cycles: a big increase is followed by big declines. How many times has that happened? I can assure you that one of the most basic assumptions about home prices prior to 2007 was that they never go down. This is what got us into the present mess. On a national basis they had virtually never declined. So how many cycles could have been captured in his research? I'll assume that he has looked at regional cycles and other data. Maybe he has captured 20 such events? I'd think that's a generous assumption.

One of the my earliest and best lessons in investing involved my only commodity trade. We were just out of college, and a good friend had taken a job as a commodities broker. He found an investment opportunity in lumber futures: it seemed that there was a seasonal pattern that had worked in 16 of the past 17 years. He put together a group of our friends to open an account and take advantage of this pattern. I think that I invested $2000.

Guess what? By the time that our contract had expired, that lumber trade's record was 16 out of 18. I lost it all. But for $2000, I learned a very valuable lesson about correlation.

One of my favorite quotes from Fooled By Randomness author Nassim Taleb:

My classical metaphor: A Turkey is fed for a 1000 days—every days confirms to its statistical department that the human race cares about its welfare "with increased statistical significance". On the 1001st day, the turkey has a surprise.

Perhaps housing prices will fall 15 to 20 percent in the next couple of years. Or maybe they'll fall 50 percent, or maybe they'll go up. Far too many unknown unknowns here. Wanna bet that if we were to interview the Professor in a few years, and it turns out that his 100% confidence prediction was wrong, he'd cite some unforseen events to explain his error? Unprecedented government intervention, currency crisis, runaway inflation, change in tax laws, etc. etc. The point is that we can rarely if ever be certain about anything. The successful investor attempts to know what he doesn't know, and makes allowances for the unknown unknowns.

Tuesday, December 16, 2008

Back to Basics

A long time ago, I had a conversation with an investment manager for relatively small firm with a good performance record. There was no secret to his process, he said. "We just buy stock in high-quality companies and hold on to it for a long time."

Bernie Madoff blows up as investors are shocked--SHOCKED-- that a strategy which reported rock steady monthly returns through 20+ years of market volatility was proven to be fraudulent. Newspaper articles go to great lengths to explain the intricacies of "split-strike options."

Today's WSJ notes that a manager who ran a fund which is down 82% this year has "stepped down." STEPPED DOWN? What were they thinking when the fund was down 50%? Why didn't they fire him then?

Hedge funds closing or restricting redemptions in the face of abysmal returns. One of the largest and most prominent is down by 50% this year, and it's got plenty of company. It becomes an accepted tenet of mainstream institutional investment philosophy that common stock investments are shunned in favor of allocations to hedge funds, private equity funds, commodity funds, and other "alternative assets".
Not so many years ago, a large pension fund would invest its assets in three categories: stocks, bonds, and cash. Today, the Harvard university endowment's asset allocation chart shows 11 separate categories of non-cash investments, about three quarters of which are things other than domestic stocks and bonds.

I'm generally a subscriber to the efficient markets theory. I believe that information gets disseminated quickly, and reflected in the market just as quickly. So you think that the economy's gonna be bad for the next six months? No kidding-- so does everyone else. That's why the stock market has fallen 40% or so. But what do you think that everyone else will be thinking next? That's the question! As Keynes said, successful investing lies in anticipating the anticipations of others.

Everyone's looking for an edge. Everybody wants to find the stock, or the asset class, or the manager or strategy that produces outsized returns (and with minimal risk, too). People stood in line, like cattle headed to the slaughterhouse, for a chance to invest with Madoff or some high-profile hedge funds.

There are literally thousands of investment management firms, ranging from esoteric black-box hedge funds to the sleepiest rural bank trust department. They're all looking at generally the same data. Some have vastly superior resources to provide for sophisticated computer analysis or local surveys of Tibet yakherders cellphone purchase intentions. But in the end they all think they can outperform the market. Some do, for a time. But even the most heralded, like Bill Miller or a prominent hedge fund, eventually find that their luck runs out. As Nassim Taleb would say, if you have 1000 monkeys picking stocks over 10 years, one of those monkeys will rank as the #1 stockpicker with the best 10-year average.

