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.

What Do Investing FOMO and Over-Eating Have In Common?

There's nothing more frustrating than seeing an asset that you had on your watchlist go up by 50% before you've had time to do work on it, or before you manage to pull the trigger. If you're anything like me, this experience causes profound feelings of regret.

Why do we have these feelings? I see at least four possible reasons:

1) Greed. This seems like an obvious one. But I don't think it's the main driver, at least for myself. It's interesting that I usually think "I can't believe I missed that 50% move", rather than "I could have made $X! And bought so much with it!"

2) The missed opportunity to seem smart to colleagues and other investors. I confess to this one. It's totally understandable - we're social creatures and desire the approval of our peers. But dulling those urges for peer approval is necessary for actually earning outstanding returns. As I argued in a recent post, the exceptional investor will at times appear imprudent, and possibly deviant.

3) Professional pride. I see this one as related to (2), if slightly different. The feelings of regret are magnified if the recently appreciated asset is in the sectors I follow, or a company I used to own. Again, it's a natural emotion, and one which can be a positive spur to performance - in moderation. 

4) The fear of missing out. This is the one I really want to focus on. There's a fine line between greed and the fear of missing out (FOMO), but the two often appear identical to outsider observers. 

First, a quick digression on over-eating. I hate wasting food, and if someone in my family offers me the last bit of something delicious, my instinct is always to say yes. It's not just simple greed. The more I've become aware of this, the more I think it has deep underpinnings in evolutionary psychology. At some level, I believe, there is part of me that fears that if I don't use the resources at my disposal and consume the food, I will face hunger and possible threats to my survival. That might sound a bit nutty, but there is certainly some evidence for it in psychology. So despite the knowledge that I am (mercifully) unlikely to go without food for long, these pangs occasionally drive me to eat more than I need to.

Back to investing. I think, at some level, we fear missing out on investments because we fear we will never have similar opportunities again, and that we will be forever denied those scarce resources. We seem to be particularly susceptible to FOMO when we know people who have profited from the move (seeing the resources "consumed" just seems to chafe more). Investing FOMO also seems to be heightened in asset classes like real estate, where there appears to be a deep psychological fear of being denied shelter. In fact, there's academic work that backs this up. (The analogy between chasing returns and over-eating isn't perfect. Over-eating delivers an excess of calories. Chasing returns usually results in negative performance. But both of those are unhealthy outcomes!)

I take two things from this realization:

a) Be aware you are subject to investing FOMO. It happens sometimes. But it probably happens less if we restrict our investing to areas where we can build up a deep wealth of experience and information. A former boss used to sagely remind me, "You can't dance with all the pretty girls" if I was frustrated at missing out on something. (I may have taken his words to heart much more than he intended. I got married while working for him.)

Furthermore, markets are cyclical, and hard as it is to believe in the moment, it's quite likely that we'll get other shots. Rather than fixating on the opportunities we've missed, there are other things waiting to be discovered. As Irving Kahn reminded Peter Cundill, "There's always something to do."  

(As an aside, when someone offers me delicious food, I try to take it home, rather than eating it on the spot. This seems to convince me that I will in fact enjoy those resources at some point, just at a later time. Psychological tricks seem to work in eating as well as in investing!)

b) Try and recognize when other investors have been swept up in FOMO. Buffett's dictum to be "fearful when others are greedy" is generally wise. But we also need to be fearful when others are fearful (of missing out). My guess is that a great many people who got caught up in the US real estate boom prior to 2007 weren't greedy, but just misguided. Sadly, it seems a cruel truth that it's those who attempt some discipline who usually capitulate right at a market top.

Investing FOMO is a powerful emotion. But being aware of it in ourselves and others is the first step to weakening its hold on us - and our investing decisions. 

Uncool, Imprudent & Deviant Investors

I've been reading the work of sociologist Howard Becker this past week, in which he makes an argument for reasoning from cases. By this, he means using detailed knowledge of one specific case to uncover more general ideas about how society works. Becker writes, "I want to avoid the fate of researchers who relied too heavily on a relatively few easily observed facts to do their explanatory work... that insistence doesn't fit well with much contemporary thinking about how social facts or events occur and develop, which instead works by measuring the connections between measured things rather than explaining how those connections produce the results we want to understand."

