Monday, March 31, 2014
Monday, March 24, 2014
Cash - Sometimes King, Sometimes Pretender To The Throne
This is an addendum to my post trying to understand why value investors hate the Fed. In the previous post, I tried to understand why value investors seemed particularly disposed among the investing community to finding fault with the Fed's actions since 2009. I'm not sure any of the answers I received convinced me individually, but as a whole, they offered some interesting parts of the puzzle.
Jason Zweig (whose excellent edited version of The Intelligent Investor was one of the first things I read on value investing many years ago, right after Lowenstein's Buffett biography) said value investors objected to the Fed's actions "because low rates goad naive investors into ignoring fundamentals". That didn't quite answer my real question, which was why value investors were more disposed than other investors to feel that way about the Fed and fundamentals (you can be a growth investor who still cares about fundamentals, I hope!).
But I thought he raised the exact issue where many value investors and I seem to disagree:
1) Low nominal rates on safe assets do not signify low rates for all actors in the economy; in fact, they usually indicate a flight to safety. Low rates on Treasuries rarely "goad" naive investors into heading back into equities until long after the smart money has sounded the all-clear.(Quick digression: I actually agree that extended periods of low nominal rates on safe assets can cause "reaching for yield" behaviour which has pernicious outcomes. But the solution, in my view, is therefore to be more aggressive from a policy standpoint early on. It's the combination of low rates for an extended period of time and a growing complacency among investors that eventually leads to financial trouble. I look forward to reading the recent Brookings Institution piece on whether QE has made financial institutions riskier.)
2) Money and credit aren't the same thing, so it's a mistake when people equate low rates with easy money. Low rates on credit instruments show the price of credit for those instruments. The price of money is of course the inverse of the price level. So when asset and goods prices fall, the price of money is higher.
I think it's perfectly correct to think of cash as an asset class, and weigh its prospective risk/return against other assets (standard mean-variance stuff - for a more interesting view, see global macro investor Jim Leitner's chapter in The Invisible Hands, though unfortunately I can't find a web link). Actually, value investors are particularly good at thinking about cash as an asset class (see Baupost - willing to be in cash as 40-50% of assets; see also Fed-skeptic James Montier on the value of cash). So I find it doubly surprising that they don't appreciate the Fed's actions to maintain price levels on track, and thereby maintain the price of money.
Perhaps another answer is the (over?) emphasis value investors place on P/E ratios. Miles Kimball noted that low risk-free rates tend to make P/E ratios look high. The anchoring bias of supposedly "fair P/E ratios" can be detrimental. But again, I'm surprised that the value investors I've listed (who are incredibly sophisticated investors) are swayed by this. One of my initial guesses noted the overlap between value investing and conservative political beliefs, despite the Democratic leanings of its most famous exponent, Warren Buffett. I have to say I still find this a persuasive guess for the bias, so I hope that the likes of David Beckworth, Ramesh Ponnuru & Jim Pethokoukis will continue fighting the good fight.
I suppose that once you've decided that low rates are bad, and P/E ratios are high, it's only natural that you find further expansion of P/E multiples dangerous. Matt Yglesias responded that value investors were in favour of policies that depress P/E ratios, which sounds a bit snarky, but it's obviously true that people like to have high prospective returns on their assets. So, if you're a value investor who goes to cash more than other investors, you enjoy it when your cash has a high price compared to assets.
If I were summarizing how this feeds into a sound investing philosophy:
- An over-reliance on P/E ratios can lead you astray; it may be more helpful to think of investing as harvesting premia when the market's offer is too high.
- Good investors should be willing and able to think of cash as another asset class. Cash isn't always king, but it's nice to have it just before its coronation.
Jason Zweig (whose excellent edited version of The Intelligent Investor was one of the first things I read on value investing many years ago, right after Lowenstein's Buffett biography) said value investors objected to the Fed's actions "because low rates goad naive investors into ignoring fundamentals". That didn't quite answer my real question, which was why value investors were more disposed than other investors to feel that way about the Fed and fundamentals (you can be a growth investor who still cares about fundamentals, I hope!).