So why don't we just buy stock in high-quality companies and hold on to it for a long time? Well, for one thing it's not in the best interests of asset managers, or brokers, or investment committees, or consultants, or fund-of-funds, or most analysts. It probably isn't such a good thing for writers of financial blogs, either. But it probably is a good thing for you.

Monday, December 1, 2008

Wherein I Achieve Peace With The Market

"All financial crises end-- and when they end, they end in ways that create spectacular opportunity" Lawrence Summers

hard to explain.

The Dow was down 680 points today.

Over the past three months, when the market got hit hard like this, I'd get depressed. Didn't want to look at my account value online-- just didn't want to know. I lost a lot of money in the market this year.

But today is very different. I'm actually glad for the selloff. In fact, I hope that the market has a similar decline tomorrow, and the next day. Why? Because the market is presenting me with a spectacular opportunity.

Why now? Why is this better than previous declines? Why couldn't I have said the same thing 2000 Dow points ago? Answer: gut feeling.

I could give a more elegant answer. I could talk about my zero boundary theory (the lower it goes, the closer it is to the bottom) I could refer you to the John Hussman (by way of Henry Blodget) web post which argues that the more the market drops, the more attractive it becomes for long-term investors.

But in the end, big stock market returns are made when everyone else is consumed by panic. We all know this ("Buy when there's blood in the streets") but it's incredibly hard to do. It's not just when the dumb money sells. They may have sold long ago, or maybe they'll never sell. Bottoms are made when us smart guys-- the "smart money"-- just can't stand it any more. We buy with both hands down 20%, and we puke down 40% ("this is a disaster-- get me out").

My gut is telling me that we're at the inflection point. That doesn't mean that today was the bottom. But it means that we're not going much lower. Into the 7's on the Dow? Maybe. Probably. But not into the 6s. So how's my gut's historical performance? Pretty good. I'm not exaggerating when I say that I feel very strongly about this: right now, today, right here. No guarantees, but it's a feeling that I don't get very often and that I've learned to trust.

I'm not predicting a near-term rally. Maybe yes, maybe no. What I'm feeling is that investments today in high quality stocks will produce substantial returns-- doubles or triples-- in the next two or three years. This is a once in a generation opportunity to acquire stakes in truly world class corporations at deeply discounted prices. They may well get cheaper, maybe much cheaper, in the next year or so. But in 2011, you'll marvel at the fact that you could have bought these stocks at those prices in December 2008.

So what to buy? It's easy. Buy the blue chips. Buy the companies that are the clear worldwide industry leaders. The ones that have the impregnable balance sheets and the multi-decade records of outsized returns to shareholders. It's truly like shooting fish in a barrel. Forget about relative performance. There will certainly be others that outperform. But names like Intel, Boeing, Microsoft, Caterpillar, Coca-Cola, Cisco, and Pfizer (among others) will give you solid double-digit returns or better plus a good dividend over the next few years. They are franchise companies that are rarely available at today's valuations.

What not to buy? Themes. Tips. ETFs. Anything that represents a guess as to the next market tick. Top down ideas like infrastructure or global decoupling. Anything dependent on interest rates, or commodity prices, or the Baltic Dry Index. Don't buy sum-of-the-parts stories, or discounts to NAV. Don't buy it if you have to look up the symbol, or if you can't immediately describe exactly what business they're in. There are just too many exceptional and truly inexpensive companies with virtually zero risk of accounting fraud, or adverse patent rulings, or competitive threats.

And yes, I know that we're in the worst recession of our lifetime. I know that housing prices haven't bottomed. I know that the payroll employment number on Friday will be a well below pessimistic expectations,that the unemployment rate is going to 10%, and that retail sales this Christmas season will be the worst since the Stone Age.

Bottom line: The market's not going much lower. It may take a while to recover--maybe a long while. But you can become an owner in some unbelievably great companies at incredibly good valuations right now. And they have dividends that compensate you very well while you wait.

