Friday, February 28, 2014

The Fundamental Analyst's Comparative Advantage

This is good advice from Stephen H. Penman. As he sees it, there are five steps in the fundamental analysis of a company:

1) Knowing the business
2) Analyzing information
3) Developing forecasts
4) Converting the forecast to a valuation
5) The investment decision: Trading on the valuation

Here's the part I find really interesting:

"An analyst can specialize in any one of these steps or a combination of them. The analyst needs to get a sense of where in the process his comparative advantage lies, where he can get an edge on his competition. When buying advice from an analyst, the investor needs to know just what the analyst's particular skill is."

Buffett's concept of a "circle of competence" only addresses Penman's point (1), but of course it is virtually impossible to be expert in points 2-5 if you fall short on (1).

What is deflation, really?

What is deflation? This seems like a fairly simple question at first blush - negative growth of some price index, possibly allied with some arbitrary decision on how many quarters of data we need to judge a trend. But that's just a technical description of how to measure deflation, which is frankly, pretty boring.

Mario Draghi has 
offered another definition of deflation. “We don’t have any evidence of people postponing their expenditure plans with a view to buying the same thing at lower prices, in other words we don’t see what is defined to be deflation,” Draghi said after a Group of 20 meeting in Sydney. 

I'm surprised more people didn't respond to Draghi's claim. Firstly, that's a symptom of deflation, so not particularly useful as a definition per se. Second, this is a symptom/definition/cause that you see in textbooks, but I find it incredibly hard to believe. Japan is obviously the most recent example of deflation, so I hope some Japanese friends can comment on this, but it seems that purchases need to be highly time-elastic (i.e. people need to be very willing and able to postpone consumption) for this to be valid. 

I think we get at the "deflation" issue better if we look at what the word means in regular English. Deflation is the condition of being deflated, either physically, or figuratively. To deflate in the latter sense
 is "to depress or reduce (a person or a person's ego, hopes, spirits etc.); puncture; dash, as in "Her rebuff thoroughly deflated me." Deflation is essentially a crisis of confidence. Workers are scared to ask for higher wages. Businesses are afraid to ask for higher prices. No-one believes they have pricing power any more. And so the crisis of confidence feeds on itself as a deflationary mindset takes hold.

It seems unusual to me that confidence is seen as an important feature of booms and busts, but less of deflation and inflation. Perhaps that's because we couch it in monetary jargon like "monetary velocity". I don't dispute Friedman's dictum that inflation is always and everywhere a monetary phenomenon, but it seems to me that sustained deflation can only occur with a dwindling of confidence. It's not the shuddering, jarring collapse of confidence we see in busts. Instead, it's a slow draining of confidence and the subtle yet pernicious readjustment of expectations.

Wolfgang Munchau reports
 that Germany's federal statistics office said last week that real wage (i.e. after inflation) fell in 2013, which, as he notes, is shocking. I've seen many friends - again, experienced professionals graduating from a well-regarded programme - who have adjusted their expectations down from expecting full-time offers to seeing internships as the only way to convince employers of their worth. It's a reflection of the power differential between them and employers. Some of those employers, meanwhile, are no doubt facing fee pressure from investors. And so the daisy chain of ebbing confidence continues. I'm not Richard Fisher - I know that's anecdotal and has specific problems related to the finance industry. But it's worth considering, and I'm sure you can think of other examples in European labour markets where the insider-outsider problem has only been reinforced by this crisis.

I've gone on and on about deflation, but the worst thing is that deflation is itself just a symptom of insufficiently low nominal GDP or aggregate demand. So, as we (hopefully) criticise the ECB for low CPI inflation verging on deflation, let's keep the bigger picture in mind: ad hoc attempts to increase inflation will likely fail if they do not raise nominal GDP in a sustained fashion. After all, one of the lessons we've learned from high inflation (especially hyperinflation) is that the cycle cannot be broken with stop-and-go policies. What's required is a firm commitment to a sustained regime change. The same, we will probably see, is true of deflation.

Thursday, February 27, 2014

The Plano Real, and a Different Sort of Model

As Rio de Janeiro prepares for Carnival 2014, I thought it would be an appropriate time to recount an interesting episode in Brazilian politics (and footnote in Brazilian monetary history), which I discovered from reading the memoirs of Fernando Henrique Cardoso (FHC), former Brazilian president and finance minister.

In 1994, FHC was cajoling legislators to accept his Plano Real (Real Plan). The introduction of the Real, a new currency, was intended to end hyperinflation, which was over 3,000 percent (annualized) by 1994. I'll write a longer post at some point on the plan, which had some very unusual features. But for the sake of this post, I'll just point out that this plan was unpopular because it unsettled entrenched political interests and was not deemed likely to succeed, even by the IMF. Against the odds, FHC seemed to be winning support for the plan, which eventually passed, but not before it was almost derailed by political scandal.

According to FHC, the 1994 Carnival was particularly spectacular, perhaps to compensate for a year of political and economic turmoil. President Itamar Franco, who was a supporter of FHC's controversial plan, decided to be the first Brazilian president to watch Carnival from Sambodrome in Rio. No-one is quite sure how, but a buxom 27 year-old model named Lilian Ramos managed to wend her way up to the special presidential balcony where Franco was sitting. She proceeded to climb on his lap, which appeared harmless enough at first, but every time she clapped her hands, her short T-shirt rose higher and higher, eventually revealing that she wasn't wearing anything below. At all. This, of course, was manna from heaven for the photographers below.

The next day, domestic and foreign newspapers launched into the story with full force. Franco was divorced, but the foreign attention annoyed the Brazilian public and military, who were sick of Brazil being made out to to be a banana republic, as well as the Catholic Church, who demanded that Franco be more supportive of family values. Some legislators threatened to impeach Franco, and FHC was apparently approached by a member of the military who enquired where FHC's loyalties would lie if impeachment occurred.

