Yesterday’s online Financial Times contains an article titled “When use of pseudo-maths adds up to fraud.” It references an academic paper (which I haven’t read yet–and may never) which concludes that while quantitative management strategies may look impressive to neophytes, many are mathematically bogus. This could be why they often fail deliver the superior investment performance they appear to promise. Anyone with mathematical training needed to construct such a statistical stock-picking system should know this.
Quelle surprise!, as they say.
There’s a powerful cognitive urge to simplify and systematize data. But that’ not why investment management companies typically create the mathematical apparatus they tout to clients.
The reality is that investment management has a large right-brain component to it. It depends on individual judgment and intuition honed by experience. This fact makes clients uncomfortable.
Typically the company treasurer, or other person in the finance department who is in charge of supervising the company pension plan, has little or no investment training or experience. He may know corporate finance, but that’s a lot different from portfolio investing. Suppose the manager I just hired begins to lose something off his fastball, he thinks. He tells me he reads 10-Ks, but suppose he just goes into his office, takes an hallucinogen and picks stocks based on the visions he experiences. How can I explain this to my boss if the pension plan returns go south?
That’s why his first step is to hire a third-party pension consultant. It’s not necessarily that the consultant knows any more than the treasurer–in my experience, the consultant probably doesn’t. Hiring an “expert” is a form of insurance.
Selecting a manager with a quantitative stock-picking system is another. The supposed objectivity of the system itself–safe from emotions or other human foibles–is a second form of defense.
Up until now, the apparent safety net created by hiring the consultant and selecting a recommended manager who relies on “science” instead of intuition has been enough to clinch the deal for many quantitative managers. Of course, while this decision may make the treasurer feel better–and may be an effective defense as/when the quantitative system in question blows up–it doesn’t eliminate the risk in manager selection. It simply shifts the risk fulcrum away from the human portfolio manager to the statistician who has constructed the stock selection model. The paper the FT references, “Pseudo-Mathematics and Financial Charlatanism,” argues that, empirically, this is a terrible idea.
I wonder if anything will come of it.
I’ve just updated Current Market Tactics. Time to nibble at former high-fliers? I think we’re getting cloae.
I stole this leadline from the FT blog of Gavyn Davies, hedge fund manager, former head of the BBC and, before that, a Goldman economist. Davies, in turn, lifted it from economist John Normand of JP Morgan.
Great Moderation 1.0
“Great Moderation” is what people began calling the period from 1984 (the recovery year after the two major oil crises of the 1970s) through 2008 (when the world financial system almost melted down). The idea was very highly conceptual and self-congratulatory–one of those end-of-history, we’ve-reached-Nirvana sort of things. Modern economics, it was asserted, had finally reached the point where it could control the business cycle. Never again would developed economies overheat badly; never again would they experience deep recessions.
Obviously, this was wrong, as events of 2008-2010 proved.
In hindsight, the manual labor-intensive parts of Western economies were suffering severe structural damage as China emerged as a global economic power. “Moderation” was being achieved only through an inappropriately loose money policy implemented by Alan Greenspan, and Mr. Greenspan’s failure to carry out his responsibility to supervise mortgage lending in the US. For their part, the US banks, freed by Congress from the shackles of Glass-Steagall in 1989, were engaging in widespread, highly lucrative, mortgage fraud. That enabled wild overbuilding of the domestic housing stock–employing all those displaced manual workers.
Then the music stopped.
Great Moderation 2.0
GM 2.0 is a different sort of animal, though. The idea this time is that developed economies are barely out of intensive care, so they can’t get much sicker. And, for the same reason, the energy necessary for wild partying just isn’t there.
The upshot of all this is that the world is in for a protracted period of slow but steady growth, with low inflation and without any sharp lurches downward.
The implications for equity markets are relatively favorable, I think.
The stock market in a slow-growth world would likely have two characteristics:
–mature companies in this sort of environment will grow mainly by taking market share away from others in its industry. Me-too firms, whose chief virtue has been the ability to rise with the tide, will likely struggle, while innovators prosper.
–rapid growth will be hard to come by. Firms in new areas or with genuinely novel products will be scarce and should therefore be highly prized. Maybe not to the loony tunes level that many had soared until recently. But, if correct, GM 2.0 is a strong argument for beginning to sort through the rubble sooner rather than later.
Pacific Investment Management Company (PIMCO) built itself into a bond market juggernaut over the past forty+ years, thanks to a soaring bond market, savvy marketing and the superior fixed income management skills of now-septuagenarian Bill Gross.
I’m an admirer of PIMCO’s organizational success. But, at the same time, I can’t help thinking that the firm’s “New Normal” campaign of the past several years is mostly marketing hype–and wrongheaded, at that. No matter what the economic or market conditions, the PIMCO conclusion is “Avoid stocks and buy more bonds!!!” For all but the most risk-averse investors, that’s bad advice. A first-rank firm should be better than that.
This is not what I want to write about, however. I just want to declare that I have a vaguely anti-PIMCO point of view.
PIMCO has been having problems recently. Mr. Gross has been underperforming. Clients–even long-term clients–have begun to head for the door. So, too, Mr. Gross’s putative successor, Mohamed El-Erian, who resigned from the firm citing irreconcilable differences between himself and Mr. Gross. Press reports suggest Mr. Gross had been beating Mr. El-Erian over the head with his lack of actual portfolio management experience as a reason for dismissing his questions and concerns.
Great gossipy stuff …but not what should concern us as investors.
Mr. El-Erian may not be an accomplished portfolio manager, but that doesn’t mean he isn’t a very shrewd individual. What would make him a high-profile, high-prestige, high-paying job, instead of just hunkering down, busying himself with his considerable marketing responsibilities and waiting Mr. Gross out?