Saturday, November 29, 2008

From the Wayback Machine

Too much time on my hands over the weekend. I dug around in the archives, both physical and electronic. From a box of old magazines, I came across Newsweek issues from December 2, 1974 (Cover story: "How Bad a Slump?") and January 20, 1975 ("Out of Work"). Some quotes that could have been lifted from today's issues:

"The recession worsens. Layoffs proliferate. Profits fall. Bankruptcies swell... And the worst is yet to come."

"Each day last week brought fresh reports of layoffs--massive ones in the auto industry and lesser ones in plants producing products as varied as textiles, electric organs and bicycles."

and from a New York Times editorial 12/29/1974 (via web archive), about a week after the market had bottomed:

"The year is ending with much of the nation in a state of deep anxiety over the course of the economy. There has been nothing like the present degree of apprehensiveness—or confusion—about the business outlook since 1930. And the question on everybody’s mind is whether years like 1931 and 1932 lie ahead."

By the way, of the many interesting things in boxes in my basement, I was most amused by the AIG 2001 annual report, which proclaimed boldly on the cover "The Greatest Risk Is Not Taking One."

Saturday, November 22, 2008

I interview myself

In this, my first blog post, I thought that I'd start out with an interview. After considering a few other candidates, I decided to interview myself.

YAIO: So what do we do now? Staring in the face of a nasty recession or worse, worldwide markets in shambles, seemingly nowhere to hide?

ME: I get the feeling that we're at an important inflection point now. Sure, there's lots of bad economic stuff ahead, and plenty of people have been blown up trying to call the bottom. I'm not saying that things won't get worse, but for the first time I'm seeing signs that we're at a turning point. We probably aren't at THE bottom, but we're near A bottom.

Just this past week I feel that the market left the path of "nasty bear" and strayed into "irrational". The thing that was most notable to me was the 9 point rally in 30 year treasury bonds on Thursday. NINE Points! I don't know what the previous record was, but I'll bet it was less than Four. Some media reports pointed to that move as an extreme manifestation of flight to safety and fear. I've got news for you: you don't buy 30 year bonds for safety, and in particular you don't buy them up nine points for safety. That was a mechanical move, probably by fixed income investors desperate for duration. It reminded me in some ways of the Volkswagen short-covering explosion last month.

YAIO: So what does that tell equity investors?

ME: We've seen some extreme moves in the markets lately. But it's dangerous to try to fade the extreme moves. Merely the fact that the stock market loses 50% of its value isn't a reason to buy-- it could certainly lose another 50% and then maybe another 50% after that!. Remember the quote attributed to Keynes: "the market can stay irrational longer than you can stay solvent". But in my experience these extreme moves that touch all asset classes often end with some type of blowoff. I think that the treasury move was a blowoff that signals a turning point.

But I'm not saying that a nine point move in the long bond is a sign that the stock market will rally. It's just an ingredient in a mix that gives me a bullish gut feeling. Here's what else is in that mix: First, the stock market's recent move is clearly an extreme. Before yesterday's rally, we were as oversold as we've ever been-- ever. Even if the S&P is going to zero, it won't go straight there. The biggest rallies occur in bear markets. That's the market's way of keeping honest. There are no free lunch, one-way trades.

Second is the zero boundary theory. Like I said, we're not going to zero, but the lower we get, the closer we are to the bottom. I can't tell you what the limit is on the upside: the S&P could go to 1500 or 15,000. P/E could go to 100x or higher. Just ask anyone who shorted tech stocks during that bubble. But I'm a lot more certain about predicting the downside limit. While individual stocks can go to zero, the entire market can't. Despite my comment above, I'm pretty confident that the market will absolutely not go below400-- let's say 500, which is still plenty conservative. That's still another 35% lower than Friday's close, which would be very ugly. But it defines your lower limit and your risk. But the upside, unlike the downside, is theoretically unlimited. I like those odds: 35% downside, unlimited upside.

YAIO: How do you know that the S&P won't go below 500? What are your valuation metrics?

