Tuesday, June 28, 2016

The Power of "Because"

Superior investment results are usually attributed to some combination of better information, better analysis, and better emotion management. The first of these, information, is central to any investing endeavour. Analysis is the synthesis of information; information is its foundation. Similarly, no amount of emotion management can overcome deficiencies in the original analysis. It's no wonder, then, that investors go to great extremes (occasionally crossing ethical lines) to obtain information that can provide them with a competitive advantage. In this age of continuous, real-time data, many investors satisfy their information cravings with a steady diet of business news on TV and the Internet. But this unceasing flow of news rarely provides the advantage that some investors think it does. If anything, it's probably harmful to the investment process.

T.S. Eliot had something to say on this subject, famously writing, "Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information?" We are confronted today with a surfeit of information, but significantly less knowledge and wisdom. The financial press is always quick to construct facile narratives for market movements. "The market fell today on fears of a hard landing in China," we hear, or, "The market rallied today in anticipation of a more dovish Fed." It's much harder to admit that markets are both random and complex. 

Chalk it up to the power of "because." Harvard social psychologist Ellen Langer demonstrated this in a series of experiments asking a small favor of people waiting in line for a library copying machine. The first request was, "Excuse me, I have five pages. May I use the Xerox machine because I'm in a rush?" An impressive 94% of those in line allowed her to skip ahead. This fell to just 64% when participants were confronted with the request, "Excuse me, I have five pages. May I use the Xerox machine?" But the real kicker was the final experiment, where participants were asked, "Excuse me, I have five pages. May I use the Xerox machine because I have to make some copies?" Amazingly, 93% of those asked agreed, even though the request contained no new information. Some justification, no matter how flimsy, was enough to secure compliance. 

In the world of investing, we see this when investors get locked into a prevailing narrative. In his book "Common Stocks and Common Sense," value investor Edgar Wachenheim recounts a winning investment in Southwest Airlines. Other investors failed to realize that a tightening in airline capacity would lead to higher pricing for airline seats. But Wachenheim is most critical of sell-side analysts, who had become so focused on short-term developments that they ended up missing the bigger picture. The so-called experts, he writes, "had become reporters of recent news, not analysts."

I prefer to leave the reporting to reporters. Intelligent contrarianism, which Philip Fisher described as "correctly zigging when the financial community is zagging", is at the heart of fundamental investing. But this is hard to do when we confuse the news with information or knowledge. We all need to stop and think a little bit harder, especially when the news offers that most seductive of words: "Because."

Saturday, June 18, 2016

Triumph of the Optimists

When interviewing people, the venture capitalist and entrepreneur Peter Thiel has a go-to question: "Tell me something that's true that nobody else agrees with." As it turns out, this is a stunningly hard question. But one of my answers would be simply, "That the world is getting much better."

We are bombarded daily with news coverage of threats like terrorism, global pandemic and economic mayhem. It's hard to follow the news without getting depressed about the future of humanity and the planet we inhabit. And yet, the truth is, the world is getting much better. This is true broadly in human health, economic well-being and safety, as documented by writers like Matt Ridley, Charles Kenny and Steven Pinker. On Twitter, I'm constantly impressed by the data visualizations compiled by Max Roser and HumanProgress.org, which highlight remarkable improvements in our world. This is not to deny that major suffering still exists, or that pockets of society in the US have seen only modest progress over the last 50 years. But looking at the big picture, I find it hard not to be awed by the strides we have made over several generations, and to therefore be optimistic about future developments.

Still, this appears to be a relatively unusual opinion. Even if it is something people agree with on an intellectual level, they often cannot help but feel differently at the visceral level. Why exactly this is the case is the cause of much debate. Personally, I'm always interested in trying to figure out how to apply contrarian opinions for practical purposes. It struck me that I use this particular unpopular stance all the time: I invest in equities for the long term. 

Contrarian optimism is hardly an unusual strategy when it comes to investing.  There are two quotes that every investing aficionado knows: (1) "Be fearful when others are greedy, and be greedy when others are fearful" (Warren Buffett), and (2) "The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell." (John Templeton). But I'm thinking here of a longer term phenomenon instead of a cyclical one. Equity investors are generally rewarded for tolerating short-term volatility and long-term uncertainty. In fact, this is one of the many findings of Dimson, Marsh and Staunton's book that produced the title of this post. I wrote a few months ago that the point of a bear market is to return risky assets to their rightful owners. Most people seem ill-equipped for a combination of volatility and uncertainty, but this prevents them from enjoying the benefits of compounding, which only accumulate over time. Looking back at long periods of history is helpful for grasping the gigantic advantage available to those who can truly invest for the long term.

