Thursday, August 27, 2009

2009 Chou Funds Semi-Annual Report

CONSTANT MATURITY SWAPS: With world governments flooding the system with liquidity and keeping interest rates unduly low, we wonder what financial instruments we can use that will protect us if inflation takes hold. We want an instrument similar to an insurance policy whereby the most we could lose is the amount of premium we pay upfront but get all the upside if the interest rate rises. We have identified two such instruments: Constant Maturity Swap Rate Caps (CMS RC) and Constant Maturity Swap Curve Caps (CMS CC).

HOW CMS RATE CAP WORKS: In simple terms, without going into the technical aspect of the transaction, let us assume that we think the 10-year U.S. Treasury will rise above 5.2% in three years (between now and 2012). The cost to buy that time option premium is roughly 100 basis points or 1.0%. Our break-even point is 6.2%. In essence, CMS Rate Caps are options to protect against rising interest rates and the most we can lose is the time option premium of 1.0%. On a notional amount of $10 million, the cost of the time option premium is $100,000 and every basis point increase above 6.2% translates into gains of approximately $1,000.

HOW CMS CURVE CAP WORKS: With a CMS Curve Cap we are assuming that the spread between short-term and long-term interest rates will widen in the future. For example, the current spread between 2-year Treasury and 10-year Treasury on the curve cap is 100 basis points. If we assume this spread will widen in three years (between now and 2012), we can buy a time option premium for 50 basis points or 0.5% that will expire in three years. We break-even when the spread exceeds 150 points; the most we can lose is the time option premium of 0.5%. On a notional amount of $10 million, the cost of the time option premium is $50,000; for every basis point the spread widens over 150 points, we would gain approximately $1,000.

The negatives are counterparty risk and, like insurance, the option premium that has been paid erodes over time and may expire worthless.

We do not intend to buy the CMSs right away. This instrument is attractive when every one is concerned about Depression, the government is providing all kinds of liquidity, interest rates are low and the time option premium for the CMSs is selling at a very low price relative to the dangers of inflation.

Tuesday, August 25, 2009

The truth about grit - By Jonah Lehrer

I’m a little late getting to this, but thanks to Dah Hui Lau, who passed it along a few weeks ago.

It’s the single most famous story of scientific discovery: in 1666, Isaac Newton was walking in his garden outside Cambridge, England - he was avoiding the city because of the plague - when he saw an apple fall from a tree. The fruit fell straight to the earth, as if tugged by an invisible force. (Subsequent versions of the story had the apple hitting Newton on the head.) This mundane observation led Newton to devise the concept of universal gravitation, which explained everything from the falling apple to the orbit of the moon.

There is something appealing about such narratives. They reduce the scientific process to a sudden epiphany: There is no sweat or toil, just a new idea, produced by a genius. Everybody knows that things fall - it took Newton to explain why.

Unfortunately, the story of the apple is almost certainly false; Voltaire probably made it up. Even if Newton started thinking about gravity in 1666, it took him years of painstaking work before he understood it. He filled entire vellum notebooks with his scribbles and spent weeks recording the exact movements of a pendulum. (It made, on average, 1,512 ticks per hour.) The discovery of gravity, in other words, wasn’t a flash of insight - it required decades of effort, which is one of the reasons Newton didn’t publish his theory until 1687, in the “Principia.”

Although biographers have long celebrated Newton’s intellect - he also pioneered calculus - it’s clear that his achievements aren’t solely a byproduct of his piercing intelligence. Newton also had an astonishing ability to persist in the face of obstacles, to stick with the same stubborn mystery - why did the apple fall, but the moon remain in the sky? - until he found the answer.

In recent years, psychologists have come up with a term to describe this mental trait: grit. Although the idea itself isn’t new - “Genius is 1 percent inspiration and 99 percent perspiration,” Thomas Edison famously remarked - the researchers are quick to point out that grit isn’t simply about the willingness to work hard. Instead, it’s about setting a specific long-term goal and doing whatever it takes until the goal has been reached. It’s always much easier to give up, but people with grit can keep going.


