No reversion to the mean?: El-Erian (II)

In yesterday’s post, I outlined the Pimco investment case, contained in a Financial Times article, which boils down to:  we’re in a time of great uncertainty, so buy government bonds.

my thoughts

For what it’s worth, I think the world is a lot less uncertain place than it was two years ago.  In a way, uncertainty is old news.  That isn’t to say our situation is good, but we now know:

1.  world governments will act to avoid the worst economic outcomes (this is the #1 worry in any macroeconomic crisis)

2.  financial regulators in the US and the EU have been doing a terrible job

3.  banks are weaker companies than we thought, and generally poorly managed, to boot.

In my opinion, a lot of this news is already reflected in security and currency prices.

What uncertainties still exist?

1.  Economically speaking, the developed world is still a fragile place.  The effects of the large excess supply of housing and business space created in the US and UK over the past few years, and of those countries stopping adding to it, are still with us.

2.  The steps that policymakers may take, and the economic effects of those actions, are hard to foresee.  The world has used up much (all?) of its safety margin for dealing with mistakes.

3.  The econometric models that economists use in predicting how our economic future will play out–essentially, elaborate trend-following devices–don’t work well in times of economic transition.  They also didn’t predict the financial meltdown.   So a major tool (bond) portfolio managers have wielded in plying their trade is out of action.  Managers are now working in a room whose lights have been turned out.  (If you believe Nobel laureate Joseph Stiglitz, however, these models were radically flawed from the outset–and were a contributing cause to our economic woes.)

3.  The behavior of economic agents, especially portfolio investors, is harder to predict.  In particular, the chances of extreme, far-from-consensus, and really bad, outcomes has increased.

What does the article conclude from this litany of sorrows?  –we are in a “world where the realized return rarely (emphasis added) equals the expected valuation.”

a curious argument

Okay.  Now comes the weird part.

We’re in a world where no one can tell how the world economy will play out and where investment managers’ portfolios are going to blow up in their faces.  But luckily for us, Mssrs. Clarida and El-Erian are affected by none of this.  They know (no explanation given) how the US economy will develop–very low growth and structural unemployment for as far as the eye can see.  They also know that while virtually every other investment strategy founders on the rocks of uncertainty, one–buy government bonds–will not.  Again, no explanation given.  Just by coincidence, both authors happen to work for a bond fund manager and have this product available for sale to us.

Another point:  The thrust of the Clarida- El-Erian argument is that economic circumstances demand that investors carefully rethink their investment strategies, because macroeconomic conditions today are radically different from what they’ve been before.  Their actual conclusion, however, is far different.  It is that investors will almost never (rarely) be able to figure things out.  In the paragraph above, I’ve pointed out that they think this situation applies to everyone except them.

My  point here is that they provide no support for the actual conclusion they draw.  What they write looks like an argument in support of a conclusion, followed by the conclusion as a logical consequence of what they said before.  But that’s just a kind of sleight of hand.  The idea that no one (except themselves) will be able to figure out what’s going on is a bald assertion, no more.

extreme outcomes don’t all favor bonds

I think it is right to give extra thought to the possibility of extreme outcomes.  In can imagine three, although I’m sure there are more:

1.  The US and EU play out like Japan since 1990.  This would mean bonds would be fine   Stocks would have a period of stability followed by maybe another 30% decline.

2.  The US and EU recover faster than we now think.  Stocks might go up by 25%.  Government bonds would fall, maybe by 15%.

3.  The rest of the world loses faith in the US and EU.  Their currencies fall by 15% vs. the rest of the world and their bond yields rise.  In this case, safety would lie in stocks, not bonds.  Stocks +35%, bonds -15%.

To me, it seems that the possibility of extreme outcomes is an argument for diversification, not  concentration in one asset class.

the authors seem to know nothing about stocks

If we exclude financial Armageddon, equity investors can operate successfully under a wide variety of economic conditions.   In particular:

Value investors do use reversion to the mean, but in a narrower sense than is used in the Pimco article.  The value investor looks for assets that are worth $100 that he can buy for $30 and hopes to sell for $60-$70.  Given that stocks are the cheapest they’ve been vs. bonds (a proxy for the cost of financing purchase of such assets) in about sixty years, this should be a fertile ground to work in.