But I thought he raised the exact issue where many value investors and I seem to disagree:
1) Low nominal rates on safe assets do not signify low rates for all actors in the economy; in fact, they usually indicate a flight to safety. Low rates on Treasuries rarely "goad" naive investors into heading back into equities until long after the smart money has sounded the all-clear.(Quick digression: I actually agree that extended periods of low nominal rates on safe assets can cause "reaching for yield" behaviour which has pernicious outcomes. But the solution, in my view, is therefore to be more aggressive from a policy standpoint early on. It's the combination of low rates for an extended period of time and a growing complacency among investors that eventually leads to financial trouble. I look forward to reading the recent Brookings Institution piece on whether QE has made financial institutions riskier.)
2) Money and credit aren't the same thing, so it's a mistake when people equate low rates with easy money. Low rates on credit instruments show the price of credit for those instruments. The price of money is of course the inverse of the price level. So when asset and goods prices fall, the price of money is higher.
I think it's perfectly correct to think of cash as an asset class, and weigh its prospective risk/return against other assets (standard mean-variance stuff - for a more interesting view, see global macro investor Jim Leitner's chapter in The Invisible Hands, though unfortunately I can't find a web link). Actually, value investors are particularly good at thinking about cash as an asset class (see Baupost - willing to be in cash as 40-50% of assets; see also Fed-skeptic James Montier on the value of cash). So I find it doubly surprising that they don't appreciate the Fed's actions to maintain price levels on track, and thereby maintain the price of money.
Perhaps another answer is the (over?) emphasis value investors place on P/E ratios. Miles Kimball noted that low risk-free rates tend to make P/E ratios look high. The anchoring bias of supposedly "fair P/E ratios" can be detrimental. But again, I'm surprised that the value investors I've listed (who are incredibly sophisticated investors) are swayed by this. One of my initial guesses noted the overlap between value investing and conservative political beliefs, despite the Democratic leanings of its most famous exponent, Warren Buffett. I have to say I still find this a persuasive guess for the bias, so I hope that the likes of David Beckworth, Ramesh Ponnuru & Jim Pethokoukis will continue fighting the good fight.
I suppose that once you've decided that low rates are bad, and P/E ratios are high, it's only natural that you find further expansion of P/E multiples dangerous. Matt Yglesias responded that value investors were in favour of policies that depress P/E ratios, which sounds a bit snarky, but it's obviously true that people like to have high prospective returns on their assets. So, if you're a value investor who goes to cash more than other investors, you enjoy it when your cash has a high price compared to assets.
If I were summarizing how this feeds into a sound investing philosophy:
- An over-reliance on P/E ratios can lead you astray; it may be more helpful to think of investing as harvesting premia when the market's offer is too high.
- Good investors should be willing and able to think of cash as another asset class. Cash isn't always king, but it's nice to have it just before its coronation.
Tuesday, March 18, 2014
Financial Services and Niebuhr's Serenity Prayer
An essay I wrote was featured in Financial News. Enjoy.
Draghi is guiding interest rates, Yellen is tapering the quantity of reserves (Guest Post by Vaidas Urba)
Readers of this blog will notice that while I write about monetary policy quite often, I usually approach this from an investor's point of view, given its importance for all asset prices in the economy. That said, I rarely delve into the technical specifics of monetary policy, which are often beyond my level of understanding. One frequent commenter in the blogosphere with no such technical limitations is Vaidas Urba, who will be familiar to many of you from his comments on The Money Illusion and Twitter, where you can follow him @VaidasUrba. Vaidas has written a (relatively non-wonkish!) guest post on the nature of monetary policy. I criticised the ECB's belief in forward guidance in a recent post, and Vaidas takes up the issue in this post. So with that, here's Vaidas:
At the zero lower bound, interest rate coordinate space has a disadvantage - the current interest rate does not help us in distinguishing between different central bank reaction functions, and we absolutely need forward guidance for this purpose. On the other hand, if we use the quantity of reserves, we get a simple albeit simplistic form of forward guidance already built in. The Fed has used this property of quantity of reserves to a great effect. With QE Infinity, every passing month had brought us stronger and stronger forward guidance. This powerful effect has disappeared when Bernanke hinted at tapering last year, and after a period of market turbulence the Fed started the process of divorcing the credibility of reaction function from QE.