One of the most important elements is teaching kids that talent takes time to develop, and requires continuous effort. Carol S. Dweck, a psychologist at Stanford University, refers to this as a “growth mindset.” She compares this view with the “fixed mindset,” the belief that achievement results from abilities we are born with. “A child with the fixed mindset is much more likely to give up when they encounter a challenging obstacle, like algebra, since they assume that they’re just not up to the task,” says Dweck.

In a recent paper, Dweck and colleagues demonstrated that teaching at-risk seventh-graders about the growth mindset - this included lessons about the importance of effort - led to significantly improved grades for the rest of middle school.

Interestingly, it also appears that praising children for their intelligence can make them less likely to persist in the face of challenges, a crucial element of grit. For much of the last decade, Dweck and her colleagues have tracked hundreds of fifth-graders in 12 different New York City schools. The children were randomly assigned to two groups, both of which took an age-appropriate version of the IQ test. After taking the test, one group was praised for their intelligence - “You must be smart at this,” the researcher said - while the other group was praised for their effort and told they “must have worked really hard.”

Dweck then gave the same fifth-graders another test. This test was designed to be extremely difficult - it was an intelligence test for eighth-graders - but Dweck wanted to see how they would respond to the challenge. The students who were initially praised for their effort worked hard at figuring out the puzzles. Kids praised for their smarts, on the other hand, quickly became discouraged.

The final round of intelligence tests was the same difficulty level as the initial test. The students who had been praised for their effort raised their score, on average, by 30 percent. This result was even more impressive when compared to the students who had been praised for their intelligence: their scores on the final test dropped by nearly 20 percent. A big part of success, Dweck says, stems from our beliefs about what leads to success.

Woody Allen once remarked that “Eighty percent of success is showing up.” Duckworth points out that it’s not enough to just show up; one must show up again and again and again. Sometimes it isn’t easy or fun to keep showing up. Success, however, requires nothing less. That’s why it takes grit.


Related previous post: What it takes to be great

Steve Forbes Interview with Bruce Berkowitz

Steve Forbes Interview with Bruce Berkowitz: VIDEO

Monday, August 24, 2009

Hussman Weekly Market Comment: Bernanke Sees A Recovery - How Would He Know?

Ben Bernanke (like Tim Geithner and his predecessor Hank Paulson), shows no hesitation in diverting the real resources of the American public to defend and compensate the bondholders of mismanaged financial companies who made reckless loans and who should have (and equally important, could have) been expected to write down principal or swap debt for equity as an alternative to receivership. This is not decisiveness. It is timidity and poor stewardship. Worse, the underlying problems are not healed - only band-aided temporarily by a flood of public money.

Unfortunately, the resources used in the recent bailout were not just free money tossed out of a helicopter. Only a partial-equilibrium economist thinks that way. No, this was an allocation of trillions of dollars of real resources that could be spent improving access of poor families to health care, finding cures for life-changing diseases, providing better education, and reversing the crowding-out of productive private investment. A public servant willing to act this carelessly with the resources entrusted to him, and so strongly in defense of fellow bankers, frankly does not deserve the job. Most likely, we will face the same credit issues a few quarters from now, given that the lull in the adjustable-rate reset schedule is near its end. We continue to expect a fresh acceleration of credit losses as we enter 2010. It would be best if we faced these challenges with more thoughtful leadership.


Related link: Hussman Funds 2009 Annual Report and Letter to Shareholders

Wednesday, August 19, 2009

Sprott August Comment: Beyond the Stimulus

It is our view that the world’s combined government stimuli have completely distorted the global economy in the short term, and have encouraged a false sense of hope in the stock market. While the market has rallied, the real economy continues to struggle, and is notably worse in many areas. Rates of employment, corporate revenues, US housing prices and retail sales all continue to decline in the face of ‘shock and awe economics’. In our assessment of recent economic data, there are only two possible explanations for the recent market rally. Either investors are discounting an incredible economic recovery that is just around the corner (hard to believe), or the extra liquidity injected into the economy has found its way into the stock market. We’re leaning towards the latter alternative.