Generally speaking, I'm sympathetic to Becker's viewpoint, particularly in a world where sophisticated quantitative analysis is sometimes used in lieu of clear, intuitive thinking, or where we focus excessively on past outcomes, rather than thinking about the future. More specifically, in the world of investing, I find myself resisting simplistic notions of following what has worked in the past. 

A current manifestation of this is the focus on "quality" stocks. As a self-professed admirer of Warren Buffett, I've written recently about his insistence on purchasing high quality businesses. Similarly, the academic work of Robert Novy-Marx finds that quality investing has been profitable. But it's hard to forget another great Buffet-ism: "What the wise man does in the beginning, the fool does in the end."

Rob Arnott, one of the fathers of the "smart beta" movement, recently caused quite a stir by suggesting the strategy could be in for a tough time. He and his colleagues wrote, "We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies." Investors who mindlessly chase performance plow headlong into what has worked, and in so doing push prices higher, providing a further signal the strategy "works" - until it doesn't, and valuations revert to historic norms. 

To be clear, Arnott et al are not suggesting this is true of low beta investing (which I take to be similar to "quality" investing). Despite observing large inflows into low beta products, they think "normal" valuations for low beta assets may have changed. But they caution that strategies like low beta "may still be an attractive investment, but for their risk-reducing characteristics, not for the alpha they have historically provided, net of their rising popularity and relative valuation."

A slavish adherence to "quality investing", therefore, is unlikely to produce satisfactory results. We have a tendency to label companies as "good" or "bad", but the reality is that "quality" is ill-defined and is a spectrum, not binary. At the right price, investors are being compensated to own businesses that are somewhat economically sensitive and which have good, but not great business moats.

There are two strategies for dealing with this reality. John Huber, who writes the excellent Base Hit Investing blog, has taken the first route, which is to identify a watchlist of 50-100 good companies, and assume that among those, "there are almost always a few opportunities at any given time for one reason or another." The second is to pursue a flexible investment philosophy that seeks value in unloved places. While we often associate this with global macro investors, it was also the hallmark of John Templeton, who people often mistake as a traditional stock-picker. Templeton said, "If you want to produce the best results in twenty or thirty years, you have to be flexible. A flexible viewpoint is a matter of avoiding a peculiar trait of human nature, which is to buy the things that you wish you had bought in the past, or to continue to buy the things that did well for you in the past." 

Ultimately, it seems unlikely that one can generate exceptional investment returns without being an intelligent contrarian. As David Swensen has written, "Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom." With customary pithiness, Jason Zweig said, "To be a great investor, you have to want to be uncool."

Being influenced by sociology, I phrased it a bit differently in 2014. I wrote then, "To succeed spectacularly, one must be unconventional, and therefore deviant." A curious coincidence, then: one of the towering figures in the sociology of deviance, and the person whose work I was channeling in that earlier post, was the same Howard Becker.

The Point Of A Bear Market

In his classic book Supermoney, the writer Jerry Goodman (aka “Adam Smith”) tells a story of an investment group therapy session gone wrong. After a vicious bear market in 1969, he convened a group of investment professionals to discuss mistakes they had made in the "Go-Go Years". For a while it appears to be going well, with participants sharing the pain collectively. The meeting, however, takes an unexpected turn when Goodman asks David Babson to speak. Babson, described as “a crusty, amiable New Englander who heads the sixth biggest investment-counseling firm in the country”, proceeds to criticize professionals who got sucked into speculation. Looking out at the crowd, Babson tells them, “Some of you should leave this business.” He then pulls out a list of former speculative high-fliers that had declined dramatically or gone bankrupt. Goodman attempts to intervene several times:

“David,” I said gently into the microphone. The audience was beginning to rustle. You can tell something has happened to the good feelings when the water pitchers start to clink nervously against the water glasses in a rising cacophony.

Babson continues reading the names of former stock market darlings.