El-Erian’s decision to leave, I imagine, came when he realized that this strategy wouldn’t work. Mr. Gross’s behavior wouldn’t change. And it could well have consequences that would tarnish Mr. El-Erian’s image, as well. After all, although apparently powerless, he was the co-Chief Investment Officer.
I imagine that because Mr. Gross has had such phenomenal success for so long with an aggressive strategy, he sees no reason to adopt a more conservative approach–even though, intellectually at least, he knows that the great bull market in bonds in the US that rewarded that behavior is over. So he continues to take extra risk. But that translates only into extra volatility in today’s world, not extra return. Think: Jon Corzine, or any number of prominent hedge fund managers.
Growth stock investors went through a similar existential crisis as the Internet bubble imploded in 2000, so it wouldn’t be surprising to me if this were the case with risk-oriented bond investors today.
My point (finally!): we know about Mr. Gross. How many invisible clones does he have, however, running banks’ bond trading desks, fixed income hedge funds or private equity operations? …what fallout will occur as/when underperformance forces all of them to change tack? Will it be six months of really ugly bond returns? How much will spill over into the equity markets?
The administration of Xi Jinping took over leadership of the Chinese Communist Party in late 2012 determined, I think, to deal with a number related issues:
–economically, China has reached the point where can no longer grow by exporting simple products made with labor-intensive methods. It also has much too much simple, inefficient basic industry. It has to shift to more sophisticated, higher value-added production.
The country, particularly in the more industrialized east, has finally run out of unskilled workers to staff labor-intensive operations at low cost. Air, ground and water pollution from primitive basic industry is becoming a very serious national problem (by the way, I’ve traveled to a lot of developing countries in my career, but Beijing is the only place where I’ve been physically ill from the poor air quality the moment I got off the plane).
The textbook way of dealing with development transition is to allow the local currency to rise to the point where simple manufactured goods are priced out of the world market. But that invariably causes large scale unemployment, which is the last thing China wants. Beijing has been taking another approach over the past few years–keeping the currency stable but mandating large wage increases for employees. As far as I can see, this approach seems to be working.
–forces of the status quo, epitomized by province and local governments, have continued to resist making the transition. They continue to strongarm local banks into making loans for old-style (and now uneconomic) construction, manufacturing and basic industry projects. Why? …some combination of: it’s easy, it’s all they know, they’re under pressure to create GDP growth and they get kickbacks from all parties concerned.
Beijing has ordered the banks to stop this sort of unsound lending. Unfortunately, the banks in China have done what banks everywhere else in the world do in the same situation. They set up non-bank subsidiaries that continue to make the dud loans. (Ever wonder why most of the horrible US sub-prime mortgage derivatives originated out of London? –to evade the regulators, of course.)
Xi Jinping has decided to crack down on the non-banks, too, even allowing s0me of their projects to fail. I don’t mean to suggest that a banking crisis is imminent in China. Far from it. As I see it, Beijing is just establishing that it will hold banks, and bankers, to account for violating the spirit of its regulations, not only the letter.
–clinging to a growth model that’s no longer viable has three “externalities,” namely, that it’s destroying the environment, it weakens the banking system and it’s seen by ordinary citizens as simply a vehicle for official corruption–which threatens the legitimacy of the Communist Party.
Ever the optimist, I think that Beijing is well-intentioned, its policies are sound and that they have a good chance of being successful. So, all in all, what’s happening is a good thing …and necessary for China’s future economic development. Maintaining the status quo would be a recipe for disaster.
Nevertheless, transitions take time, and:
–GDP growth in China will be lower as export-oriented manufacturing disappears faster than domestic-demand, consumer-oriented businesses can be built up to replace them
–there’ll be less basic industry in China, and less demand for metals
–there’ll be more focus on technology and, as time goes on, on export of consumer goods
–there already is a shift in the luxury goods market away from foreign brands toward local. This will likely continue and eventually spread to other areas.
size by GDP
The EU is a close second, with GDP of $15.8 trillion.
China is in the #3 spot, with GDP of $13.4 trillion.
Together, the trio make up about half the world’s GDP. (A quarter century of stagnation has left former co-#1, Japan, a mere shadow of its former self, with GDP of $4.7 trillion.)
China’s economic strategy
Since turning away from central planning toward a market economy under Deng Xiaoping, China has faced two related issues:
–creating enough new jobs to absorb new entrants to the workforce, thereby avoiding political instability, while at the same time,
–reining in the inefficient, loss making, often corrupt state-owned industrial sector, which accounted for three-quarters of all employment in the late 1970s.
Two other constraints: China had to do this without an effective central bank and with a cadre of state and local government officials who thought (many still do) that the fastest and most lucrative road to the top was to create more labor intensive, inefficient (and corrupt) local analogues of big state-owned enterprises.
China has achieved spectacular economic growth by embracing capitalism. To some degree, the remaining state-owned sector, which now accounts for just over one quarter of the economy, has also shaped up. But while doing this, China has tended to lurch between periods of substantial credit restriction to try to force state-owned enterprises to become more efficient or die, followed by excessive expansion when layoffs become too severe.
the latest wrinkle
Emerging economies, following the post-WWII Japan model, start by offering cheap labor for simple manufacturing businesses, so that they can acquire training and technology from foreign firms. At some point, a given country will run out of labor. It must then transition to higher value-added endeavors. Few succeed without a lot of heartache, because–I think–vested interests attached to the status quo are so powerful.
China now finds itself at this transition point, an issue which dominates its current economic policy.