Friday, August 14, 2009

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