ME: I suppose that's possible. But you can't protect against every single risk, or you'd never ride in an airplane or walk across the street. If a sub-500 S&P would cause you to lose your house or cause your family to starve, you shouldn't be in the equity market. I'm not saying that there's absolutely no chance of the market going to that level or lower, but it seems like a pretty safe bet. And as far as valuation, 500 would be 10x a $50 S&P earnings level. I'm not a big fan of valuation metrics because they seem to be least helpful just when you need them the most. But 10x $50 seems pretty dire.

YAIO: Some have suggested that both bull and bear forecasts will be wrong, and that the market will just flop along around this level for a long time-- possibly years.

ME: That could be. Bob Farrell predicts that we'll trade in a range of Dow 7800-98oo for a while, probably into next summer or so. That sounds about right to me. But from today's level, it gives us a pretty good trading opportunity. I'd be a seller if we neared the upper end of that range any time soon. But that's up over 20% from here.

YAIO: What do you think about the fact that you seem to be in line with the consensus in saying the market is cheap? Don't we need to wait for some type of capitulation?

ME: Frankly, that does bother me a bit. I think that most investment advisors are telling their clients not to sell-- it's too late, and that it's a mistake to puke at the bottom. However, if they're not recommending selling now, it's hard for me to believe that they'll get bearish at lower levels, even if the economy continues to weaken. Also, keep in mind that people running investment advisory businesses have a built-in bias. They've already seen their assets under management (and therefore their fee income) drop by nearly half. If you advise people to go to cash, why do they need an investment advisor? So you stay long, and if the market recovers, your business recovers. If the market continues to go down, the advisor's not worse off than if clients sold everything and went away.

But I am watching the consensus/contrarian thing. I see both bullish and bearish indicators every day. I think that when we ultimately bottom, it won't be because we've reached a point of maximum pessimism on some indicator. Rather, I think that we'll bottom after we go through a period where people just don't care about the equity markets for a while.

YAIO: Sounds like you're saying we're due for a bounce, but you don't have much confidence in the long term. What should we be buying now?

ME: That's about right. It depends on your time horizon. I'd focus on two strategies. First, there's the silly cheap stocks. They're short term trades into the bounce. Pick your own favorites here, but look for companies with fundamental franchise value even if the near term earnings picture is poor. Most of the large cap (or should I say "formerly large cap") banks fit this category. Also some media companies like NYT. I'll think about it and come up with some more names in subsequent posts.

The second strategy is to use this as an opportunity to make long-term investments in great companies at attractive prices. Boeing, Caterpillar, Exxon, Coca-Cola, Pfizer and IBM are a few that come to mind. If you're willing to invest for five years or more, I think that the risk-reward tradeoff for stocks like these is extraordinarily favorable. Take half-sized positions now, and prepare to buy more if they get cheaper (if you've got the stomach for it, consider selling out-of-the-money puts for the other half position, but that's a discussion for another day). The problem with this strategy is that most people don't have the required level of patience and discipline. They watch the value of their account and are likely to get scared out in a market selloff. Some very smart investors counsel to never add to a losing position. It's hard to do, but I think if you've got the right investments and the market gives you an opportunity to buy more at a lower price, you take it.

Finally on the topic of long-term investments, be sure to look for long-term growth opportunities. Although you'll hear plenty of advice to avoid investments in technology companies due to a cyclical downturn, many tech innovations are as anti-cyclical as you can get. Computers and cell phones will always get cheaper and better. The internet is a huge influence in our lives today, but it will only get more important in the future. Pick your own way to play tech, but be sure to have some in your portfolio. For my money, there's not much better than Google, and at yesterday's price of about 250, it's got a great risk/reward profile.

YAIO: Hmmm... you sound like a pretty smart guy. I presume that you've been a successful investor?

ME: honestly, not really. My biggest mistake was to steadily add to my equity portfolios over the past 20 years, and although I did quite well in the early years, that strategy has been a net loser since about 1998. I was brought up on the philosophy that as long as you've got a long-term horizon, stocks are the only place to be. "Long-term equity returns average 10%..." we all assumed that was true. But it's a lot more likely to be true in the near future now that we're back at the 1998 index levels.

that's it for now.