How exactly Ramos found herself on the balcony with Franco is a matter of some speculation. FHC argues that the moment was politically motivated and engineered in an attempt to embarrass Franco, and derail the Real Plan, a theory he says is corroborated by the fact that Ramos later announced plans to run for political office. That, of course, will probably never be known, but it is highly doubtful that a politically sensitive and ambitious agenda like the Real Plan could have been implemented if the country had been forced into further turmoil. Given the importance of this plan in ending hyperinflation and setting the stage for reform and growth in Brazil, it's fortunate that the scandal passed, so we can relegate the incident to an amusing footnote in Brazilian political and economic history. I'll leave you with this comic gem (non-Portuguese speakers, relax, you can use Google Translate). I imagine this was a fairly family-friendly version of some of the comics going round at the time:

Wednesday, February 26, 2014

Let A Thousand Blogs Bloom (or Sumner's Hydra)

I was both pleased and flattered to see my post on Rick Mishkin draw a response from Scott Sumner. For a relatively new blogger, this was the equivalent of having Michael Jordan comment on a sign I was waving in the crowd. Personal satisfaction aside, however, it was an opportunity to reflect on the history of market monetarism as an idea. The essence of my post on Mishkin was to show that his textbook (literally) ideas on monetary policy could have mitigated some of the effects of the Great Recession. Of course, Mishkin was hardly the only proponent of such ideas. Early on, Sumner joked that his gravestone should read: "Devoted his life to blogging on Hetzelian ideas". But here's the funny thing: I've read quite a bit of Hetzel, and while I understand his ideas, they didn't make as much on an impact as the work of Sumner and others. I commented tonight that I enjoyed Marcus Nunes and Benjamin Cole's book on market monetarism more than I enjoyed Hetzel's book on the 2008 recession. To some, that's probably an act of intellectual heresy (or inferiority). I can just hear it now: "Seriously, dude? You liked the Lord of the Rings movies more than the book? Wow." I think what this really shows is that any idea needs different expositors. Like the movies, blogs have a certain immediacy, and are an excellent introduction to a more complex medium. Some people respond to the written word. Some people respond to the spoken word (listen to Sumner's early expositions on market monetarism, and compare them to later, more refined versions where he deftly anticipates many of the criticisms). Some people respond to pictures (one of the undoubted strengths of Nunes and Beckworth's blogs). Some of us needed The Money Illusion to understand why Cassel and Hawtrey were worth reading.

It's interesting to trace the genealogy of the movement. Sumner encouraged Marcus Nunes to start his own blog. Nunes allowed Lars Christensen to do a guest post on "market monetarism", thereby giving a name to an idea that only seemed inchoate because it had not yet been appropriately named. The efforts of all these bloggers (and others like David Beckworth, David Glasner and Nick Rowe - sorry, I'm not sure how or if they fit in this family tree) eventually pushed me to write to explore things I didn't (and still don't) understand fully. I'm fairly sure that young, talented bloggers like Evan Soltas and Yichuan Wang got their starts from being mentioned by Sumner. Again, this dispelled the idea that market monetarism was an arcane idea that belonged to the select few. Besides the generational span, there is a diversity of nationalities (Brazilians, Danes & Singaporeans, to name a few!) and areas of focus (academic economists to market practitioners) represented. The last is important because these ideas can be tested every day in markets. People don't talk about reflexivity because Soros is a great philosopher. They talk about it because he's a billionaire, and because he thinks it works. What the blogosphere needs to continue to do is convince people that this is a worthwhile idea because it works.

The analogy that stands out to me is how the value investing credo has spread. Benjamin Graham basically created the concept. His Graham-Newman partnership spawned Buffett, Ruane and Schloss. You'd have to be completely ignorant not to know the influence that generation has had on today's fund management industry. Or, to take a modern day version, Julian Robertson's Tiger Management gave birth to Tiger Cubs, grand-cubs, and hangers-on who are happy to claim any lineage at all.

I say that last bit with complete self-awareness. I don't for a second imagine that the quality of posts or originality of ideas here merit the influence that Sumner has had (nor do I intend to focus primarily on monetary policy). Equally, I'm sure Buffett would be horrified at the simplistic version of value investing you sometimes see espoused on Internet fora. But value investing as a discipline has proceeded beyond Graham's relatively simple quantitative measures of value. That's why it's fascinating to see the Hydra in action. Monetary policy is still seen as something that only the high priests of the FOMC and ECB can call on. It would be dangerous if monetary policy became subject to populism, but it equally should not be something that ordinary citizens shrug their shoulders at, particularly at a time when major central banks consistently fail their institutional mandates, or when money mischief is being wrought on the people of Venezuela & Argentina. 

But don't get me wrong - I'm optimistic. It's a slow process, but the battle of ideas is being won, one retweet at a time. So, as Sumner himself might say, let a thousand blogs bloom.

Tuesday, February 25, 2014

The Lucky and the Skillful, The Contrarian and the Reckless

A few days ago, I wrote a post entitled "The Sociology of Quant Investing - Is There A Moneyball for PMs?", as I pondered the luck vs. skill debate. Today, there's an excellent article from aiCIO which tries to answer that question. Naturally, this sentence caught my eye: "Stan Altshuller intends to be the Billy Beane of hedge funds." Having read the description of Altshuller's process, I salute his intention, but I don't really understand how or if the process works. Presumably he doesn't want to share proprietary details. Kenneth French, appears to be skeptical of a quantitative approach: “Either before or after the fact, it’s an extremely difficult statistical problem." "If you insist on hiring an active manager,” he says, “at least get someone cheap.”

This makes excellent sense. Unfortunately, manager selection (or asset allocation) doesn't always appear to be sensible. There are two main reasons for this. First, the clear difficulty of quantifying manager skills leads some to lean on reputation. Better, as Keynes says, to fail conventionally than to succeed unconventionally. Second, asset allocation, for some, takes on the form of conspicuous consumption, i.e. the spending of money on and the acquiring of luxury goods and services to publicly display economic power. If you invested in Paulson pre-2008, not only did you make a lot of money, you probably got a frisson of excitement from sharing that fact at a bar (or a cocktail party - I guess Paulson investors don't go to bars the way I do.) 

