Oaktree Capital & Howard Marks' Review of 2009

Via Market Folly: Oaktree Capital & Howard Marks' Review of 2009

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Murray N. Rothbard on forecasters and the Kondratieff Cycle (1984 article)

At the end of Sprott’s latest commentary, they mentioned the Kondratieff Cycles, which I had never heard of. When I searched for more information, I came across a 1984 article from Murray Rothbard that discussed the topic and that I thought was interesting, although I enjoyed his comments about forecasters - in which he uses one of Munger's favorite words, "twaddle" - more than the comments about the Kondratieff Cycle. Some excerpts and a link to the article are below.

Excerpts:

In the same way, the astrologers fudge on their predictions. If you are a Pisces, they will proclaim that you are a mystic, who loves water. If you say, "You're right," they will smile triumphantly upon this confirmation of their analysis. But if you say, "Wrong. I'm a skeptic who hates water," they'll say, "Ahh, that's because your Jupiter is rising, and you're fighting your stars," or some such twaddle. The key point is that, with any guru worth his salt, there is no way ever to prove him wrong. He will always come up with the fudge factor. And, it should be clear to the wise that a prediction that somehow can never be proved wrong is worth far less than the paper it is printed on.

Furthermore, when anyone spends a lot of time predicting, on whatever grounds, once in a while some of these forecasts are bound to be proved right, just by chance. And so, in the world of economic as well as astrological forecasting, the soothsayers trumpet any successes they may have ("I predicted . . . !") while quietly burying their mistakes.

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It should be recognized that most business-cycle theories – Keynesian, Marxist, Friedmanite, or whatever – and remedies are grounded in the assumption that the cycle stems from some deep flaw in the free-market economy. But if micro-theory is correct, then it must apply to the "macro" sphere as well. The economy is not some entity split between a micro and macro half; it is a seamless web, inextricably linked together by the use of money and the price system. Therefore, whatever applies to one part of it must apply to all. The explanation for business cycles must somehow be integrated with the explanation of the micro-economy.

The Cycles Multiply

One of the worst things about the "business cycle" is its name. For somehow the name "cycle" caught on, with its implication that the wave-like movement of business is strictly periodic, like the cycles of astronomy or biology. An enormous amount of error would have been avoided if economists had simply used the term "business fluctuations." For man is all too prone to leap to the belief that economic fluctuations are strictly periodic and can therefore be predicted with pinpoint accuracy. The fact is, however, that these waves are in no sense periodic; they last for few years, and the "'few" can stretch or contract from one wave to the next. The periodic notion was unfortunately fed by the fact that the early panics seemed to be ten years apart: 1837, 1847, 1857, but pretty soon that periodicity broke down.

At that point, those who had made their reputations as forecasters of the cycle had two options: they could have simply given up the idea of periodicity. But that would have detracted from their aura of omniscience. And so, many of them introduced the first big fudge factor: the idea that cycles, despite appearances, are still strictly periodic, except that there are several mystical cycles all occurring simultaneously beneath the data, and that if you manipulated the data long enough, you could find these simultaneous, parallel, strictly periodic cycles, all going on at the same time. The apparently non-periodic data are only the random result of the interactions of the strictly periodic cycles.

This doctrine is mystic for two basic reasons. In the first place, very much like the "epicycles" of the Ptolemaic astronomers who fought against the Copernican Revolution, there is no way ever to prove the cycles wrong. If the cycles don't fit the facts, you can always conjure up one or two more "cycles" so as to make a perfect fit. Note that the fit has to keep changing in order to adapt to the new data that are always coming in. More epicycles get folded into the data. Secondly, as we noted above, the market is a seamless web. All facets of the market are interconnected through the price system, and the profit-and-loss motive. Booms and busts spread throughout the system; that is precisely why they are important. It is absurd to think that one part of the economy can peg along on a nine-year cycle, another on a three-year cycle, and still another on a 25-year cycle, with each of these cycles barreling along on a hermetically sealed track, not influencing and modifying each other. In fact, there can only be one real cycle going on in the economy at any one time.

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Why Business Cycles?

If "the Kondratieff cycle" is a myth and a chimera, why are there business cycles at all? There is no space here to present a positive solution to the business-cycle phenomenon. But we have already seen (1) that since the market is interrelated and a seamless web, there can be no multiple "underlying" and interacting cycles; there is only one business cycle. And (2) the real business cycle is in no sense periodic, but is a continuing, wave-like motion that varies considerably in length and intensity.