In the world of government stimulus, the size and speed of the injections are critical to their impact. Once the taps are turned on full bore, any reduction to the stimulus will have almost the same negative impact as removing it entirely. We are now seeing this reduction on three fronts: the Federal Reserve threatening to close the window on its 'quantitative easing’ program; the tax cuts and transfers already paid out to US citizens; and the Chinese banks now reining in their excessive lending. In trader terms - we will soon have no "dry powder" left to burn.

In their 2008 annual report, the Bank for International Settlements (BIS) recently reviewed previous banking crises and suggested that a sustainable recovery would require the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuild capital bases. The BIS concludes that “these conditions are not being met and any stimulus will therefore only lead to a temporary pick up in growth followed by protracted stagnation.” We agree wholeheartedly, and have seen nothing yet to suggest that the real problems plaguing the world’s banking system are being addressed. In our view, the threat of a double dip recession remains real. When the stimulus effects wear off there will be nothing left to replace the artificial demand they have induced. Investors should be prepared for what awaits us beyond the stimulus.

NY Times Op-Ed: The Greenback Effect - By Warren E. Buffett

The Greenback Effect



IN nature, every action has consequences, a phenomenon called the butterfly effect. These consequences, moreover, are not necessarily proportional. For example, doubling the carbon dioxide we belch into the atmosphere may far more than double the subsequent problems for society. Realizing this, the world properly worries about greenhouse emissions.

The butterfly effect reaches into the financial world as well. Here, the United States is spewing a potentially damaging substance into our economy — greenback emissions.

To be sure, we’ve been doing this for a reason I resoundingly applaud. Last fall, our financial system stood on the brink of a collapse that threatened a depression. The crisis required our government to display wisdom, courage and decisiveness. Fortunately, the Federal Reserve and key economic officials in both the Bush and Obama administrations responded more than ably to the need.

They made mistakes, of course. How could it have been otherwise when supposedly indestructible pillars of our economic structure were tumbling all around them? A meltdown, though, was avoided, with a gusher of federal money playing an essential role in the rescue.

The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.

To understand this threat, we need to look at where we stand historically. If we leave aside the war-impacted years of 1942 to 1946, the largest annual deficit the United States has incurred since 1920 was 6 percent of gross domestic product. This fiscal year, though, the deficit will rise to about 13 percent of G.D.P., more than twice the non-wartime record. In dollars, that equates to a staggering $1.8 trillion. Fiscally, we are in uncharted territory.

Because of this gigantic deficit, our country’s “net debt” (that is, the amount held publicly) is mushrooming. During this fiscal year, it will increase more than one percentage point per month, climbing to about 56 percent of G.D.P. from 41 percent. Admittedly, other countries, like Japan and Italy, have far higher ratios and no one can know the precise level of net debt to G.D.P. at which the United States will lose its reputation for financial integrity. But a few more years like this one and we will find out.

An increase in federal debt can be financed in three ways: borrowing from foreigners, borrowing from our own citizens or, through a roundabout process, printing money. Let’s look at the prospects for each individually — and in combination.

The current account deficit — dollars that we force-feed to the rest of the world and that must then be invested — will be $400 billion or so this year. Assume, in a relatively benign scenario, that all of this is directed by the recipients — China leads the list — to purchases of United States debt. Never mind that this all-Treasuries allocation is no sure thing: some countries may decide that purchasing American stocks, real estate or entire companies makes more sense than soaking up dollar-denominated bonds. Rumblings to that effect have recently increased.

Then take the second element of the scenario — borrowing from our own citizens. Assume that Americans save $500 billion, far above what they’ve saved recently but perhaps consistent with the changing national mood. Finally, assume that these citizens opt to put all their savings into United States Treasuries (partly through intermediaries like banks).