What's needed is a theory of deviance in investing. To succeed spectacularly, one must be unconventional, and therefore be deviant. The folks at aiCIO seem to agree: "According to
Martijn Cremers, a finance professor at the University of Notre Dame, a measurement of active share—the portion of a portfolio that’s unique from the benchmark—can help further differentiate competence from chance. “Active share ignores returns completely,” Cremers says. “It only looks at holdings and can serve as a complementary measure to tracking error volatility.” The concept derives from the basic premise that a fund can only outperform a benchmark if it’s different, and quantifies the proportion of the portfolio skill that is actually applied and contributes to said outperformance." 

Of course, just because deviance is a prerequisite for success does not mean that all deviants will succeed. Some ideas are stupid for a reason, and some mavericks will blow their funds up. It seems to me that the tools for separating the lucky from the skillful, and the contrarian from the reckless, still have a long way to go.

Sunday, February 23, 2014

What Would Mishkin Have Done?

I promised myself I wouldn't get sucked into the black hole of the 2008 Fed transcripts, but that has proven an impossible promise to keep. In my previous post, I speculated that Rick Mishkin's departure from the Fed considerably weakened it at a critical time. I also said this was nothing more than an amusing parlour game. That was wrong - amusing, yes, unimportant, no. I don't know Mishkin, though I'm aware his reputation took a bit of a beating thanks to the Inside Job. But when I was trying to learn more about monetary policy four years ago, it struck me that Scott Sumner kept saying, "This isn't unorthodox. You get this from Mishkin's textbook, which is the best-selling book on the subject." So I read Mishkin's book. It is thus of incredible importance and interest what the textbook writer himself was saying as we entered the teeth of the crisis. It's too much trouble to go through all of the transcripts - I'll leave that to Binyamin Applebaum and team - but here are some crucial points from Mishkin's last meeting on Aug 5 2008. Mishkin's actual words from the transcripts are in italics.

1) Focus on core inflation, not headline. Also, anecdotal evidence should really, really be taken with a pinch of salt. This should be obvious to experienced policymakers, but going through the psychological barrier of $100 oil (not to mention $13 natural gas) had clearly rattled some. Richard Fisher was pushing his inside knowledge from CEOs as evidence of inflation expectations becoming untethered. Mishkin responded:

Monetary policy does not control...relative price shifts. Although there are some problems in terms of core, the effect has actually been quite limited given the incredible rise in energy prices. While it’s important to think about headline in the long run, the information from core is very useful in terms of thinking about policy because it tells you whether this is spilling over into underlying inflation. 

I am very skeptical of consumer surveys because, exactly what behavioral economics tells us, there is framing. If headline inflation is high, short-term inflation expectations go up, which should happen, but long-term inflation expectations also go up. When headline goes down, then they will come down. 

One of my concerns about going to anecdotal information and why I think we need to use an analytic framework in thinking about what is really driving the inflation process is that we do need to focus on the longer-run because that’s what monetary policy can control. I get a bit nervous about these anecdotal concerns, which I think can tell us something about headline. Then we have to ask what they tell us about the longer-run context but not put too much weight on them. That’s one reason that I think some of the analytic frameworks that we’ve developed here are very useful for thinking about these things.

I think that this is very important—it is why I stressed the issue of the analytic framework for thinking about the inflation process and what monetary policy can do. We can’t control relative prices, but we can do something about long-run inflation expectations and expectations about future output gaps.

I'll note that Mishkin himself was not immune to the importance of oil prices, worrying that it would actually lead to long-term inflation expectations changing:

Let’s hope and pray—let’s all get around in a circle and hold hands—that oil prices fall, which will also help us not get boxed in.

2) Inflation was less of a concern than macro stability.

When you have very big downside risks to economic activity, you want to deal with inflation expectations when they actually indicate that there is some problem. And I just do not see that at this juncture. 

3) The federal funds rate does not indicate the stance of monetary policy. Instead, look to all asset prices.

Let me talk about the issue of focusing too much on the federal funds rate as indicating the stance of monetary policy. This is something that’s very dear to my heart. I have a chapter in my textbook that deals with this whole issue and talks about the very deep mistakes that have been made in monetary policy because of exactly that focus on the short-term interest rate as indicating the stance of monetary policy. In particular, when you think about the stance of monetary policy, you should look at all asset prices, which means look at all interest rates. All asset prices have a very important effect on aggregate demand. Also you should look at credit market conditions because some things are actually not reflected in market prices but are still very important. If you don’t do that, you can make horrendous mistakes. The Great Depression is a classic example of when they made two mistakes in looking at the policy interest rate. One is that they didn’t understand the difference between real and nominal interest rates. That mistake I’m not worried about here. People fully understand that. But it is an example when nominal rates went down, but only on default-free Treasury securities; in fact, they skyrocketed on other ones. The stance of monetary policy was incredibly tight during the Great Depression, and we had a disaster. The Japanese made the same mistake, and I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me. 

4) The Great Depression and Japan were appropriate parallels to be thinking about in Aug 2008. See the quotes in part (3) as well as the now famous one below:

Remember that in the Great Depression, when—I can’t use the expression because it would be in the transcripts, but you know what I’m thinking—something hit the fan, [laughter] it actually occurred close to a year after the initial negative shock.

So there you have it. Mishkin knew what he was talking about, and I think it's pretty clear that his departure was a loss. Whether he would have been able to influence the entire group is subject to (even more speculative) debate.  But if there's one lesson here, it's that orthodox, textbook monetary policy should and could have prevented 2008 from being as bad as it was. I just hope someone in Europe has a copy of Mishkin's book.

Saturday, February 22, 2014

Some Comments on the Fed Transcripts

Joao Marcus Nunes has provided a wonderful reading of the Fed transcripts, replete with his customary graphs that tell a thousand words. Please read the linked post. I find it impossible to deny his charge that the Fed was overly focused on inflation.

I just want to make a few additional points, which he may not agree with:

1) The oil price shock in Greenspan's time is an excellent point that I did not know about. Rather than an oil price shock, the 2008 Fed was responding (incorrectly) to the threat of an oil price shock to inflation expectations. I think crossing the $100/bbl barrier for WTI crude (and the concomitant China demand story) had a serious psychological effect on policymakers. Thankfully, Bernanke did not make that mistake again when the Arab Spring occurred. His critics (see next point) suggested that QE was leading to inflation, but he held firm.  Again, I can't prove it, but I think we should be grateful for the development of shale resources in the US. Not only was there the promise of future oil production, but there was a HUGE difference in natural gas prices in '08 and '11 (crossed $13/mmBtu in '08 but sub $5 in early '11).