We can only sum up the correct answer to the problem of the business cycle. We have already seen a hint of the solution: that inflation and the inflationary boom are caused by bank credit expansion generated by governments. In fact, government's central banking system provides the key causal element for all business cycles, a cause exogenous to the market economy. Continuing government intervention sets in motion business cycles by generating inflationary booms. Because these booms distort the signals of the market place in interest rates and in relative prices they bring about grave distortions of production and prices, which must be corrected by recessions and depressions.

In short, government intervention cripples the market economy, and recession or depression is the painful but necessary adjustment by which the market reasserts itself, and liquidates the distortions committed by the government's inflationary boom. After each depression, the government generates inflation once again, because it is the government's natural tendency to inflate. Why? Quite simply, whoever is granted a monopoly of printing money (e.g., the Fed, the Bank of England) will use that monopoly and print – to finance government deficits, or to subsidize favored economic groups. Power will tend to be used, and the power to create money out of thin air is no exception to the rule.

And so we see – and this is the great insight of the "Austrian" theory of the trade cycle – that micro and macro economics are in harmony after all. The free market does tend to adjust harmoniously without boom and bust, without incurring clusters of severe business losses. It is government intervention in the market that creates the business cycle, and unfortunately makes the corrective adjustment of recessions necessary. The cause of the boom-bust cycle is not some mystical periodic Force to which man must bend his will; the fault, dear Brutus, is not in our stars but in ourselves, that we are underlings.

Link to Article

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Related previous post: Economic Depressions: Their Cause and Cure - by Murray N. Rothbard

A Crisis of Understanding - By Robert J. Shiller

Found via Simoleon Sense.

Few economists predicted the current economic crisis, and there is little agreement among them about its ultimate causes. So, not surprisingly, economists are not in a good position to forecast how quickly it will end, either.

Of course, we all know the proximate causes of an economic crisis: people are not spending, because their incomes have fallen, their jobs are insecure, or both. But we can take it a step further back: people’s income is lower and their jobs are insecure because they were not spending a short time ago – and so on, backwards in time, in a repeating feedback loop.

It is a vicious circle, but where and why did it start? Why did it worsen? What will reverse it? It is to these questions that economists have been unable to offer clear answers.

The state of economic knowledge was just as bad in the Great Depression that followed the 1929 stock market crash. Economists did not predict that event, either. In the 1920’s, some warned about an overpriced stock market, but they did not predict a decade-long depression affecting the entire economy.

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Indeed, the crisis knows no end to the list of its causes. For, in a complicated economic system that feeds back on itself in many ways, events that start a vicious cycle might be as seemingly trivial as the proverbial butterfly in the Amazon, which, by flapping its wings, sets off a chain of events that eventually results in a far-away hurricane. Chaos theory in mathematics explains such dependency on remote and seemingly trivial initial conditions, and explains why even the extrapolation of apparently precise planetary motion becomes impossible when taken far enough into the future.

Weather forecasters cannot forecast far into the future, either, but at least they have precise mathematical models. Massive parallel computers are programmed to yield numerical solutions of differential equations derived from the theory of fluid dynamics and thermodynamics. Scientists appear to know the mechanism that generates weather, even if it is inherently difficult to extrapolate very far.

The problem for macroeconomics is that the types of causes mentioned for the current crisis are difficult to systematize. The mathematical models that macroeconomists have may resemble weather models in some respects, but their structural integrity is not guaranteed by anything like a solid, immutable theory.

The most important new book about the origins of the economic crisis, Carmen Reinhart’s and Kenneth Rogoff’s This Time Is Different, is essentially a summary of lessons learned from virtually every financial crisis in every country in recorded history. But the book is almost entirely non-theoretical. It merely documents recurrent patterns. Unfortunately, in 800 years of financial history, there is only one example of a really massive worldwide contraction, namely the Great Depression of the 1930’s. So it is hard to know exactly what to expect in the current contraction based on the Reinhart-Rogoff analysis.

This leaves us trying to use patterns from past, dissimilar crises to try to infer the likely prognosis for the current crisis. As a result, we simply do not know if the recovery will be solid or disappointing.

60 Minutes: Inside The Collapse

Part 1

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Part 2

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Web Extra: Is Wall Street Overpaid?

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Web Extra: Bailout Blues

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Web Extra: The $8.4 Billion Bet

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Web Extra: Wall Street Misfit

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Related previous post (Michael Lewis article about Michael Burry):

Betting on the Blind Side - By Michael Lewis

To read some of Dr. Burry's letters to investors, go HERE.