Even with these heroic assumptions, the Treasury will be obliged to find another $900 billion to finance the remainder of the $1.8 trillion of debt it is issuing. Washington’s printing presses will need to work overtime.

Slowing them down will require extraordinary political will. With government expenditures now running 185 percent of receipts, truly major changes in both taxes and outlays will be required. A revived economy can’t come close to bridging that sort of gap.

Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes. In fact, John Maynard Keynes long ago laid out a road map for political survival amid an economic disaster of just this sort: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.... The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

I want to emphasize that there is nothing evil or destructive in an increase in debt that is proportional to an increase in income or assets. As the resources of individuals, corporations and countries grow, each can handle more debt. The United States remains by far the most prosperous country on earth, and its debt-carrying capacity will grow in the future just as it has in the past.

But it was a wise man who said, “All I want to know is where I’m going to die so I’ll never go there.” We don’t want our country to evolve into the banana-republic economy described by Keynes.

Our immediate problem is to get our country back on its feet and flourishing — “whatever it takes” still makes sense. Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.

Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.


Tuesday, August 18, 2009

The New American Dream: Renting - By Thomas J. Sugrue

For most Americans, until the recent past, home ownership was a dream and the pile of rent receipts was the reality. From 1900, when the census first started gathering data on home ownership, through 1940, fewer than half of all Americans owned their own homes. Home ownership rates actually fell in three of the first four decades of the 20th century. But from that point on forward (with the exception of the 1980s, when interest rates were staggeringly high), the percentage of Americans living in owner-occupied homes marched steadily upward. Today more than two-thirds of Americans own their own homes. Among whites, more than 75% are homeowners today.

Yet the story of how the dream became a reality is not one of independence, self-sufficiency, and entrepreneurial pluck. It's not the story of the inexorable march of the free market. It's a different kind of American story, of government, financial regulation, and taxation.

We are a nation of homeowners and home-speculators because of Uncle Sam.

It wasn't until government stepped into the housing market, during that extraordinary moment of the Great Depression, that tenancy began its long downward spiral. Before the Crash, government played a minuscule role in housing Americans, other than building barracks and constructing temporary housing during wartime and, in a little noticed provision in the 1913 federal tax code, allowing for the deduction of home mortgage interest payments.

Until the early 20th century, holding a mortgage came with a stigma. You were a debtor, and chronic indebtedness was a problem to be avoided like too much drinking or gambling. The four words "keep out of debt" or "pay as you go" appeared in countless advice books. As the YMCA told its young charges, "If you can't pay, don't buy. Go without. Keep on going without." Because of that, many middle-class Americans—even those with a taste for single-family houses—rented. Home Sweet Home didn't lose its sweetness because someone else held the title.

In any case, mortgages were hard to come by. Lenders typically required 50% or more of the purchase price as a down payment. Interest rates were high and terms were short, usually just three to five years. In 1920, John Taylor Boyd Jr., an expert on real-estate finance, lamented that "increasing numbers of our people are finding home ownership too burdensome to attempt." As a result, there were two kinds of homeowners in the United States: working-class folks who built their own houses because they couldn't afford mortgages and the wealthy, who usually paid for their places outright. Even many of the richest rented—because they had better places to invest than in the volatile housing market.

The Depression turned everything on its head.


And that brings us back to those desperate homeowners who gathered at Atlanta's convention center, having lost their investments, abruptly woken up from the dream of trouble-free home ownership and endless returns on their few percent down. They spent hours lined up in the hot sun, some sobbing, others nervously reading the fine print on their adjustable rate mortgage forms for the first time, wondering if their house is the next to go on the auction block. If there's one lesson from the real-estate bust of the last few years, it might be time to downsize the dream, to make it a little more realistic. James Truslow Adams, the historian who coined the phrase "the American dream," one that he defined as "a better, richer, and happier life for all our citizens of every rank" also offered a prescient commentary in the midst of the Great Depression. "That dream," he wrote in 1933, "has always meant more than the accumulation of material goods." Home should be a place to build a household and a life, a respite from the heartless world, not a pot of gold.