Interestingly, the ECB is trying to get away with not using QE to bolster the forward guidance. Instead of a blunt message delivered by the rising line in the quantity of reserves chart, we are getting subtle signals about the ECB reaction function every month. "Firmly reiterate the forward guidance“ has replaced "confirmed its forward guidance". A bit later "a presence of slack" has joined in. Now we are getting "euro exchange rate increasingly relevant in our assessment of price stability" and "real rates are set to fall over the projection horizon". Unfortunately, marginal market players are still looking at that old-fashioned quantity of reserves chart.
For the sake of science, I hope the ECB will succeed in avoiding QE, as in this case we would get a clean test of Woodfordian theory. For the sake of the European economy, I hope the ECB will start QE soon. Let's use the QE language everybody understands, or the ECB reaction function might get lost in translation.
Draghi is
guiding interest rates, Yellen is tapering the quantity of reserves
What
is monetary policy? Is it concerned with setting interest rates, or is
concerned with setting the quantity of reserves? This question makes no sense.
We might as well be asking "Is it colder in Celsius or in Fahrenheit?”. Monetary
policy is all about central bank reaction functions. We may describe a central
bank reaction function in interest rate coordinate space, but we could express
the same reaction function in terms of quantity of reserves - both ways are
equivalent mathematically.
At the zero lower bound, interest rate coordinate space has a disadvantage - the current interest rate does not help us in distinguishing between different central bank reaction functions, and we absolutely need forward guidance for this purpose. On the other hand, if we use the quantity of reserves, we get a simple albeit simplistic form of forward guidance already built in. The Fed has used this property of quantity of reserves to a great effect. With QE Infinity, every passing month had brought us stronger and stronger forward guidance. This powerful effect has disappeared when Bernanke hinted at tapering last year, and after a period of market turbulence the Fed started the process of divorcing the credibility of reaction function from QE.
Interestingly, the ECB is trying to get away with not using QE to bolster the forward guidance. Instead of a blunt message delivered by the rising line in the quantity of reserves chart, we are getting subtle signals about the ECB reaction function every month. "Firmly reiterate the forward guidance“ has replaced "confirmed its forward guidance". A bit later "a presence of slack" has joined in. Now we are getting "euro exchange rate increasingly relevant in our assessment of price stability" and "real rates are set to fall over the projection horizon". Unfortunately, marginal market players are still looking at that old-fashioned quantity of reserves chart.
For the sake of science, I hope the ECB will succeed in avoiding QE, as in this case we would get a clean test of Woodfordian theory. For the sake of the European economy, I hope the ECB will start QE soon. Let's use the QE language everybody understands, or the ECB reaction function might get lost in translation.
Sunday, March 16, 2014
Everybody Knows That
The ability to be contrarian effectively is one of the most important traits an investor or analyst needs. You'll notice how I phrased that: being contrarian effectively means going against the grain of consensus opinion, but understanding that you may be either wrong or early, and managing that risk accordingly. In my first job, I'd sometimes criticize prevailing views I disagreed with, and my boss would retort, "Soros used to say consensus is only wrong at inflection points." That was both a reminder of the "wisdom of crowds" and that when the crowd failed, it could "stay irrational longer than [we] could stay solvent", just to fill this sentence with lots of lovely cliches.