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Hussman Weekly Market Comment: Ordinary Outcomes of Extraordinary Recklessness

The first thought that the above quote might provoke is - why would I begin a weekly comment by quoting an economic analysis that is nearly 5 years old? Two reasons. First, it should be evident that the recent credit crisis did not emerge as some unpredictable surprise, but was instead the very ordinary outcome of extraordinary recklessness. Though the mounting problems in 2005 were utterly ignored by the stock market for more than two years after this analysis was published, the fact is that even with the recent rebound, the S&P 500 remains below where it was in mid-2005. Overvaluation and reckless lending do not always translate into near-term market weakness, but they invariably haunt investors in the form of poor long-term returns.

Second, I've chosen a 5-year old analysis of mortgage lending specifically because the Alt-A (no documentation) and Option-ARM (negative amortization) loans discussed by the Economist commonly sported reset dates 5 years into the loan terms. So the observation that "payments surge as principal repayment kicks in" is not an event that was occurring then. Rather, it is an event that has just begun to occur with loans now hitting their resets. And while current ARM interest rates are only about 4.5%, these mortgages now demand a combination of interest plus principal repayment, on a loan balance that is most likely well above the current market value of the home. This is likely to be onerous relative to a previous payment that was less than the interest alone.

Mohnish Pabrai on Bloomberg - Pimm Fox podcast

Thanks to Phil for passing this along. Mr. Pabrai comes in around the 14-minute mark.

Link to: Mohnish Pabrai on Pimm Fox's podcast

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Greece Lifts a Page From Citigroup’s Playbook - by Jonathan Weil

Is it too much to ask for the world’s titans of government and finance to speak credibly when they open their mouths? Some of them sure seem to think so, judging by the latest news from the financial-crisis front.

To hear Vikram Pandit tell it, Citigroup Inc. was a healthy institution when it got bailed out by the U.S. government. The problem back in November 2008, Citigroup’s chief executive officer told a congressional oversight panel last week, was that short sellers were driving down its stock price in spite of the bank’s fundamental strength.

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In April 2008, Lehman Brothers Holdings Inc. CEO Dick Fuld declared the “worst is behind us,” while blaming short sellers for his bank’s faltering share price. (In a short sale, an investor sells borrowed shares in hopes of buying them back at a lower price later and pocketing the difference.)

By July, the Securities and Exchange Commission had unveiled the first in a series of emergency short-selling rules that made it harder for investors to bet against the stocks of Lehman and 18 other “substantial financial firms.” Instead of helping the companies, the move wound up highlighting which financial-services companies the government was worried about the most, including Fannie and Freddie.

That same month, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke testified in Congress that Fannie and Freddie were adequately capitalized. Two months later, Paulson directed the government to seize both companies because they were insolvent.

TED Talk - Bob Thurman says we can be Buddhas

Public Pension Funds Are Adding Risk to Raise Returns

Does anyone think this is likely to end well?

States and companies have started investing very differently when it comes to the billions of dollars they are safeguarding for workers' retirement.

Companies are quietly and gradually moving their pension funds out of stocks. They want to reduce their investment risk and are buying more long-term bonds.

But states and other bodies of government are seeking higher returns for their pension funds, to make up for ground lost in the last couple of years and to pay all the benefits promised to present and future retirees. Higher returns come with more risk.

"In effect, they're going to Las Vegas," said Frederick E. Rowe, a Dallas investor and the former chairman of the Texas Pension Review Board, which oversees public plans in that state. "Double up to catch up."

Though they generally say that their strategies are aimed at diversification and are not riskier, public pension funds are trying a wide range of investments: commodity futures, junk bonds, foreign stocks, deeply discounted mortgage-backed securities and margin investing. And some states that previously shunned hedge funds are trying them now.

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Towers Watson, a big benefits consulting firm, surveyed senior financial executives last year and found that two-thirds planned to decrease the stock portion of their companies' pension funds by the end of 2010. They typically said their stock allocations would shrink by 10 percentage points.

"That's 10 times the shift we might see in any given year," said Carl Hess, head of Towers Watson's investment consulting business. Economists have speculated that a truly seismic shift in pension investing away from stocks could be a drag on the market, but they say it would not be long-lasting.

