The Absolute Return Letter - November 2012: The Era of Kakistocracy

We are now five years into a crisis that just doesn't want to go away. Policy makers continue to throw whatever policy tools they have at the crisis. Meanwhile, investor anxiety about the inflationary implications of such policy moves continues to grow. Hence we re-visit the old inflation vs. deflation discussion we first opened in 2009 and conclude that high inflation is not at all the most likely outcome of this crisis. This doesn't imply, though, that the outcome is good. Far from it.

Richard Duncan quote

“When the United States removed the gold backing from the dollar in 1968, the nature of money changed. The result was a proliferation of credit that not only transformed the size and structure of the U.S. economy but also brought about a transformation of the economic system itself. The production process ceased to be driven by saving and investment as it had been since before the Industrial Revolution. Instead, borrowing and consumption began to drive the economic dynamic. Credit creation replaced capital accumulation as the vital force in the economic system.” –Richard Duncan, The New Depression

Some Thoughts on Election Eve - by Gene A. Hoots

Soon we will know the result of what has been billed as “the most important election in our lifetime.”  I suspect that when you look back years from now it will be hard for you to believe that is so.  Poles, computer programs, and pundits are forecasting everything from an Obama landslide to a Romney landslide with many saying it is too close to call either way.  Like stock market forecasts, somebody is going to be right and will be heralded as a genius, probably just by being lucky.  I will forecast one thing – the sun will rise on November 7 just as it has every day for a long time and we will get on with our business and the nation’s business.

In 1980 just before the Carter Reagan election, I had the pleasure of sitting next to the great historian Will Durant at a dinner in Los Angeles.  He was asked who he thought would win that election.  He viewed the world from about 75 years of studying and writing history.  His answer was, “It isn’t going to make any difference.  The mood of the country has shifted to conservative and either President will ultimately bend to the will of the people.”  This is nearly always the case, although it takes time.  This election presents a real problem for the president because the “people” seem to be so polarized that we don’t know where we want to go.

This situation reminds me of an incident with my Uncle Ken.  He was on the street in Mocksville one day when a stranger stopped and asked if he could recommend a restaurant in town.  Ken said, “We have C’s Café at one end of town and the Barbecue Pit at the other end.  It won’t matter which one you go to, you’ll always wish you had gone to the other one.”

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Related book: Pay Attention to the Thin Cow

Related previous posts:

Pay Attention to the Thin Cow – By Gene A. Hoots

The thin cow…

Don't Enlist In the 7th Cavalry - by Gene Hoots

GR-NEAM Reflections: 11/02/2012 - Primate In Distress

Rising uncertainty about the future is evident in a number of empirical indicators, and is understood to have a cost in suppressing hiring and investment. Large-scale experimentation by central banks may itself contribute to a problem that they are trying to solve.

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Related previous post: A.M. Best Webinar: Asset Management Perspectives (video)

Buttonwood: Back to the Shiller p/e

ONE key reason why I have been pessimistic about the outlook for the US stockmarket is based on the use of the Shiller price-earnings ratio. Ben Graham, the doyen of securities analysis, devised a version of this measure, but it has become associated with Robert Shiller, the Yale professor who can claim credit for calling both the dotcom and housing bubbles in his book Irrational Exuberance. He maintains the data on his own website.

The Shiller version tries to eliminate the effect of the economic cycle on valuations; without it, stock markets look expensive when earnings collapse in recessions and look cheap when earnings are high in booms. So it averages earnings over 10 years, and adjust them for inflation; at the moment, the p/e is 21.5, well above the historical mean.

So what? The noted quant, Cliff Asness, head of fund management group AQR, published a third quarter commentary in which he looked at future equity returns when the Shiller p/e was at current levels. The average 10 year real return was just 0.9%. Indeed, if you rank years by Shiller p/es, then you get an almost perfect relationship between valuations and future returns; real returns when the Shiller p/e was at its lowest ranged between 10.3 and 10.4%.

Now Mr Asness points out that there is a danger of small-sample bias and that the standard deviation of results is quite high. Nor is the Shiller p/e much use as a market timing signal; it was already high in the late 1990s and got even higher by the spring of 2000.

Hussman Weekly Market Comment: Stream of Anecdotes

Is the economy at an inflection point, or are we simply in the calm before the storm? Though economic reports have been relatively muted on balance, they have also come in somewhat above expectations in recent weeks – particularly the advance estimate of third quarter GDP at 2%, and October non-farm payrolls at 171,000. The lack of clear deterioration in recent reports begs the question of whether this is enough to dispose of any concern about recession, and instead look forward to continued positive – if slow – economic progress.

The answer to that question largely depends on how one draws inferences from economic data. The consensus of Wall Street economists, as well as the broader economic consensus, has never successfully identified a U.S. recession until well after it has begun. I believe that much of the reason is that economists tend to interpret reports one-by-one as what I’ve called a “stream of anecdotes.” From that perspective, a series of positive anecdotes, such as the reports we’ve recently seen on GDP and non-farm payrolls, encourages views that the economic landscape is all clear.