One of the reasons I blog is to keep myself intellectually honest. It's a tough task, not because I'm unusually dishonest, but because as Richard Feynman said, "The first principle is that you must not fool yourself, and you are the easiest person to fool." So, writing thoughts down in a public forum is a good way to keep track of what I thought at a particular point in time. It's also a great way to elicit comments from others, and as you probably know, I worry constantly that I've tricked myself into thinking that I'm open-minded when I'm not (probably better to be biased and realistic about it).
So, with that preamble, welcome to the first edition of "Everybody Knows That", a list of commonly held opinions. The title of this post is a long-running family joke. Often, one person in the family will say something they think is unusual or little-known, and one of my sisters invariably responds, "Yeah, everybody knows that." But what does Everybody Know about the global economy and financial markets? I'll loosely define these as things that 2/3 or more of educated market participants, commentators or observers believe. I neither endorse nor deny these assertions (well, I do, but that's not the point of writing them down). The point is simply to get a feel for "consensus", and either shoot against that consensus in my writing or investing, or simply to observe when consensus has shifted. For example, I'd guess that as late as Dec 2012, Everybody Knew That emerging markets were the best place to be. Today, that of course looks very different. Equally, there are very smart people arguing against some of these views (e.g. on labour slack, see Evan Soltas). Again, not the point - I'm just trying to identify Things Everybody Knows. So here we go:
1) The Fed has been keeping interest rates low, but global interest rates are headed up.
2) As a result of (1), you'll lose money on bonds.
3) Emerging markets are slowing down, especially China.
4) China is rebalancing its economy from one that is driven by investment and exports to one driven by domestic consumption.
5) The Chinese shadow banking system presents a serious threat to the stability of the Chinese (and world) economy.
6) The slowdown of emerging markets, particularly China, will hurt the demand for commodities. Investing in commodities will be difficult, as will investing in commodity-driven economies, even developed ones like Australia and Canada.
7) Debt ratios are too high for advanced economies and its households.
8) Europe will probably go through a long period of slow growth (more than 3-5 years) as it goes through a deleveraging process.
9) Most of the advanced economies will grow slowly too, as they also deleverage, but faster than Europe.
10) There's a lot of slack in the US economy.
Feel free to add more in the comments section!
One of the reasons I blog is to keep myself intellectually honest. It's a tough task, not because I'm unusually dishonest, but because as Richard Feynman said, "The first principle is that you must not fool yourself, and you are the easiest person to fool." So, writing thoughts down in a public forum is a good way to keep track of what I thought at a particular point in time. It's also a great way to elicit comments from others, and as you probably know, I worry constantly that I've tricked myself into thinking that I'm open-minded when I'm not (probably better to be biased and realistic about it).
So, with that preamble, welcome to the first edition of "Everybody Knows That", a list of commonly held opinions. The title of this post is a long-running family joke. Often, one person in the family will say something they think is unusual or little-known, and one of my sisters invariably responds, "Yeah, everybody knows that." But what does Everybody Know about the global economy and financial markets? I'll loosely define these as things that 2/3 or more of educated market participants, commentators or observers believe. I neither endorse nor deny these assertions (well, I do, but that's not the point of writing them down). The point is simply to get a feel for "consensus", and either shoot against that consensus in my writing or investing, or simply to observe when consensus has shifted. For example, I'd guess that as late as Dec 2012, Everybody Knew That emerging markets were the best place to be. Today, that of course looks very different. Equally, there are very smart people arguing against some of these views (e.g. on labour slack, see Evan Soltas). Again, not the point - I'm just trying to identify Things Everybody Knows. So here we go:
1) The Fed has been keeping interest rates low, but global interest rates are headed up.
2) As a result of (1), you'll lose money on bonds.
3) Emerging markets are slowing down, especially China.
4) China is rebalancing its economy from one that is driven by investment and exports to one driven by domestic consumption.
5) The Chinese shadow banking system presents a serious threat to the stability of the Chinese (and world) economy.