Growth investors do have deep economic concerns, but they’re  generally microeconomic, not macro.  Will, for example, well off thirty- and forty-somethings continue to buy iPhones and iPads?  Will TIF continue to sell jewelry to Europeans trading down or to newly affluent Asians trading up?  Will the casinos in Macau keep on booming?

Yes, if world economies implode again, equities will be in trouble, at least for a while.  But equity investors don’t need to understand the entire globe to be successful.  All they need is a stable playing field and one or two places where they’re ahead of the consensus.

mutual fund investors and their investment advisors

the ICI survey

I was looking on the Investment Company Institute (the trade organization for the fund management industry) website for aggregate data on the size of tax losses held inside mutual funds and ETFs–the topic of Sunday’s post–when I found a report on a survey of mutual fund investors and their investment advisors.  This was supplemented by a later survey that elaborates on the types of financial advisors used.  I thought the information was interesting, and certainly not what I had expected even though I marketed my products to financial advisors for twenty years.  Here are the survey results:


The survey was done by phone in 2006, before the financial meltdown.  1003 households were interviewed by a third-party professional surveying company.  The report didn’t contain either the survey questionnaire or the raw survey data.

Two characteristics of phone surveys to keep in mind:

–they almost never use cellphone numbers because laws in most states prevent machine dialing of cells, so surveys that include them are more expensive.  This distorts the twenty-something demographic, which probably isn’t so important in this case.

–phone respondents tend to portray themselves in what they consider a more favorable, or more conventionally acceptable, light than they would in an internet survey.

The survey wanted to find out about financial assets held outside workplace retirement plans.

The survey defined a financial advisor as “someone who makes a living by providing investment advice and services.”  This includes not just traditional “full service” brokers, but also independent financial planners, bank and financial institution investment representatives, insurance agents and accountants.

the customer base

1.  Almost all the respondents (82%) had access to professional financial advice.

–Almost half (49%) bought mutual funds exclusively through financial advisors.

–A third bought both through advisors and on their own (through discount brokers or directly from fund companies).  No explanation for this behavior, although I think many customers try to control the fees they pay to financial professionals by maintaining two accounts.  One will be  wrap-fee account with a financial advisor;  the second will be a no-fee discount broker “clone” of the first.

–14% bought exclusively on their own.

–4% had no clue where the funds came from.

A total of 60% of the assets were held through financial advisors.

why customers seek advice

For most customers, there’s an event that triggers the search for a financial advisor.

For people in their twenties or fifty-plus, the event is usually receipt of a large lump sum, either an inheritance or payout of a work-related investment account.

For thirty- or forty-somethings, the event is lifestyle-related, usually marriage or the birth of a child.

what they need

The top four things customers want from a financial advisor are:

1.  help with asset allocation

2.  an explanation of the characteristics of the financial instruments they can buy

3.  help in understanding their overall financial situation

4.  assurance that they’re saving enough to meet their financial goals

Although a large minority(about 40%) of respondents seem to want to turn their money over to an advisor and forget about it, most regard their advisor (correctly, I think) as a consultant rather than a money manager and want to play an active part in making the decisions that define their portfolios.

demographics of advice seekers

The predominant characteristic of people with ongoing relationships with financial advisors is that they don’t use the internet to get financial information.  This group is twice as likely to have a financial advisor as those who do use the internet for financial data.  Here the survey really seems to break down, because it doesn’t say whether these customers don’t use the internet to get any information (my guess) or whether it’s just financial information they get elsewhere–if they get any at all.

What’s also interesting is that this (Luddite) behavior is not characteristic of mutual fund holders as a whole.  Other ICI research from around the same time shows that mutual fund owners tend to be intensive users of the internet, with financial information a particular area of interest.  Apparently, this latter–probably younger and more affluent–group doesn’t use financial advisors.

The other ICI research also suggests that the third of respondents who had some advisor-related funds and some not were predominantly in the latter camp.  The fact that 60% of the assets were bought through financial advisors suggests that the non-internet users are substantially wealthier, and probably older, than internet savvy respondents to the financial advisor survey.

Female decision maker households are 50% more likely than average to have an ongoing financial advisory relationship, as are families with over $250,000 in household assets (remember, this is pre-crisis).