2) I said that we shouldn't abuse the transcripts to play "gotcha" with those who got it wrong, or said things that were slightly wrong. However, I do want to say something about Richard Fisher. Not only was he completely wrong in 2008, he refuses to hold his hands up and admit the mistakes, and continues to peddle the same line. He says some quite sensible things on TBTF regulation, but his record on monetary policy is frankly dreadful. It is actually quite scary that so many people still hold him up as a monetary expert.

3) Joao Marcus is absolutely right that the level of inflation expectations was lower than in the Greenspan era, and it therefore seems strange that Bernanke reacted by "leaning" against inflation. That said, I think we have to realize that (in human fashion), they were paying attention to the change, rather than the absolute level. As his graph shows, the Fed could conceivably have been concerned about the run-up from sub 2%. This does not absolve them of the mistake, but it's a charitable interpretation of the complex issue they were dealing with.

4) People often play the "what if" game, which is nothing but a pleasant parlour game. In the monetary history I've read, the biggest "what if" is how Benjamin Strong would have responded to the onset of the Great Depression. Many argue that he would not have allowed the monetary tightening that worsened the downturn. Totally unprovable but fun to think about it. So here's my little addition to the game (probably premature since I haven't read all the transcripts yet). I think Rick Mishkin's departure from the FOMC weakened the Board of Governors at a crucial time. He submitted his resignation on May 28, his departure was effective on Aug 31, and 15 days later, the Lehman bankruptcy occurred. This is important because he was one of the members who was incredibly concerned about a severe recession, and was calling it a financial crisis by mid-March. Mishkin's reputation has taken a bit of a battering thanks to the Inside Job, but there's no doubt that he had a lot of foresight as to what was developing. Would he have been able to convince Bernanke to focus on the brewing storm? We'll never know.

Rooney's Contract Is A Statement - But Of What?

Wayne Rooney has signed a new four-year contract with Manchester United, reportedly worth 300,000 pounds a week, which will extend his stay at the club till he's 6 months shy of his 33rd birthday. Upon retirement, he'll remain as club ambassador. The deal has been hailed by the media as a "statement of intent" from Moyes.

It's a statement of something, alright, but I'm not sure "intent" is the word I would have used. More like "desperation", to me.

Let's get this out of the way: like many fans, my personal feelings for Rooney have dimmed after the revelations that he wanted to leave twice. Perhaps one of the saddest things about this current Manchester United side is that it contains so few players who deserve the adulation that we, the fans, proffer so willingly on a weekly basis. But I respect the fact that footballers are professionals, who deserve to bargain for wages and alternate employment, despite it rubbing fans the wrong way. Managers and clubs treat players like commodities, and they in turn respond by seeing their contracts as a professional relationship. Not pretty, but fair enough.

In addition, Rooney has been excellent this season. His poor form last season had much to do with consistently being played out of position (and in a variety of positions) by Fergie. He's a known quantity, and avoids the transfer wrangling for a replacement in the summer, which is a relief, given the decidedly mixed history of those attempts. And finally, it avoids sending the signal that the rats are deserting a sinking ship.

But all of this at what price? 300k a week is a truly staggering figure. As good as Rooney has been this season, he hasn't merited that sort of lucre. Who else would pay him that money? Chelsea have made it clear that they'd pursue him (though frankly, I wouldn't put it past Mourinho to make those statement just to unsettle the player). But I find it hard to believe that Rooney would merit the same wage packet as Cavani and Falcao - or Suarez, for that matter, who despite his odious actions on the pitch, remains one of the most thrilling forwards in the world.

Nor does he deserve to be the clear exception to the club's policy of only offering one-year contracts to players over 30. It's a shocking move, especially considering Rooney's history of weight & fitness issues. Treat him right, by all means, but don't treat him special. Again, offering to make him a "club ambassador" is both silly and insulting. Rooney should earn that respect - as he's done this season - rather than being assured of it.

The club's propaganda machine, unsurprisingly churned out this gem:

Should we be thrilled that he's decided to stay? Pleased, perhaps, excluding the cost, but it might be a bit much to expect fans to be doing Jiminy Cricket dances. 

So what does this all say about the state of the club? First, there is a desperation to stabilize the ship at any cost. Second, the economics of running this club just got a lot worse, as I posted previously. And third, the job of managing this squad just became even harder when one player has been so obviously singled out for special treatment and virtually assured a position of primacy. I am very skeptical that Moyes is the right man for the job, but if he's still here in 3 years, he's going to have to manage a powerful and divisive figure in the dressing room who will likely be in athletic decline. Unveiling this contract, Moyes said, "I want to bring more Wayne Rooneys to Manchester United." That, I fear, would be the worst possible thing for the club.

Friday, February 21, 2014

Goldilocks & The European Bears Have Breakfast with the ECB

I attended a breakfast this morning with a former ECB official (I realize this is the second post in a row where I've talked about an unnamed person. It's a little annoying, because I realize I'm not exactly Bob Woodward, but I'm trying my best to respect Chatham House rules). I'll keep it vague - he was quite highly placed, but left around the time Draghi took over.

1) German constitutional court decision was on net positive, despite its tone, because it didn't explicitly forbid OMT.
2) Broadly optimistic on the future of the Eurozone:
a) Jean Monnet recognized that the European vision would only be forged through crisis, and so far, the Eurozone had responded whenever its collective back was against the wall.
b) Institutions like the banking union were coming together.
c) Things are starting to improve even in the periphery.
3) However, he was very cautious on what he deemed the limits of monetary policy. He was very concerned that appropriate conditionality be met before programmes like OMT could be launched, and would prefer to see the ECB try to ease monetary conditions by improving credit transmission (possibly even directly buying loans & ABS).
4) There was some resignation that Japan-ification could happen in the Eurozone because of "structural factors" (don't get me started).