The problem is that the stream of anecdotes approach places no structure on the data – there is no analysis of leading/lagging or upstream/downstream relationships, no examination of the frequency and size of revisions to the data – particularly around economic turning points – and no attempt to place the data points into a larger “gestalt” that captures relationships between dozens of other economic reports. Moreover, it's natural for analysts to gauge “trends” by comparing recent reports to past data, with a look-back horizon somewhere in the range of 13-26 weeks. If analysts then form expectations by extrapolating recent surprises, it then becomes very easy to produce regular “cycles” of economic surprises. We’ve been able to generate that phenomenon even using randomly generated data. In practice, the cycle of economic “surprises” tends to run about 44-weeks in U.S. data (see The Data Generating Process). As it happens, much to the chagrin of conspiracy theorists, we would expect the present cycle to peak out roughly the week of the election.

In any event, a series of positive economic surprises can easily be interpreted as an important inflection point. Looking deeper into the data, however, we really don’t see the sort of broad, persistent strength in economic reports or leading indicators that would indicate a significant shift in economic fundamentals. To the contrary, we continue to believe that the U.S. entered a recession last quarter and that some of the more prominent data points (GDP, non-farm payrolls) will be revised downward within several quarters, as we’ve regularly seen around economic turning points throughout history. The regular pattern of revisions around economic turning points has also been emphasized by ECRI, which uses much different methods than we do, but shares our concerns about recession risk. We could hardly choose better company on this particular deserted island.

Fitting Factors Into the Formula

Found via Mebane Faber.

For this issue’s Morningstar Conversation, we talk with two quant-investing legends— Cliff Asness, co-founder of AQR Capital Management, and Robert Arnott, chairman of Research Affiliates—to gain insights on where academic theory is being practically applied in the marketplace. AQR, a hedge fund shop, recently rolled out a suite of factor-exploiting products in the mutual fund arena. Gone are the days of 2-and-20 fees for access to exotic betas a la carte. Research Affiliates, through its subadvisory of PIMCO All Asset PAAIX and its Fundamental Indexing concepts, has taken active quant investing to the masses (with strong performance, to boot).

While both of these investors are renowned in both academic and practitioner circles for their cutting-edge work in quantitative analysis, they haven’t always seen eye to eye. In this conversation, we focus not on where the disagreements reside, but instead on where there is common ground. The result is some sage advice on how investors can assess and implement factor-based investing strategies today. Our discussion took place Aug. 21. It has been edited for clarity and length.

Buffett to Welch: How Do You Sell Purple Shoes?

Link

Blind Faith by Steven Romick

Blind faith has gotten us into trouble repeatedly throughout history. Just consider the rogue’s gallery of false idols, dictators, and charlatans we have followed, hoping for something different, something better. That misplaced conviction corrupts and destroys.

Daily life does require we put our trust in others, but we should do so judiciously. Each one of us has our circle of competence: performing brain surgery, hitting home runs, defending the accused in court or teaching high school math. However, doctors make mistakes and patients die, ballgames are lost on errors, innocent people go to jail and some students don’t understand division. In some cases, the fault is ours, for failing to consider that the people in whom we’ve placed our faith are incompetent, that the supreme confidence they have in their own ability is unjustifiable.

Which leads us to the blind faith placed in our current Federal Reserve Chairman Ben Bernanke. Mr. Bernanke told us in 2006 “that house prices will probably continue to rise,” and that he did “not expect significant spillovers from the subprime market to the rest of the economy or to the financial system” in 2007. In 2008, he then told us that Fannie Mae and Freddie Mac were “adequately capitalized (and in) no danger of failing” and that the “Federal Reserve is not currently forecasting a recession”. And, in 2009, he said “The Federal Reserve will not monetize the debt." A good education, deep experience, and a nice title don’t make you right. Our leaders in Washington seem to have recklessly accepted Fed decisions that threaten the delicate weave of economy and society.

Despite Mr. Bernanke’s poor batting average in predicting the future, his confidence appears unshaken. He continues to speak with the same self-assurance he always has, even though what he thought wouldn’t happen did, and what he thought would happen didn’t. He’s betting trillions of dollars that he’s right – counting on an academic argument alchemizing into reality. If Mr. Bernanke were experimenting in a medical lab, instead of a monetary one, the FDA would require extensive clinical trials proving safety and efficacy before he could release his grand experiment on the American public.

Mr. Bernanke skips ahead armed with his good intentions, despite many failed prognostications, but does concede that central bankers “have been in the process of learning by doing.” Perhaps, that’s another way of saying, “If at first you don’t succeed, try, try again.” If he’s wrong, our economy and possibly our society will suffer the consequences, unintended though they may be.

Baltasar Gracián quote

“Reach perfection. No one is born that way. Perfect yourself daily, both personally and professionally, until you become a consummate being, rounding off your gifts and reaching eminence. Signs of the perfect person: elevated taste, a pure intelligence, a clear will, ripeness of judgment. Some people are never complete and are always lacking something. Others take a long time to form themselves. The consummate person—wise in speech, prudent in deeds—is admitted to, and even desired by, the singular society of the discreet.”-Baltasar Gracián, The Art of Worldly Wisdom