FRBSF Economic Letter: U.S. Household Deleveraging and Future Consumption Growth

Thanks to Matt and Mike for passing this along.

It seems the deleveraging process may take longer and be more painful than most people think (and certainly longer and more painful than much of the media portrays…..surprise, surprise).

U.S. household leverage, as measured by the ratio of debt to personal disposable income, increased modestly from 55% in 1960 to 65% by the mid-1980s. Then, over the next two decades, leverage proceeded to more than double, reaching an all-time high of 133% in 2007. That dramatic rise in debt was accompanied by a steady decline in the personal saving rate. The combination of higher debt and lower saving enabled personal consumption expenditures to grow faster than disposable income, providing a significant boost to U.S. economic growth over the period.

In the long-run, however, consumption cannot grow faster than income because there is an upper limit to how much debt households can service, based on their incomes. For many U.S. households, current debt levels appear too high, as evidenced by the sharp rise in delinquencies and foreclosures in recent years. To achieve a sustainable level of debt relative to income, households may need to undergo a prolonged period of deleveraging, whereby debt is reduced and saving is increased. This Economic Letter discusses how a deleveraging of the U.S. household sector might affect the growth rate of consumption going forward.

Monday, August 17, 2009

Freeman Dyson on Charlie Rose

A conversation with theoretical physicist and mathematician Freeman Dyson: VIDEO


Related previous posts:


Friday, August 14, 2009

Martin Capital Management - Fireside Chat No. 6

Although nobody seems to care at the moment, rapidly rising prices make stocks more expensive—and thus riskier. Referring to the Graham/Shiller PE (below, in the written version), as highlighted in the 2008 MCM annual report and subsequent writings, its utility as a valuation tool for long-term investors is in its design: It was constructed to smooth out short-term fluctuations in earnings by using a 10-year moving average and, because it’s a longer-term measure, the effect of inflation/deflation on both earnings and the value of the S&P 500 index is largely nullified. While Graham/Shiller states the obvious, it isn’t commonly employed as a valuation tool. Given its several indisputable bubble warnings over the last 10 years, one must presume that neither Greenspan nor Bernanke is aware of its existence.
As noted on the chart, the PE fell to a month-end low of 13.3 times in February and is currently at 17.5. With one exception, no bubble market in the last 130 years—defined as one in which the Graham/Shiller PE rose above 20 times earnings—escaped the ignominy of sinking to single-digit PEs in the bust that followed. The exception, at least thus far, is the current bear market (or is this a new bull market?). The game is tight, the time short, and all about us are on their feet screaming for the home team. In the marketplace the rational player must keep his game face, and his seat, stoically aware that "the opera ain't over till the fat lady sings."
The following appeared in our 2005 annual report and seems as apropos today as it was then:
John Kenneth Galbraith had the following to say about those who had the temerity to utter caveats when the “wonderful process of enrichment” was under a full head of steam. “There are, however, few matters on which such a warning is less welcomed,” he wrote. “In the short run, it will be said to be an attack, motivated by either deficient understanding or uncontrolled envy, on the wonderful process of enrichment. More durably, it will be thought to demonstrate a lack of faith in the inherent wisdom of the market itself.” Duty leaves us no choice. If the future proves us misguided, we will have cost you opportunity. If we are closer to the truth than even we would like to be, we may have protected your capital and, more importantly, your capacity to venture forth into an always uncertain investment world in the future, perhaps when low hanging fruit is begging to be picked…
Related books:

Advisor Perspectives: At the Risk of Repeating Ourselves – By Michael Lewitt, Editor, The HCM Market Letter

Gillian Tett’s book about how the credit default swap market became the monster that swallowed not just Manhattan and London but the entire global economy is an instructive and entertaining read. Ms. Tett is one of the more astute financial journalists on the scene today, and HCM found the explanation of her holistic approach to interpreting the financial markets to be similar to our own. Both in writing this newsletter and in providing investment services for our clients, HCM has attempted to apply our background in literature, history, philosophy and law.