While I thoroughly respect the experience he has, I don't quite buy the story that the Eurozone is entering a Goldilocks period. I don't want to be overly wedded to the bearish story: if European equity and credit prices improve, this is an implicit monetary loosening (which could then start a virtuous circle if combined with other indicators). But it seems to me that a modicum of skepticism is warranted when others start to project linear increases in economic and corporate earnings growth, particularly when the need for aggressive policy action has waned. To be continued, no doubt.

The Sociology of Quant Investing - Is There a Moneyball for PMs?

I attended a lecture given by a fund manager of one of the largest equity quant funds in Europe last night. The lecture was excellent: he addressed many of the criticisms of quant funds, and convinced me to a large extent that quant funds, which incorporate much of the newest (and old, but ignored) research on investing should play some part in my externally-managed portfolio in the future.

But another thing I couldn't help but notice was how extraordinarily young the manager was to be co-heading some of the largest quant funds in Europe. I asked whether quant funds were more amenable to young PMs, and if so, what was gained or lost by that fact.

His answer was generally, yes, quant funds are more open to having young PMs, for two reasons:

1) Quant investing, at least at the big shops, is more of a team process, relying on collaborative decision-making underpinned by a vast army of internal and external researchers. You rarely rely on superstar managers, so there's more chance for young managers to rise to senior positions alongside older managers.

2) As a result of (1), marketing for quant funds relies less on the manager's cult of personality (my words, not his). It's virtually impossible to market a discretionary fund headed by a young manager, but this isn't a problem for quant funds.

I thought that was very interesting. I see experience in PMs being valuable for 3 reasons:

a) Higher pattern recognition of cycles
b) Greater likelihood of having lost money at some point in one's career, and hopefully greater sensitivity to hubris
c) Larger toolkit & knowledge base

However, you don't want to overpay for or over-value experience (or conversely, penalize youth too heavily).

I'm familiar with the basic outlines of factors that quant funds try to exploit in equities. Is anyone running a quantitative fund of funds? I'm sure there must be, and see how that could be done quite easily with a mean-variance optimization framework (though I have my doubts about the appropriateness of that framework). More interestingly, is there a Moneyball of portfolio managers? If anyone has information on how this, I'd love to hear more about them. There's often a highly discretionary component to the identification of talented young managers. Most young managers striking out on their own seem to have built a track record internally at a larger fund - how do you judge skill vs. luck in these circumstances? This seems considerably harder than identifying growth stocks, which is in itself a highly speculative process.

Thursday, February 20, 2014

Manchester United, David Moyes & the Middle Income Trap

In an earlier post, I described the circumstances that led to David Moyes being hired by Manchester United, as well as the mediocre form the team has shown this season. Sports writers and fans can point to several reasons for United's poor performance. As a starting point, I'll take this handy summary from Republik of Mancunia. Alex Ferguson is gone, the Glazers aren't selling, and injuries are presumably just bad luck so the things you can do something about are: (1) a thin squad, and (2) Moyes.

Clearly, all the above have played some role. But watching Moyes at close quarters for the first time this season, I've become increasingly disillusioned with his inability to draw the best from his players. It's precisely because of the squad's deficiencies that it's been painful to watch Moyes repeatedly consign Shinji Kagawa to the left wing, a mistake he seems to be repeating with Juan Mata. This tactical rigidity is the hallmark of someone who doesn't trust his players to express themselves. I'm not suggesting that tactics and formations have no place in football. I'm saying that strategy should be designed to harness the assets one has, and that to compete in the upper echelons of football, you need to give players a license to be creative and unpredictable. The great Brazilian sides have successfully married technical ability and unpredictability ("in Brazil, the land of improvisation, nothing ever goes quite as planned" - former President Fernando Henrique Cardoso.)

From an organizational perspective, one could argue that Moyes's Everton never made the leap from Good to Great. In the world of macroeconomics, we see this with countries who get stuck in the middle income trap, which is "the phenomenon of hitherto rapidly growing economies stagnating at middle-income levels and failing to graduate into the ranks of high-income countries." Think, for example, about Latin American countries such as Peru, Mexico & Brazil, who have not reached the income levels of countries like Taiwan, South Korean & Singapore.  

Without going into too much detail, researchers of national growth break it down into labour (total hours worked), capital (machines & other productive assets which complement labour) & total factor productivity (or TFP, mainly consisting of technological and institutional improvements). The IMF reports that "Steep falls in TFP growth appear to have played an important role in past growth slowdowns... It may be that at very low levels of income, the development of a basic framework of property rights and contract enforcement has a large impact in staving off slowdowns, but once this condition is more or less satisfied the capacity of the private sector to grow and innovate becomes relatively more important."

We can ignore capital (in the economic, not the financial sense) since it doesn't really apply to football teams. Other than that, this is the David Moyes era in a nutshell. He's been great at building solid defenses and competent midfields, which are the equivalent of property rights and contract enforcement, but he can't for the life of him seem to figure out how to get his teams to consistently innovate (and for the record, he's doing a pretty poor job of settling the defense right now). This is exactly why he favours players like Antonio Valencia, Ashley Young and Tom Cleverley - you know exactly what you're going to get from them. This consistency is reassuring when you don't trust your players. What's worse is that Moyes seems to think that increased labour (more frequent and more intense training sessions) will do the trick. Sadly, just as the Chinese growth model would not work in the U.S., this version of David Moyes seems to be a poor fit for the attacking players at his disposal.

If I've convinced you that Moyes is the biggest problem now, then the next question is, what should the board and owners of MUFC do about it? Paul Ansorge argues (convincingly, in my opinion) that it would be better to concede that Moyes was a mistake, sack him, and move on. I think it comes down to this: do you think Moyes can adapt, or will he constantly be one step behind other top managers? I fear that the latter will be true. If his post-match comments are anything to go by, he's generally clueless how to adapt mid-course. Even his adaptation has taken on a predictable form (taking off Rafael and putting Valencia on at right-back, even though it inevitably results in United conceding a goal.) And if that's true, he has to go. The competition at the top has become far too close for any part of the organization to function at a sub-optimal level.