The fourth defining characteristic is age. Respondents who were 55+ were 40% more likely than average to have a financial advisor.

who doesn’t want a financial advisor?

This group, a small minority according to the survey, has three defining attributes:

–they want control of their own investments, a desire that increases in intensity with age

they (think they)know enough and have access to all the resources they need to make intelligent decisions on their own.  Sixty-somethings and older hold this conviction the most strongly, followed by the under 45 set.  Those in the 45-59 bracket think so too, but have more doubts.

they don’t like advisors. They think they’re too expensive and that they put their own interests ahead of their clients’.

One in seven respondents, under 45 more often than not, said that they don’t need professional advice because they get it for free from a friend or family member.  Other than my children–who get excellent, if aggressive, investment advice, this group seems to be one fated to live on public assistance later in life.

my thoughts

I wonder if a survey conducted today would get the same results?

Despite long-term planning and all that, many individual investors seem to have sold their equities at the bottom and put the money into bonds, missing the subsequent equity rebound.  According to ICI data, they continue to allocate assets away from stocks and into bonds, despite the fact that bonds haven’t been so expensive vs. stocks in almost sixty years.  Is this conservative move spurred on by financial advisors?  Probably not.

I remember a story that ran in the Wall Street Journal just after the stock market collapse of 1987.  It was about a prescient retail broker in Connecticut who called up all his clients in late summer of 1987, just before the crash, and convinced them to sell all their stocks–which they did.  He called them back in November, at the market bottom, to advise them to buy again.  No one returned his calls.  He packed up and left for Oregon to try to rebuild his business there.

Maybe the same has been happening today.

Another aspect to 1987.  I think the market decline marked a paradigm shift by individual investors.  Prior to that, people typically bought individual stocks through full-service brokers.  Post-crash, I think that many individuals, like those Connecticut customers, lost faith in brokers and turned to independent financial advisors and mutual funds.

Does the financial crisis mark another structural turning point?  Maybe.  If so, it’s probably away from mutual funds to ETFs and away from using financial advisors as consultants with specialized financial expertise to self-reliance.

Bill Miller: US large caps are “bargains of a lifetime”

my present market quandary

I’ve been really scratching my head about the US stock market over the past few weeks.  Stocks have been going down all month, which is never pleasant.  But what has struck me is how negative the tone of most commentators has been.  Expert after expert (maybe I should put that word in quotes) appears in the financial press, or on radio or TV to deliver an unremittingly negative message.  The factual or theoretical starting points may differ, but the conclusion is the same–stocks have no chance of going up (because the economy will fall back into recession, or because earnings won’t come through as strong as anticipated, or…) and stand a good chance of continuing to decline.

The negative message is not the issue–it’s better to find out you’re wrong before the bottom drops out of your portfolio, no matter what the source or how damaging to your ego.  Invariably, the expert makes some totally insipid comment about stocks that suggests that he/she has no practical knowledge or experience in the equity market, and no particular desire to get any.

If you’ve been reading this blog for a while, you probably know my positive stance on stocks is based on several ground-level assumptsions:

–a large portion, maybe 50%, of the earnings of S&P 500 companies comes from foreign economies, virtually all of which are faring better than the US,

–of the US portion, maybe half is exposed to the overall economy.  That’s trouble.  But the other half is either focussed on servicing corporations, whose profits are booming, or the 90% of the American workforce still employed.   Since the top 5% of wage earners do about a third of all discretionary purchasing, and the top 20% a bit less than two-thirds, the second half should have pretty solid profit underpinnings.

–S&P profits will be up in 2011, maybe by 10%.  This would imply an index level of 1300+ sometime next year.  Before 2010 is over, Wall Street will begin to discount this possibility.

My case, then, depends on investors believing that, say, three-quarters of S&P earnings and perhaps a larger part of its profit growth, are not closely tied to US nominal GDP.  While 10%- unemployment is a terrible social problem, it will not prevent most US publicly traded companies from posting earnings increases.