6) The slowdown of emerging markets, particularly China, will hurt the demand for commodities. Investing in commodities will be difficult, as will investing in commodity-driven economies, even developed ones like Australia and Canada.
7) Debt ratios are too high for advanced economies and its households.
8) Europe will probably go through a long period of slow growth (more than 3-5 years) as it goes through a deleveraging process.
9) Most of the advanced economies will grow slowly too, as they also deleverage, but faster than Europe.
10) There's a lot of slack in the US economy.
Feel free to add more in the comments section!
Friday, March 14, 2014
Forward Guidance, Backward Progress: Taking Aim at Draghi
A few days ago, I tweeted: "When forward guidance with a reputation for credibility tackles an economy with a reputation for low NGDP growth, it's the reputation of the economy that remains intact." This was a poor and much less funny paraphrasing of Buffett's quip that "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."
Mario Draghi's latest speech gives me another chance to point out what are some of the weaknesses of forward guidance. First of all, let me give Draghi credit for acknowledging "too low inflation" is currently more relevant than inflation being too high. Second, the acknowledgement of the dearth of capital for SMEs is positive because thankfully, he isn't saying "but rates are low in the Eurozone!". I also think the review of the banking sector is both necessary and welcome (if fraught with political issues).
Nevertheless, I simply couldn't resist disagreeing when he came to the section on monetary policy. Draghi said:
- The Governing Council is committed to keeping interest rates at present or lower levels for an extended period of times, which will help the deleveraging process through balance sheet channels.
- Forward guidance creates a de facto loosening of policy stance, leading to falling real interest rates. Falling real interest rates will support the demand for credit by encouraging higher business investment.
- A declining real interest rate spread between the Euro area and the rest of the world will, all else equal, put downward pressure on the exchange rate. Given the current levels of inflation, the level of the exchange rate is "becoming increasingly relevant in our assessment of price stability."
- Risks of deflation appear quite limited, but the longer inflation remains low, the higher the probability of such risks emerging. That's why the ECB has been preparing additional non-standard monetary policy measures to guard against such an event and why it stands ready to take further decisive action when needed. Any material risk of inflation expectations becoming unanchored will be countered with additional policy measures.
Some of this sounds reasonable enough. But let me make a few points:
1) Forward guidance is a weak tool:
- No serious person should think that investors' views are dominated by real interest rates (I mean those pursuing investment in the economic, not financial, sense). Talk to any businessperson and ask if they are thinking of expanding their operations. I can guarantee that their decision will be based on two things - growth and profitability. Businesses in the Eurozone aren't investing because their expectations of future economic growth are low. Committing to low future rates is much less powerful than committing to higher rates of future NGDP growth. I used to think that this "textbook" view of the interest rate channel was just the the way monetary policy was taught to simplify it for beginners. But it appears that policy makers genuinely believe that view, and I just think it's wrong.
- Interest rates are currently low for safe assets in the Eurozone. This is not translating to healthy credit to SMEs. Unless the banking sector clean-up happens faster than anticipated (and more challenging, in an environment of low economic growth), why should the promise of low rates encourage investors that they will enjoy healthy credit in the future?
- Credibility is a nebulous notion. I think the ECB has credibility to (a) not let inflation rise above 2% and (b) not let the economy fall into complete and utter chaos. I do not think they have credibility to (c) improve economic growth. I think the Fed was similarly credible in ways (a) and (b) but only gained (c) when they announced the unemployment target. But that's obviously up for argument.
2) If inflation expectations become unanchored, the ECB will have already failed. I suspect that if inflation expectations become unanchored, it won't happen in a vacuum. It will probably happen with a decline in asset prices, the Euro and possibly outright panic. This volatility is almost certain to deter investors, and harm the real economy. After all, you'd naturally demand a higher real interest rate for a riskier investment. So this could well end up offsetting any decline in real interest rates. Why not act in a resolute fashion now and just head the whole thing off?