I don't think Moyes will be sacked in the summer. And I wish him the best because he seems like an honest, hardworking man, and it would be wonderful for him to succeed at the biggest club in England (yes, I said it!). But I wonder if the veneer of humility is for real. The activist Jane Jacobs had a long-running feud with New York City's "master builder" Robert Moses, and said of his meticulous plans: "Only an unimaginative man would think he could; only an arrogant man would want to." Perhaps that's harsh on Moyes. But as a United fan first and foremost, I can only hope that this crucial organizational decision won't become another kind of cautionary tale. Miller, Kleberson and Djemba-Djemba all got three seasons at United. At the rate Moyes is going, that would be too long.

Wednesday, February 19, 2014

Symbolic Interactionism & The Stock Market

Jason Zweig has written an excellent tribute to Jerry Goodman, better known as the financial writer "Adam Smith". He quotes Goodman writing in "The Money Game":

"A stock is, for all practical purposes, a piece of paper that sits in a bank vault. Most likely you will never see it. It may or may not have an Intrinsic Value; what it is worth on any given day depends on the confluence of buyers and sellers that day. The most important thing to realize is simplistic: The stock doesn’t know you own it. All those marvelous things, or those terrible things, that you feel about a stock, or a list of stocks, or an amount of money represented by a list of stocks, all of these things are unreciprocated by the stock or the group of stocks. You can be in love if you want to, but that piece of paper doesn’t love you, and unreciprocated love can turn into masochism, narcissism, or, even worse, market losses and unreciprocated hate."

This is a lovely bit of writing, and at the risk of ruining a powerful, direct paragraph, it captures the realities of a symbolic interactionist view of investing. Symbolic interactionism can be summarized in three points:

1) Humans act toward things on the basis of the meanings they ascribe to those things.
2) The meaning of such things is derived from, or arises out of, the social interaction that one has with others and the society.
3) These meanings are handled in, and modified through, an interpretative process used by the person in dealing with the things he/she encounters.

There are lots of alternative ways of viewing this interaction between an investor and his assets. I think it was Kindleberger (and not Minsky) who came up with the word "revulsion", capturing quite brilliantly the visceral aversion investors can feel in a downturn. The "equity risk premium" might sound like a nice, solid, finance-y concept, but behind it lies an ephemeral symbolic interactionism.

So, say what you want about art historyPresident Obama, but for my money (no pun intended), sociology remains an incredibly important discipline and lens for the real-world investor.

Not Too Loose, Not Too Tight - And Let The Crumple Zone Do Its Job

The recent volatility in emerging markets has reignited debates about the appropriate level of currency flexibility and capital mobility. It's clear that excessive volatility in currencies and capital flows can be destabilizing to a domestic economy. But it seems to me that the systems have worked exactly as they should in most countries.

To make an analogy, if you're anything like me, you'll look at this picture and think...

"Holy sh*t, I hope no-one was hurt." That's a natural reaction, and totally fair. But to some extent the damage we see is designed precisely to prevent passengers from being hurt. The crumple zone in the front part of the vehicle is designed to absorb energy from a collision through controlled deformation. 

From Wikipedia: "Crumple zones work by managing crash energy, absorbing it within the outer parts of the vehicle, rather than being directly transmitted to the occupants, while also preventing intrusion into or deformation of the passenger cabin. This better protects car occupants against injury. This is achieved by controlled weakening of sacrificial outer parts of the car, while strengthening and increasing the rigidity of the inner part of the body of the car, making the passenger cabin into a 'safety cell', by using more reinforcing beams and higher strength steels." 

To take the analogy further, appropriate monetary policy and supply-side reform are the rigid inner body of the car, while some accumulation of foreign reserves is an airbag. The crumple zone and airbag in most economies have worked as designed, so there's no reason for a resurgence of "fear of floating".

I'm not arguing for complete capital mobility, though, particularly in small economies with poorly developed financial systems. I especially detest it when hedge funds criticize countries for restricting capital mobility. That's just hypocritical: hedge funds employ "lock-ups" to manage capital flow volatility, quite rightly arguing that investor panic can hurt not only the withdrawing investor, but other investors too, if the fund is forced to liquidate assets in a fire-sale. Similarly, policymakers have every right to slow the flow of hot and fickle money.

So I guess what I'm arguing for is a plucking model of central banking. No, not the plucking model made famous by Milton Friedman. Rather, another theorist noted that "The over-tight string produces an unpleasant sound and is moreover likely to break at any moment. The string that is too loose does not produce a tuneful sound. The string that produces a tuneful sound is the string that is not too tight and not too loose."

That was, of course, a disciple of the Buddha, whose attempts at meditation were in fact hampered by his excessive control. Not too loose, not too tight - and let the crumple zone do its job.

Tuesday, February 18, 2014

Peter Praet Goes "Structural", or the Eurozone Develops Sensory-Motor Amnesia

The ECB's Peter Praet, unsurprisingly, praised his own institution today, saying,"The ECB has been central in stabilizing the euro area economy. Looking ahead, the task of all euro area policymakers is to ensure that the improvement in confidence will be validated by actual outcomes. If implementation of structural reforms is pursued ambitiously and the reform momentum upheld, it seems likely that growth will surprise on the upside in the coming years."

You can read Praet's full remarks here. On the surface of it, there's little controversial about Praet's statement. The Eurozone periphery economies are certainly in need of structural reforms, and the achievement of such reforms would undoubtedly boost economic growth. But I'm going to object to his statement on the grounds that it's just another way of saying "It's structural." Marcus Nunes has done an excellent series of posts battling the notion that the downturn has been structural. Perhaps Praet did not mean it this way. But I find it very concerning when a central bank concerns itself primarily with structural reform rather than the appropriate provision of money.

I've been reading a very interesting book called "Somatics: Reawakening The Mind's Control of Movement, Flexibility  & Health" by Thomas Hanna. I'm only halfway through, so I'm not going to recommend it just yet, but its somewhat heterodox position is that many of the ailments we associate with old age start as responses to stress and trauma. They're misdiagnosed as structural (rather than somatic, or psychological) issues and therefore not treated at the fundamental level. Eventually the body begins to forget how to move in a natural way, only feeding the cycle of pain and inactivity. Hanna goes so far to say, "Age is a crypto-pathology... the basic problem [is] really the same: involuntary contraction of the muscles in the body's center of gravity, affecting the periphery of the body; or involuntary contraction in the periphery of the body, causing a compensating contraction in the center of gravity."