I can’t find any recent evidence in communications media or in brokerage research that anyone else believes this.  So I keep thinking to myself that in the land of the blind, the one-eyed man isn’t king, he’s must a guy with a bad sense of hearing.  Or, if the game is backgammon but you think it’s checkers, you’re not going to win many games.

who Bill Miller is

Then I read an article in yesterday’s Financial Times by veteran portfolio manager Bill MIller.  Who is Mr. Miller?  –the chief investment officer for Legg Mason, and the manager who became famous a few years ago for beating the S&P 500 every year for over a decade.  Although Mr. Mill has caught my eye for making extra-large, and very successful bets on internet stocks like Amazon, he bills himself as a value investor.

what he said

His point about stocks shows his value roots:

US stocks have underperformed US bonds for over twenty years.  They’re now the cheapest they’ve been vs. bonds since 1951, almost sixty years ago.  Even better, you can’t find a soul who has a good word to say about them.  To Mr. Miller, stocks today are in the same position that bonds were in the early Volcker years–despised, misunderstood, and about to begin a huge run of outperformance.

When might that run begin?  No one knows, but when it starts it will be something to behold.  (Value investors typically believe that can get a good handle on what is likely to happen, but not on the when.)

The article, which is Legg Mason’s July letter to holders of its Value Fund with some stuff edited out, is worth reading, in my opinion.  You can get the edited version by clicking the link above, or you can get the entire thing from the Legg Mason website.

a Pimco joke deleted?

I was amused to see that one of the sections the FT deleted was an apparent jibe at Bill Gross, another modern legend, who built  the Pimco bond business.  Miller’s points out that while Gross is talking down global economic prospects as part of building his positive case for bonds, he is quietly starting an equity business for Pimco.  He seems to be saying that one should watch what people do, not what they say.

I was cheered up by realizing that in true value style, the MIller argument is all forest and no trees.  It’s simple.  Stocks are really cheap, so you should buy them and not worry about what happens in the next six months or so.

Bill’s recent investment performance–whoops

As one final matter, I figured I should report on the Legg Mason Value Fund’s recent record.  So I clicked onto that section of the Legg Mason site.

The picture isn’t pretty, to my eyes.  It appears that Mr. MIller followed his stunning streak (more on this topic in a couple of days) with a deep three-year slump in 2006-08.  My guess, based admittedly on almost nothing, is that his fondness for financials did him in.  After an above-average 2009, the Value Fund is underperforming again in 2010.  The net result is that for almost any period over the last ten years, the fund lags the S&P.

It would have made a better story if Mr. Miller had returned to his old winning ways.  It would also have been easier to figure out how to take the article/shareholder letter he published.

my thoughts

I have three reactions:

–would I give Mr. Miller my money to manage?  No.

–do I think he has a good point?  Yes.

–does he help solve my worry that I may be out of step with everyone else because I’m wrong, not because I’m ahead of the curve?  No.

I’m not exactly back where I started, though.  I have another good reason for thinking that stocks may do well.  Yesterday’s sharp rise in the S&P, while gratifying to any holder of stocks, also makes me scratch my head a bit.  All of the information that seems to have triggered the rally–ISM factory data and employers’ difficulty in finding workers to hire–was already available to the market for some time, both in reports from international transport companies and in bureau of Labor Statistics data (see my recent post on this topic).

Maybe we’ll get more clarity after Labor Day.

Russell Napier on the future of the US?

Who is Russell Napier?

Russell Napier of CLSA wrote the Market Insight column that appeared on Wednesday in the Financial Times.

Mr. Napier is a highly skilled, very thorough financial analyst.  He also has a bearish temperament.  I started to write that he’s a “professional bear,” but that’s not right.  Unlike doomsayers who are always available with a quote about how the world is about to go to hell in a handbasket–usually the same sentiment they have been furnishing to reporters for the past twenty-five years (think: Marc Faber or Andrew Smithers), Mr. Napier is not a publicity hound.

That makes his analysis of the future for the US and European economies, which I find eerie, even more disturbing.

His argument:

1.  The US and Europe have already saddled themselves with so much government debt that they are incapable of lowering it in any meaningful way.  At the very least, there is no political leadership (Germany possibly excepted, and they’re stuck with the rest of Euroland) willing to address the problem.  It may also be that there is no national political will among citizens to pay the money back.

2.  Simply servicing the existing debt will end up with new government debt issues crowding out private capital-raising activities.  To raise more funds, as well as to make government securities look more attractive, governments will levy new taxes that reduce the earning power of private securities.