Goodman tries to interject again:

“Don’t read the list,” I said. The audience was beginning to scrape its chairs. My massive group therapy session had taken a sour turn. Nobody was going to confess if they were being accused.

Unrelenting, Babson continues to read names. Finally, Goodman cuts in:

“David,” I said, “you have passed the pain threshold of the audience.”

Phew. I attended a much milder version of a group therapy session gone awry in 2009. At a well-attended investment conference in New York, one panelist repeated a Wall Street aphorism I had never heard before. “The point of a bear market”, he said smugly, “is to return capital to its rightful owners.” There was an uncomfortable silence, as a noticeable tension filled the air. While the speaker had obviously avoided the worst of 2008, there were many in the room to whom financial markets had been less forgiving.

That adage has stayed with me all these years. But I don’t think our self-satisfied friend was quite right. The point of a bear market, I think, is to return risky assets to their rightful owners.

Put simply, assets exist on a continuum of safety. US Treasury notes are one extreme, while equities are another. As anyone familiar with the risk/reward trade-off knows, equities usually offer the possibility of high returns, but these returns face great variability. High returns compensate the investor for bearing risk.

In finance, we use the prosaic phrase "equity risk premium" to represent this truth. The equity risk premium, combined with a company-specific risk premium, is an important input to discount future cash flows. Together, these are the whole basis of valuation. The investor's task is to understand when the market is wrong about future cash flows or about risk. But behind the jargon lies a simple fact: risky assets aren't for everyone. Some people crave stable returns to meet near-term liquidity needs. Others are just temperamentally incapable of facing volatility. That's why people are wrong to criticize financial markets as zero-sum games. When a bear market occurs, risk premiums increase, and risky assets return to those who are willing to bear the discomfort of an uncertain outcome. The sellers discover to their horror they were accepting lower risk premiums than they should have. Some of these sellers will almost certainly be so-called professional investors, realizing they woefully underestimated the riskiness of previously beloved assets. 

David Babson, I am sure, would never have made that mistake.

If You Want Profit, Prepare For Loss

It's that time of year in the US Northeast where the weather is changing from bitter cold to more bearable temperatures. Unfortunately, something about the shift in weather seems to make people more susceptible to coughs and colds. I readily confess to being a bit of a germaphobe, so it's hard for me not to cringe when people are coughing or sneezing around me. It certainly seems like I use even more hand sanitizer than normal this time of year. But sometimes I meet people who are even more militant about hygiene:

Me: *Cough*
Them: "ARE YOU SICK?"
Me: "No, I'm choking on something."
Them: "Oh, that's fine then."

Charming, to say the least! Lack of empathy aside, it struck me that you can really take the whole hygiene thing too far. No-one wants to get sick, but there's a point when it become unhealthy to obsess over every sniffle around you, and when hyper-vigilance probably detracts from your overall health and well-being. This is especially true since common coughs and colds, while unpleasant, are usually short-lived.

Much of this applies to investing. No-one wants to lose money, but it's bound to happen at some point all the same. Despite the analyst's best efforts, markets occasionally sell off, taking good companies with them. Maybe a company's fundamentals change. Or sometimes - again, despite one's best efforts - the original analysis is proven flawed. There is an optimal level of insecurity analysis that should occur when investments go sour: too little, and you risk missing important feedback; too much, and you turn yourself into the very bag of nerves that characterizes Mr. Market.

The second part of this is ensuring that you can bounce back from losses, whether temporary or permanent. At a recent investor presentation, ExxonMobil CEO Rex Tillerson said that in his 41 years in the oil business, he hadn't learned any more about his ability to foresee the price of oil. Instead, he has learned more about how to deal with the market's gyrations. Similarly, a robust investing philosophy ensures that no one event can knock you out of the game, as unpredictable as that event may be. Reasonable diversification is one solution. Avoiding leverage is another. I'm a huge fan of the Buffett admonition: "If you're smart, you don't need it, and if you're dumb, you have no business using it." 

The final piece of this is committing to learning from losses, whether temporary or permanent. Nassim Taleb coined the term "antifragility" to describe things that gain from disorder. This is an even higher bar than merely being robust to disorder. Few securities, other than US Treasury bonds, seem to meet this criterion. Nevertheless, the investor who learns from mistakes over time is in fact benefiting from that disorder, and is thus long-term antifragile.