I'm sure you see the parallel. Again, I'm not disagreeing with Miles Kimball's view that money has a deep magic, and the supply side has a deeper magic (although I'm sure his wife, as a massage therapist, will readily grasp the importance of correctly diagnosing so-called structural conditions!). But there is a crypto-pathology afflicting the Eurozone, and no-one - least of all the ECB - should be allowed to forget it.

Sunday, February 16, 2014

Oh When The Stock... Kept Marching Down (Manchester United & the Economics of Sports Teams)

Last May, Sir Alex Ferguson announced he was retiring as manager of Manchester United (MUFC) after 26 years in charge. While the timing was unexpected, it was of course no shock that the 71 year-old had decided to step down at last. A favourite game among fans (well, me and my friends, at least) was to speculate on who would eventually replace him. After all, what's better than making bold claims about things you cannot possibly control, especially after a few drinks? My personal preference was Carlo Ancelotti, who struck me as a cultured man with a proven pedigree at major clubs. I would have taken Pep Guardiola in a heartbeat but he'd recently agreed to take over at Bayern Munich. Other popular picks were Jose Mourinho (too egotistical for my liking, not to mention the small matter of once poking a rival manager in the eye), David Moyes (perennial over-achiever at Everton, though with questions about his ability to actually win trophies) and Jurgen Klopp (his Dortmund side were playing some very attractive football at the time, but he had something of a "Flavour of the Week" feel, even though he appears to be doing a great job there). I'm not sure if Ancelotti was ever really in the running, but was heading to Real Madrid anyhow. It was somewhat controversial, though, when the club's management opted for Moyes over Mourinho. Chatting with my friend Cory, I said I hoped it wouldn't matter too much if Moyes hadn't won any major trophies because Fergie had instilled a culture of excellence at the club. I think I paraphrased Warren Buffett who said he "liked businesses that are so wonderful that an idiot can run them - because sooner or later, one will."

No such luck. As I write this, MUFC sit seventh in the Premier League. Galling as the league position is, it's the manner of the performances that has drawn heavy criticism from the fans. The team has been shaky in defence, timid in midfield and lifeless in attack. The debate over whether Moyes is the right man for the job has only grown more heated.

My hope that MUFC would succeed with or without Moyes has proven unfounded, but to be fair, that was the hope of a fan, and not the unbiased assessment of an analyst. In my day job as a financial analyst, I had been asked in March 2013 to evaluate MUFC as a business given its recent IPO. I'm not a specialist in valuing sports teams, but it seemed to me that they didn't make very good businesses. To quote Buffett again, "The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down." The same goes for sports teams. The last I looked, MUFC was actually doing a pretty good job in generating revenue from three streams: (a) commercial revenue (sponsorship deals, retail, merchandising & apparel sales, and new media & mobile), (b) broadcasting revenue, and (c) matchday revenue. My major concern, though, was on the costs side. Players' wages and transfer fees continue to march upwards, being subject to the economics of superstars. And if you want to continue driving revenues, you've got to continue spending on top-notch players, meaning that the free cash flow wedge is incredibly hard to maintain.

That still left me with the question of how to actually value the stock. Like airlines in the old days, elite sports teams are trophy assets whose owners are rarely focused on a financial return. This means that the valuation of sports teams contains a hugely speculative component, which is the "glamour premium" - something that's more susceptible to the vagaries of the market than I'd like as a common equity investor. (Not the first time I'd made this point - when I was in college, I took a class on Financial Booms and Busts, and we had to write a paper on an asset class of our choice that was a bubble. I chose Premiership football teams. That was 2006, so I guess I could have had my pick, but it was more fun writing about football as a subset of LBOs.) Furthermore, given the predominance of Middle Eastern and Russian investors who set the prices for these assets, I was concerned that private market valuations were much more closely tied to the global commodity cycle and world economy than ever before. My conclusion was that the stock was certainly not a buy, and possibly an outright short. I felt a little stupid as the stock climbed from $17/share to $19/share. But then, of course, Fergie retired, since which the stock is down 20% (which should perhaps make me feel stupid again, since I wasn't actually short the stock).

I promise the point of this isn't to tell you how smart I am (and perhaps you can laugh at this 2 years from now when Moyes rights the ship, and MUFC stock is much higher. I haven't analyzed the financials closely in about 9 months, and so don't have a strong view on valuation, but the stock trades at $14.84/sh at last close). Instead, I want to make three points on how the economics of elite sports teams are even worse than I thought.

1) Even a club like Manchester United is not a self-sustaining institution, but what's worth remembering is how quickly even the best can go off the rails. Sports fans know this. Financial analysts, mmm, not so sure. I'm not suggesting that MUFC is going to enter a long period of decline a la Liverpool, and I'll save comments on the Moyes era for my next post. But it does mean that sporting fortunes can change pretty quickly, and when free cash flow is already so hard to come by, there is a lot of implicit operating leverage.

2) It's a cliche but this is one of those businesses where your best assets walk out of the door every night. Yes, they're signed to long-term contracts, but we all know those aren't worth much. Last year Robin van Persie was hugging Fergie and embracing the little boy inside him on the way to his first Premiership title. This year we're hearing rumours that he's disaffected with the Moyes regime and looking for a way out. True or not, it's a stark reminder how quickly things can change (linked to point 1).

3) The rise of the nouveau riche clubs (I don't mean that in a pejorative way... oh, who am I kidding, yes, I do) shows just how hard it is to sustain a competitive advantage in this business. If you gave me $2b, I couldn't create the next BMW or Louis Vuitton. By comparison, while Chelsea and Manchester City don't have the same history as MUFC, you can't scoff at results and the very attractive football they've been capable of playing. Basically, you CAN buy success, or some modicum of it.  

So there you have it folks. Sports clubs are wonderful playthings for the rich these days, but probably unsuitable for the retail investor unless valuations are extremely favourable. It kind of reminds me of that old joke: "What's the best way to make a small fortune in oil? Start with a large one."  

In my next post, I want to analyze what's going wrong at MUFC by drawing a parallel between the club and the middle income trap. Because what's sexier than football and growth empirics??