I know, I know. Even if Draghi agreed with the above, the politics is too hard. But the only way the political balance will ever tilt that way is if the drumbeat of public opinion allows the audacious to outvote the timid. So I persist. As I said above, the review of the banking sector is both necessary and welcome. But what the Eurozone needs first and foremost is NGDP growth. Without it, promises to keep future interest rates low are a mere sideshow. As far as I'm concerned, relying on forward guidance is backward progress.
Mario Draghi's latest speech gives me another chance to point out what are some of the weaknesses of forward guidance. First of all, let me give Draghi credit for acknowledging "too low inflation" is currently more relevant than inflation being too high. Second, the acknowledgement of the dearth of capital for SMEs is positive because thankfully, he isn't saying "but rates are low in the Eurozone!". I also think the review of the banking sector is both necessary and welcome (if fraught with political issues).
Nevertheless, I simply couldn't resist disagreeing when he came to the section on monetary policy. Draghi said:
- The Governing Council is committed to keeping interest rates at present or lower levels for an extended period of times, which will help the deleveraging process through balance sheet channels.
- Forward guidance creates a de facto loosening of policy stance, leading to falling real interest rates. Falling real interest rates will support the demand for credit by encouraging higher business investment.
- A declining real interest rate spread between the Euro area and the rest of the world will, all else equal, put downward pressure on the exchange rate. Given the current levels of inflation, the level of the exchange rate is "becoming increasingly relevant in our assessment of price stability."
- Risks of deflation appear quite limited, but the longer inflation remains low, the higher the probability of such risks emerging. That's why the ECB has been preparing additional non-standard monetary policy measures to guard against such an event and why it stands ready to take further decisive action when needed. Any material risk of inflation expectations becoming unanchored will be countered with additional policy measures.
Some of this sounds reasonable enough. But let me make a few points:
1) Forward guidance is a weak tool:
- No serious person should think that investors' views are dominated by real interest rates (I mean those pursuing investment in the economic, not financial, sense). Talk to any businessperson and ask if they are thinking of expanding their operations. I can guarantee that their decision will be based on two things - growth and profitability. Businesses in the Eurozone aren't investing because their expectations of future economic growth are low. Committing to low future rates is much less powerful than committing to higher rates of future NGDP growth. I used to think that this "textbook" view of the interest rate channel was just the the way monetary policy was taught to simplify it for beginners. But it appears that policy makers genuinely believe that view, and I just think it's wrong.
- Interest rates are currently low for safe assets in the Eurozone. This is not translating to healthy credit to SMEs. Unless the banking sector clean-up happens faster than anticipated (and more challenging, in an environment of low economic growth), why should the promise of low rates encourage investors that they will enjoy healthy credit in the future?
- Credibility is a nebulous notion. I think the ECB has credibility to (a) not let inflation rise above 2% and (b) not let the economy fall into complete and utter chaos. I do not think they have credibility to (c) improve economic growth. I think the Fed was similarly credible in ways (a) and (b) but only gained (c) when they announced the unemployment target. But that's obviously up for argument.
2) If inflation expectations become unanchored, the ECB will have already failed. I suspect that if inflation expectations become unanchored, it won't happen in a vacuum. It will probably happen with a decline in asset prices, the Euro and possibly outright panic. This volatility is almost certain to deter investors, and harm the real economy. After all, you'd naturally demand a higher real interest rate for a riskier investment. So this could well end up offsetting any decline in real interest rates. Why not act in a resolute fashion now and just head the whole thing off?
I know, I know. Even if Draghi agreed with the above, the politics is too hard. But the only way the political balance will ever tilt that way is if the drumbeat of public opinion allows the audacious to outvote the timid. So I persist. As I said above, the review of the banking sector is both necessary and welcome. But what the Eurozone needs first and foremost is NGDP growth. Without it, promises to keep future interest rates low are a mere sideshow. As far as I'm concerned, relying on forward guidance is backward progress.
Thursday, March 13, 2014
Why Do Value Investors Hate the Fed?