Obviously, it's possible to take this optimism too far. Investors often overestimate a company's long-term prospects. And the great bubbles in history have been the unfortunate byproduct of excessive optimism, greed and a pernicious fear of missing out. There's no doubt that we all need a healthy dose of skepticism to counter the inherent bullishness of the Wall Street machine. So an optimistic outlook needs to be combined with a finely-tuned malarkey detector. But while the pessimists sit on their hands, predicting the next financial collapse or outbreak of hyperinflation, positive change continues to happen all around us. As Ben Carlson notes, "Investors now spend 90% of their time planning for events that happen 5% of the time." This hardly seems like the best way to plan for the future. Instead, the best financial strategies focus on the powerful improvements unfolding over the long term while acknowledging the short-term challenges that always exist.

Of course, only time will tell if I'm right. But I'm relatively confident in betting that the next 50 years will prove to be yet another triumph of the optimists. 

Tuesday, June 7, 2016

Four Goals Good, Five Goals Bad

In my last post, I argued that despite talk of the Fed's dual mandate, it is targeting at least four goals:

1) Price stability
2) Full employment
3) International stability, seeking to implement monetary policy in a way that (a) harmonizes internal and external realities, and (b) recognizes the Fed's influence on global economic, monetary and financial conditions
4) Financial stability, avoiding both unwarranted booms and busts in asset prices.

Tim Duy has two theories (again, see previous post) for why the Fed seems surprisingly keen on raising rates. I think the Fed's recent actions appear much more understandable in light of their unstated financial stability goal.

One narrative of the cause of the financial crisis is that the Fed was directly responsible for the financial crisis of 2007-2009 by keeping interest rates too low for too long. A more generous view is that, as Hyman Minsky warned, stability breeds instability, and the success of "the Great Moderation" unfortunately encouraged high leverage and complex financial instruments at fragile institutions. 

Despite the Fed's best efforts to insulate itself from political pressure, it's unthinkable that it can have remained impervious to the two views above. In this sense, "normalization" can be seen as an attempt to head off any reprise of the financial crisis. Two more concerns are extant:

1) The notion that market participants have somehow become "addicted" to monetary stimulus. (Side note: If there's one thing that automatically sets my teeth on edge, it's references to the economy or financial markets as an alcoholic or drug addict, and to the Fed as a shameless enabler.) The problem is that this bias leads observers to see the 2013 taper tantrum and the 2016 Jan/Feb sell-off as evidence that financial markets are relying on low rates indefinitely. 
2) The notion that Fed actions have pushed all asset markets to overvalued levels. 

Part of the financial stability goal is clearly aimed at keeping unbridled speculation at bay. In Paul Blustein's "The Chastening", he recounts how Larry Summers famously told his bailout negotiating team, "We want to keep markets calm and the Russians scared." The Fed is playing an even more difficult game where it wants to keep markets calm and the speculators scared. This is already attempting to thread the needle, but even more difficult given the Fed's other three goals. 

I've been endlessly critical of hard money types, but it's worth acknowledging that they're not the only ones who may find this expanded array of goals troubling. Those who advocate different types of rules-based monetary policy, such as nominal GDP level targeting, may also consider the monetary policy Apocrypha too hard to achieve. Their concerns are understandable. In its attempt to fulfil its Apocryphal financial stability mandate, the Fed is failing to meet its Canonical dual mandate. Furthermore, in doing so, as Narayana Kocherlakota points out, the Fed is jeopardizing its credibility to meet the Canonical Mandates. I was stunned to read the well-known economist (and former Fed vice-chair!) Alan Blinder lament the limits of monetary policy. "If there is a cyclical downturn in a year or in the next several months, there would be nothing in that shotgun," Blinder warns. If a former Fed vice-chair believes that the Fed is out of ammo (another image I don't care for), it's unlikely economic and financial markets fully believe the Fed can stabilize economy in future downturns.