Tuesday, February 11, 2014

The Legal News Kept Slipping Into The Financial Section, or You Do It To Yourself

Scott Sumner famously remarked that the worst part of reading microfilm of the 1930s financial news was the fact that "the political news kept slipping into the financial section", something echoed by Lars Christensen many times. We have long passed the point in this crisis when we should be surprised about political news slipping into the financial section, but now we have legal news slipping into the financial section - and how much more boring can it get than bothering with opinions from the German constitutional court? 

The court's swipe at the ECB's OMT has been well reported by Ambrose Evans-Pritchard. Most people appear to be missing the ramifications for monetary policy, but it seems like this is part of an even bigger story, which is a dent to the entire crisis-fighting mechanism that has been constructed since Sep 2012. That thought crossed my mind when I was reading this Aug '13 report from the Brookings Institution:

"At the present juncture, the base case of transiting into a more stable long run in the euro area seems to rely primarily on improving the incentives and control mechanisms (six-pack, two-pack, European semester, and other torture instruments). The status quo does not provide for debt restructuring (beyond Greece) and does not foresee any mutualization of debt. It relies on the Outright Monetary Transactions (OMT) of the ECB, and beyond that it is based on the hope that the adjustment process and the structural reforms that debtor countries are undergoing will eventually bring rewards in terms of higher growth. The present strategy of dealing with the legacy debt is risky since it requires an extremely long and unilateral adjustment process on the side of the high-debt countries. It could easily derail for a number of reasons—for example, if growth fails to pick up for a few more years, if the credibility of the OMT fails or if the political will to drive reform is exhausted."

Whoops. Hope, as they say, is not a strategy.

In some ways, the German court's ruling was entirely justified and utterly predictable. Mario Draghi has managed the politics of the crisis quite well - better than I would have imagined, and better than I like to give him credit for, since I'm just sitting on the sidelines taking potshots. But the risk of being a canny political operator is that people will begin to see you as such, and the German court's ruling is surely a response to the increased political role of the ECB.

The German court said it would rule on the legality of the ESM on Mar 18. As I understand them, the ESM's Primary and Secondary Market Support Facilities look similar to the OMT with the big difference that they are not conducted exclusively by the ECB, and require an MOU from the Troika. So presumably they are not as controversial as OMT. But should the German court challenge the ESM, which has already been deprived of its silent guardian (OMT), the Eurozone will have a big problem, and it may require more than the dulcet but resolute tones Mario Draghi has employed so far. 

Perhaps I'm overstating this, and European growth will pick up without ever needing the ESM, the OMT or any other arcane acronym. And let's not forget that there are forms of monetary expansion that should not be construed as QE, as Jacob Kirkegaard describes . But this all seems an awful risk for anyone to take. There have been lots of opportunities to get ahead of this crisis, but the ECB has consistently persisted in waiting till the last minute to act. There's a line in Radiohead's "Just", where Thom Yorke sings, "You do it to yourself, you do, and that's what really hurts is you do it to yourself, you do, you and no-one else." It's just human nature, I suppose, to find it harder to pity people when they seem intent on self-destruction. Unfortunately, this seems to apply to the ECB. 

Wednesday, February 5, 2014

When Is A Bubble A Bubble?

This post will have me both on well-trodden ground AND thin ice, to hopelessly mix my metaphors. There's loads of economic and popular literature on bubbles out there, with a wide range of opinions. Scott Sumner generally dismisses their existence. I don't agree, since I think complex adaptive systems do occasionally lend themselves to bubble-like phenomena. Let's for the sake of argument that bubbles do happen, by which I mean an asset price increases out of line with its fundamentals. The next question is rightly "When do we know that increases are unjustified?" You can go wrong for all kinds of reasons. In 2009, I mistakenly thought that the rise in the stock market was unsustainable because I didn't understand the effect of looser monetary policy on earnings and the discount rate on equities. (By 2010, I started to realize that the market monetarist model seemed to work better empirically than my Internet Austrianism.)

As with most things, I'm no expert on property prices, but I've lived recently in London, New York and Singapore, all places where prices have risen strongly since 2008, are high on a per square foot basis, and where the topic figures frequently in conversation. In fact, in London, home prices are such a hot topic that it dominated a recent Mark Carney press conference. I'm in the process of learning more about the intricacies of real estate as an asset class, and will perhaps post when I have better data, but for the time being, let's say there are several possibilities in the London market, just to take one example:

1) Prices are being bid up by speculators, who think prices will continue to rise and allow them to enjoy capital appreciation.
2) Prices are being bid up by nervous homeowners who fear that prices are going to continue rising, and if they don't act now, they'll never own homes, much less their dream homes. They feel compelled to take on leverage to do so.
3) Investors think that rents are going to rise, which will justify the prices being paid.
4) Investors are demanding lower yields on property assets. This is a variety of the safe asset shortage problem described by David Beckworth among others. 

My social circle naturally informs my purely anecdotal impressions, but I hear a lot of (4), with a little bit of (2). I've had Singaporean friends say to me "Central London property always holds its value", which sounds to me like "The asset has low volatility of returns", or more simply, "It's a safe asset." I think reasons (1) and (2) would be cause for concern, (3) depends on whether there is some basis for those beliefs, and (4) is a secular change that has to be respected. (And please, I'm not suggesting that London property is therefore a good buy, since that depends on investor preferences at various yields).

This may be horribly naive, but maybe... we could just ask people. We use well-designed surveys for lots of things, so why not here? I know there are flaws: people may not understand their true reasons, or may be hesitant to explain those reasons, particularly if they're institutional investors. It may also be more or less appropriate for specific asset classes. But hey - sometimes the best way to know why someone is doing something is to ask them!  It seems like some economists and finance professionals spend an awful lot of time creating models and speculating about various indicators and not enough time understanding what exactly is going on in investors' heads (I'm sure real estate consultancies do this sort of work, though I bet few central bankers deign to listen to them). If bubbles do exist, we'll do a hell of a lot better responding to them if we just talk to people and understand what's driving them. And if they don't exist at the moment, then we'll certainly do better not to shoot at imagined ghosts in the night. Tampering with monetary policy to stem imagined bubbles would be an unfortunate ricochet.