Seth Klarman is undoubtedly one of world's top money managers. Klarman is one of the most successful exponents of the philosophy known as value investing, fathered by Benjamin Graham and popularized by Warren Buffett. His fund, The Baupost Group, has grown into a $30b beast, despite generally eschewing leverage, and has racked up mid-teen returns over its lifetime, which is a truly impressive feat. Klarman's book, Margin of Safety, sells for an absurdly high price on Amazon, because it's out of print, and his insights are understandably sought after (you can, however, find free copies on the Internet - that's arbitrage for you!).
But even the rich and brilliant should be challenged. In late 2010, Klarman and a host of other investors, economists and commentators penned an open letter to Ben Bernanke, asking him to reconsider and refrain from further monetary easing. In his latest investor letter, Klarman is full of disdain for the Fed. Here are some choice excerpts:
- "Someday, rising stock and bond markets will no longer be government policy. Someday, QE will end and money won't be free. Someday, corporate failure will be permitted."
- "As experienced traders who watch the markets and the Fed with considerable skepticism (and occasional amusement), we can assure you that Fed's itinerary is bound to be exceptional, each stop more exciting than before. Weather can suddenly turn foul, the navigation faulty, and the deckhands hard to understand. In short, the Fed captain and crew are proficient in theory but lack real world experience. This is an adventure into unexplored terrain, to parts unknown; the Fed has no map, because no one has ever been here before. Most such journeys end badly."
- Comparing the US economy to The Truman Show, where the lead character lives in a totally fabricated, made-for-TV environment: "Every Truman under Bernanke's dome knows the environment is phony. But the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no-one wants it to end, and no-one want to exit the dome until they're sure everyone else won't stay on forever."
All investors are entitled to their own views of where the economy is headed. As I discussed in a previous post, that call can sometimes make or break an investment. It's worth pointing out that Klarman is no bull - he is, after all, returning $4b in capital to his investors due to concerns about market valuations. But he's not alone among value investors in chiding the Fed. Fellow successful value disciple David Einhorn garnered a lot of attention for comparing Fed policy to a steady diet of jelly donuts. Value junkie and financial writer Jim Grant continually bashes Fed policy, and even gets quoted by Klarman in the letter: "the Fed can change how things look, it cannot change what things are."
Please don't misunderstand me here - I'm neither wildly bullish on the prospects for equities in the near-term, nor a devout supporter of all Fed policy. I don't even mean to disparage the value philosophy. Applied correctly, it is a powerful foil to human tendencies to over-optimism and faddishness. (However, I'm critical of dogmatic value investing, which Aswath Damodaran demolishes quite effectively here and here.) And ironically, the decision to return investor capital could look very bright in retrospect for exactly the wrong reason, i.e. a concerted tightening by the Fed and the PBoC while the ECB dithers. But part of the challenge of investing, or analyzing its success, is trying to be right for the right reasons. It would be equally disappointing if value investors resorted to what I've called "the Zhou Enlai theory of monetary policy." It's often reported that Zhou, when asked in 1972 what he thought of the French Revolution, responded that it was too early to tell. Ignoring the fact that this story is almost certainly apocryphal, it's disingenuous to say "we don't know yet what the results of Fed policy have been" unless you set up an explicit counterfactual, or provide a prediction of what you think will happen and in what timeframe. At some point, no doubt, the economy will turn down and financial crisis will ensue... but sorry, you don't get any prizes for stating the obvious.
My question is, why do value investors hate the Fed? One answer that I'll reject out of hand is that Klarman and his friends are rich hedge fund types who are indifferent to the suffering of the unemployed and luckless. Klarman, for example, is renowned for his philanthropy,as is Elliott Associates' Paul Singer. I believe Klarman, Singer, Chanos et al when they say they are genuinely concerned that Fed policy will harm the economy. Perhaps the question I mean to ask is "why are value investors more predisposed to look unfavourably upon Fed action?" Here are some possible answers:
1) The correlation is not between value investors and Fed-haters, but between conservatives and Fed-haters. Despite the best efforts of David Beckworth, Ramesh Ponnuru & Jim Pethokoukis (among others) , conservatives still seem more likely to view Fed policy as pernicious. It just so happens that many value investors are conservatives (although we should then ask why...) - Jonathan Haidt and Miles Kimball would probably suggest that value investors/conservatives have strong leanings towards karmic retribution.