Corporate America's change of heart is notable all on its own, after decades of resistance to anything other than returns like those of the stock markets. But it's even more startling when compared with governments' continued loyalty to stocks. When governments scale back on the domestic stocks in their pension portfolios these days, it is often just to make way for more foreign stocks or private equities, which are not publicly traded.

Government pension plans cannot beef up their bonds that mature many, many years from now without dashing their business models. They use long-range estimates that presume high investment returns will cover most of the cost of the benefits they must pay. And that, they say, allows them to make smaller contributions along the way.

Most have been assuming their investments will pay 8 percent a year on average, over the long term. This is based on an assumption that stocks will pay 9.5 percent on average, and bonds will pay about 5.75 percent, in roughly a 60-40 mix.

(Corporate plans do their calculations differently, and for them, investment returns are a less important factor.)

The problem now is that bond rates have been low for years, and stocks have been prone to such wild swings that a 60-40 mixture of stocks and bonds is not paying 8 percent. Many public pension funds have been averaging a little more than 3 percent a year for the last decade, so they have fallen behind where their planning models say they should be.

A growing number of experts say that governments need to lower the assumptions they make about rates of return, to reflect today's market conditions.

But plan officials say they cannot.

"Nobody wants to adjust the rate, because liabilities would explode," said Trent May, chief investment officer of Wyoming's state pension fund.

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Wisconsin, meanwhile, has become one of the first states to adopt an investment strategy called "risk parity," which involves borrowing extra money for the pension portfolio and investing it in a type of Treasury bond that will pay higher interest if inflation rises.

Officials of the State of Wisconsin Investment Board declined to be interviewed but provided written descriptions of risk parity. The records show that Wisconsin wanted to reduce its exposure to the stock market, and shifting money into the inflation-proof Treasury bonds would do that. But Wisconsin also wanted to keep its assumed rate of return at 7.8 percent, and the Treasury bonds would not pay that much.

Wisconsin decided it could lower its equities but preserve its assumption if it also added a significant amount of leverage to its pension fund, by using a variety of derivative instruments, like swaps, futures or repurchase agreements.

Hussman Weekly Market Comment: The Rubber Hits the Road

A deleveraging cycle is much like a secular bear market in that the market experiences a great deal of volatility, but tends to establish a sequence of troughs, each at lower levels of valuation (even if not at lower absolute prices). In that environment, there is significant risk of abrupt spikes in risk aversion (which implies abrupt price spikes to the downside), so you can't trade with "hot" valuation or market action criteria. It should be no surprise that Graham and Dodd wrote Security Analysis following the post-credit crisis period of the 1920's and 1930's. If there's one lesson from those environments, it is that valuations and the idea of a "margin of safety" takes precedence over all other considerations.

In post-war data where investors have not been concerned about credit and banking crises (and especially since the mid-1990's), valuations have been a less reliable investment guide except over the complete bull-bear cycle. Even in the face of valuation bubbles and pertinent risks that have predictably harmed investors over the longer term, investors have demonstrated themselves to be quite willing to ignore those risks and speculate. While there has always been this element in post-war data, it has become very exaggerated in the past 15 years. An important feature of post-war cycles is that when credit crisis is not a concern, you've generally been able to cut losses before the real damage is done by paying very strict attention to market internals. Risk aversion doesn't spike as abruptly. In contrast, the losses in a credit crisis can slam investors from left field.

Basically, trends, technicals and market internals have played a larger role in post-war data, and particularly since 1995, allowing the market to periodically tolerate valuations that would have collapsed much sooner in earlier times. Still, valuations have remained important in determining the extent to which market returns are durable. Ultimately, valuations have determined long-term returns regardless of what portion of history you examine. Speculative advances in richly valued markets are invariably surrendered later.

The S&P 500 is still below where it was a decade ago, and even with the benefit of its recent advance, has underperformed Treasury bills for nearly 13 years. The reason is that investors could not have cared less about valuations during the late-1990's, and failed to recognize that they were still inappropriately rich between 2004-2007 (as they are again today). Speculators can get all kinds of enticing advances going over the short-term, but over time (complete market cycles and longer), regardless of whether one looks at post-war data or pre-war data, valuations determine the long-term returns that investors achieve in stocks.

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Last week, we observed a subtle shift in yield pressures, which has historically been associated with fairly abrupt "air pockets" in which stocks have typically lost 10% or more within the span of about 6 weeks. As usual, this isn't a forecast, but given that we are already defensive on the basis of broader considerations about overvaluation and the overbought status of the market, the pressures we're seeing on the yield front make our aversion to market risk somewhat more pointed.