3.  Private capital will respond by trying to leave the country, but will be prevented from doing so by newly-legislated capital controls.

4.  Mr. Napier concludes his article with the statement that “The ‘new normal” is not sub par economic growth.  The new normal is the roll back of the free markets.”

I’d add a #5.  Assuming #1-4 come to pass, our children will emigrate to countries that offer better economic prospects, much as Europeans came to the US after WWII or as high taxes and limited opportunities caused educated Australians and New Zealanders to seek foreign jobs a generation ago.

What caused our present sorry state?

–in Napier’s opinion, the “North Asian” economic growth model with its emphasis on overproduction in manufacturing made us the parasite to their host.  (I don’t believe this, but that’s what he said.  In any event, I’m not sure diagnosing the cause of our heavy indebtedness is that important.)

too bleak?

What a bleak outlook!

Is the “fall” of the West already written in stone?  I don’t think so.

Certainly, many in the Pacific and Latin America already look at the US in the same way many Americans regard the UK–as a place that time has passed by, whose citizens console themselves in dreams of their past glory.  But that’s just the inevitable consequence of their recent rise to world economic prominence.

One thing has changed, though, in my opinion.    Sixty years ago, Wall Street figured that Republicans were good for business and Democrats were bad, but that perception has long since been relegated to the junk pile.  It has been replaced by what my thirty+ years as an investor have taught me–that Washington is basically like Disneyworld, a collection of strange characters, an interesting and entertaining place to visit that’s largely irrelevant to the running of the economy, and therefore to the rise and fall of stock prices.  Gridlock is the optimal political state, since that minimizes the possibility of bizarre government ideas messing up commerce.

We now know that picture isn’t right, either.  Somehow, with the tacit approval of voters, professional politicians have succeeded in pretty much maxing out our national credit cards.  And for what?–McMansions in Miami and Las Vegas, Vietnam-like wars in the Middle East, and entitlements.  The lightbulb is just starting to come on about how deeply in debt–both through outstanding Treasury bond issues and promises of future retirement and medical benefits–we are.

Suddenly, what Washington does is important.  The picture Mr. Napier paints is what happens if we stick with business as usual.

investment implications

There are investment implications.  The most obvious, and the most important for us today, are that diminishing economic growth prospects in the US and Europe imply emerging markets will do relatively well and that in developed markets multinationals will be better performers than their Europe- or US-centric peers.  This is the strategy I see most investors following anyway.

The next thing to monitor is whether, as Mr. Bernanke has been calling for repeatedly, Washington is able to come up with a credible medium-term roadmap for reducing the government deficit.  If not, as crazy as it sounds to an American, the beginnings of capital flight may not be far behind.

Stay tuned.

Coasting toward yearend–HAPPY HOLIDAYS!!!

If you look at a chart of the S&P 500, you’ll see that it has been moving sideways in an amazingly orderly way since mid-November.  You’ll also see that this behavior contrasts, both in monthly movements and in intraday swings, from what the index has been doing during the recovery from the March lows.  Yes, there are swings in the prices of individual stocks, but they haven’t been enough to nudge the needle up or down for the S&P as a whole.

Why is this?

One “reason” is actually a description of the market’s behavior–investors don’t see any economic factors, positive or negative, that need to be factored into today’s prices.  In particular, I think there’s still considerable uncertainty about how the global economy will play out in the early months of 2010, so investors figure there’s no rush to make a bet in either direction.

Also, I think professional equity investors have decided that they’re satisfied with the year they’ve had and have more or less gone home until January.  About the only thing left to look for in 2009, I think, are the inevitable “quirky” (read: deliberate stock manipulation) movements that may occur in small-cap stocks on the last trading day of the year–a date that will differ from market to market.

Apropos of  nothing, I think it’s noteworthy that Pimco is reported to be raising huge amounts of cash by selling Treasury bonds.  It’s also starting an equity division.  On the other hand, Pimco, you may know, has been vigorously pounding the drum for the “New Normal,”  the idea that world economic growth will be anemic for a long period of time–and that therefore investors should still be buying bonds despite the fact that interest rates are at historic lows.  Hmm?  What’s that all about?

Finally, I’d like to thank all my readers for their support this year and wish you a happy holiday season and a prosperous 2010.