As unwieldy as the quadruple mandate may be, it seems to be the right approach to central banking in the US. There's no doubt that it's incredibly challenging to manage these four goals, but I don't see any other way. If, for example, we're aware that our diet will affect our teeth, skin, weight and ability to build muscle, it's challenging to choose the right food - but we have no choice but to constantly manage the trade-offs between these effects. Why, you may argue, should the Fed restrict itself to four mandates? Why not five? Why not six? I don't have a great answer to that, and recognize the danger of over-reach: in fact, one of the problems here is that policy-makers do indeed seem to have taken on a fifth mandate, "Normalization", which is at odds with many of its more worthwhile goals.

One of my favourite books is John Kay's "Obliquity." In it, he writes, "Good decision making is pragmatic and eclectic. Oblique approaches rely on a tool kit of models and narratives rather than any simple or single account. To fit the world into a single model or narrative fails to acknowledge the universality of uncertainty and complexity." Yellen's Fed has presumably used a dashboard of indicators to guide its policy-making thus far. It would be a huge mistake to fixate on one or two of those, despite the political appeal and intellectual comfort of doing so. While financial stability is a perfectly valid goal for the Fed to consider, the balance of risks does not appear to require a hasty set of rate hikes. If anything, it is that new mandate, "Normalization", that should be abandoned in favour of the four mandates that have historically served the Fed. 

The Fed's Monetary Policy Apocrypha

In a blog post simply titled "Curious", Tim Duy ponders why so many FOMC participants seem eager to raise rates despite failing to meet either of its official mandates (price stability and full employment). Duy has two theories: (a) the FOMC does not view the removal of QE as tightening, and therefore believes it has yet to remove accommodative policy, and (b) the FOMC views a much higher level of interest rates as "normal" and is eager to reach these higher rates.

I find the second argument more convincing (by which I mean, I find it convincing as explaining Fed policy. As I will try to argue, it is a problematic stance for the Fed to take, since giving too great a weight to "normalizing policy" makes it ever hard to reach those levels). The Fed's desire for "normalization" may also reflect some view of the "normal" size of its balance sheet. But really, this argument is a sub-set of a much broader argument - one which makes the Fed's action far less curious. Simply put, the Fed is trying to meet not two, but (at least) four mandates.

No doubt this is already raising the ire of hard money types in particular, who think central banks should be focused solely on price stability, and to whom a full employment mandate is already venturing into dangerous territory. Many of these folks are likely to lionize Paul Volcker for successfully driving inflation down, even at the expense of causing a recession. But here's the funny thing: if you listen to Volcker himself, he was focused on at least three mandates throughout his lauded career. Yes, price stability was incredibly important to him. No, he didn't think the full employment mandate was particularly helpful. But he was also focused on mandates no. 3 and 4, namely international considerations and financial stability. This is strongly apparent in an excellent two-part interview he recently gave the FT's Cardiff Garcia.

Broadly speaking, I would define the extra mandates as follows:

Mandate 3: The Fed seeks to implement monetary policy in a way that (a) harmonizes internal and external realities, and (b) recognizes its influence on global economic, monetary and financial conditions.

Mandate 4: The Fed seeks to implement monetary policy in a way that maintains financial stability, avoiding both unwarranted booms AND busts in asset prices.

These mandates are hidden from the public eye. The Greek phrase for "hidden things" is Apocrypha - a phrase most commonly used in reference to a group of non-canonical writings only included in some Christian Bibles. These books are called Apocrypha "because of the belief that the men who wrote them were not addressing their contemporaries but were writing for the benefit of future generations; the meaning of those books would be hidden until their interpretation would be disclosed at some future date by persons qualified to do so." In a similar vein, the Fed's monetary policy Apocrypha are implemented for the benefit of future generations, but are largely shielded from the eyes of current observers (presumably because they lie outside the Fed's official purview).

I mainly want to talk about Mandate 4 (financial stability), but let me make some brief comments on Mandate 3. Mandate 3a is something every central bank must grapple with, particularly if it has pegged its exchange rate. Mandate 3b, however, only applies to major central banks, like the Fed, the ECB, the PBoC, and the BoJ. David Beckworth coined this the "monetary superpower" phenomenon, which I covered in a prior post.

The hidden financial stability mandate appears to be the biggest source of controversy at this point, and I cover this in my next post.