There's a saying: "If you want peace, prepare for war." I happen to think that rings true, even if it's often misused by people who have no desire for peace. I would paraphrase it this way: if you want profit, prepare for loss. Recognize that losses will happen at some point, and (1) prepare to approach them with equanimity and clear thinking, (2) prepare so that losses will be manageable, and (3) prepare to learn from the episode. This is the foundation for dealing with, and ultimately benefiting from, adversity in the investing arena.

Berkshire Hathaway: Come For The Returns, Stay For The Philosophy

The release of Berkshire Hathaway's annual letter to shareholders is always a wonderful opportunity to learn from Warren Buffett. As usual, the letter has already been picked over by the media and blogosphere, but I wanted to record some of my own thoughts. This post can be read in tandem with an older piece I did on Buffett's shareholder essays. 

1) Simplicity. Buffett's letters are remarkable for their clarity. This is extremely unusual in a world where investment managers often aim to wow their clients with technical sophistication and jargon. Instead, with Buffett, we are left with the impression of someone who is able to take the complexities of investing and cut right to the core of the problem. Here's one example: Buffett notes that he and Munger expect Berkshire's normalized earning power to increase every year. This is a simple statement, but powerful in conveying that every investor can dramatically simplify his life and improve his returns by focusing on his portfolio's normalized earning power, rather than explicitly trying to generate high returns.

2) Dealing from strength. Buffett highlights Berkshire portfolio companies that pressed their advantage over competitors by making investments in new equipment. He notes, "Dealing from strength is one of Berkshire's enduring advantages." The source of strength is having dry powder when others don't, which requires patience and discipline. Buffett famously said, "Lethargy bordering on sloth is the cornerstone of our investment style." Similarly, there's a Munger quote that I love: "We don't mind long periods in which nothing happens...You look at [Buffett's] schedule sometimes and there's a haircut. Tuesday, haircut day." Instead of fretting about his portfolio, Buffett reveals that he spends ten hours a week playing bridge online - one way to combat boredom, which I've referred to in the past as the third emotion of investing. But of course the flipside of this is being aggressive when opportunities arise, and when competitors are unable or unwilling to act. 

Obviously, no-one sets out hoping to operate from a position of weakness, but prioritizing it as a strategic goal helps. As I've noted before, one of the mortal sins of investing is compounding earlier errors, and this typically happens when one is operating from a position of weakness and reacting to events in a haphazard fashion.

3) Business quality. For someone who is known as the doyen of value investing, Buffett makes surprisingly little mention of the prices paid for the businesses he purchased. Rather, he focuses on their quality. I'm not suggesting that Buffett ignores price; his discussion of insurance underwriting reveals, as always, a keen grasp of risk and reward, as does a note of caution on prices paid for bolt-on acquisitions. Nevertheless, his emphasis on quality, rather than cheapness, is telling. Despite his ability to be patient, Buffett is clearly not just waiting for cyclical lows. Unlike most investors who agonize endlessly over whether equities are cheap, Buffett continues to pour money into investments that he believes will pay off over the long run (Precision Castparts, Wells Fargo, Coca-Cola). 

4) Optimism. We're bombarded by soundbites from pundits (and truth be told, investors) who usually appear smarter for being negative. Buffett, on the other hand, comes across as unusually optimistic (a view shared by his friend, Bill Gates). Having a long-term horizon helps, but Buffett's success is supported by Dimson, Marsh and Staunton, who lauded the "Triumph of the Optimists".  

5) Come for the returns, stay for the philosophy. I'm guessing that most people start following Buffett and Munger because of the prospect of mimicking their investment success. I'm also willing to guess that most of those who stick around do so because they're attracted by the duo's integrity and life philosophy. In this year's letter, Buffett wrote, "There is no one more important to us than the shareholder of limited means who trusts us with a substantial portion of his savings." In a world of relentless asset-gathering masquerading as investing, Buffett's easy manner is why I, like many others, look forward to his letter year after year.