We are certain that our quantitative-minded competitors will find this admission appalling, but hopefully not as appalling as the massive losses they have incurred over the years by placing undue reliance on investment models that are flawed in conception and execution.HCM believes that one must be a close reader of financial markets, and reading is a skill best learned through a thorough grounding in the humanities. Science and math have their place in the investment world, but too much emphasis on these disciplines has too often led to disaster (i.e. Long Term Capital Management). Investing is far more art than science. HCM long ago concluded that investors would be better served by studying psychology than economics in trying to understand the markets, and the school of thought known as behavioral finance has undertaken to combine these two fields very effectively. As Ms. Tett’s history of a good idea gone wild demonstrates, a familiarity with the irrational is far more valuable than quantitative and technical knowledge in evaluating the market landscape.


The ability to digest information and place it within any kind of meaningful context has been compromised by the constant stream of information that is overwhelming in its volume and underwhelming in its relevance. Nonsense has been elevated to the level of news, while news has been devalued to the level of nonsense.

Despite what the pundits would have you believe, nobody has the faintest idea whether the economy is going to experience sustainable growth once the government stops stimulating it. The Armageddon trade is clearly off the table, but the Return to Nirvana trade is nowhere on the horizon either. Second quarter earnings were impressively ahead of estimates, but like first quarter estimates were again based on cost cutting and balance sheet reparation, not revenue growth. In fact, revenues were sharply down in virtually every industry, suggesting that the economy is still shrinking. An economy can’t shrink itself to prosperity, so sooner rather than later either revenue growth will appear or there will be more trouble ahead.


Is China’s Growth For Real?

Skeptics that we are, we have been bemused by the willingness of market observers to accept China’s growth story at face value. At the very least, China’s growth (like America’s recovery) is largely attributable to massive government stimulus and is still lacking a sustainable domestic demand story. The stimulus plan announced by China’s government last November amounted to a whopping 14 percent of GDP. As a percentage of GDP, that is three to four times the size of the U.S. stimulus plan. On July 15, 2009, China reported a 7.9 percent growth rate for the second quarter of 2009 compared to the same period a year earlier.

Our concerns about the quality and sustainability of China’s growth were confirmed by someone whose views we admire very much and from whom we unfortunately hear from all too rarely these days, Morgan Stanley’s Steven Roach. He warned in the Financial Times on July 29, 2009 that he was beginning to worry about the China growth story. His concerns arise from the short-term nature of China’s fiscal stimulus package and the fact that a public capital expenditure drive has accounted for 88 percent of Chinese GDP growth this year, a clearly unsustainable pace. Mr. Roach points out that China accounted for two percent of global economic growth in the second quarter of 2009 and contributed significantly to export growth throughout the rest of Asia. In other words, little of China’s growth has come from sustainable domestic sources, and the end of government spending could spell trouble not only for China but for the rest of Asia and the world. Without China’s Herculean stimulus, the global economy would be considerably further behind the curve on the road to recovery.

While providing a short-term boost that offers hope for those around the world grasping for green shoots, China’s stimulus is more likely a recipe for inflation and ultimately for boom and bust. HCM has always believed that China would be a story of booms and busts, and recent activity seems to support this view. Recent unrest in China’s provinces is likely a coincidental indicator of the difficulties inherent in managing such a vast economy. Investors in China should proceed cautiously and look under the surface to understand the real forces driving growth. If China is the future of the world, as many believe it is, the future may not be as great as it’s cracked up to be. Future economic growth certainly isn’t going to be as smooth or simple as some would like it to be.


Related book: Fool’s Gold