2) It's a subconscious response to stocks becoming fairly valued. Buffett once said he was like "an oversexed guy in a harem" when stocks became cheap in the 1970s. I assume that means that when equities are fairly valued, he feels like, well, every guy of average libido. Perhaps this is a variation of Benjamin Cole's criticism that Richard Fisher gets upset when a strong economy raises rare book prices.
3) Value investors are broadly mean reversionists, and are trained to look for cycles & bubbles (unlike growth investors, who are more interested in secular stories). The Fed is an obvious contributor to the business cycle, and is therefore particularly odious to value investors. The existence of investor favourites like Tesla and Netflix is merely anecdotal, but reinforces value guys' belief that the cycle is turning.
Frankly, none of these seem like particularly strong theories to me. I'd appreciate comments with other theories - please, no comments saying "if you're so smart, why aren't you rich?". But let me end by saying that whether they like it or not, successful value investors owe the Fed. Those who have made their names buying at "cheap valuations" have profited from the fact that the Fed didn't pull a 1929 or a Japan. I can only assume Japanese value investing was a fool's errand for 20 years. And some of those who made their names shorting overvalued securities from 2006-2009 (whether it was the homebuilders, the bond insurers or banks) profited from the Fed's failure to stabilize nominal GDP. Not all of them, mind you - lots of these securities were over-valued given the industry conditions. But bearish bets were made to look much better by the economy's unimpeded march downwards. Sadly, the investors just don't seem to know it.
But even the rich and brilliant should be challenged. In late 2010, Klarman and a host of other investors, economists and commentators penned an open letter to Ben Bernanke, asking him to reconsider and refrain from further monetary easing. In his latest investor letter, Klarman is full of disdain for the Fed. Here are some choice excerpts:
- "Someday, rising stock and bond markets will no longer be government policy. Someday, QE will end and money won't be free. Someday, corporate failure will be permitted."
- "As experienced traders who watch the markets and the Fed with considerable skepticism (and occasional amusement), we can assure you that Fed's itinerary is bound to be exceptional, each stop more exciting than before. Weather can suddenly turn foul, the navigation faulty, and the deckhands hard to understand. In short, the Fed captain and crew are proficient in theory but lack real world experience. This is an adventure into unexplored terrain, to parts unknown; the Fed has no map, because no one has ever been here before. Most such journeys end badly."
- Comparing the US economy to The Truman Show, where the lead character lives in a totally fabricated, made-for-TV environment: "Every Truman under Bernanke's dome knows the environment is phony. But the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no-one wants it to end, and no-one want to exit the dome until they're sure everyone else won't stay on forever."
All investors are entitled to their own views of where the economy is headed. As I discussed in a previous post, that call can sometimes make or break an investment. It's worth pointing out that Klarman is no bull - he is, after all, returning $4b in capital to his investors due to concerns about market valuations. But he's not alone among value investors in chiding the Fed. Fellow successful value disciple David Einhorn garnered a lot of attention for comparing Fed policy to a steady diet of jelly donuts. Value junkie and financial writer Jim Grant continually bashes Fed policy, and even gets quoted by Klarman in the letter: "the Fed can change how things look, it cannot change what things are."
Please don't misunderstand me here - I'm neither wildly bullish on the prospects for equities in the near-term, nor a devout supporter of all Fed policy. I don't even mean to disparage the value philosophy. Applied correctly, it is a powerful foil to human tendencies to over-optimism and faddishness. (However, I'm critical of dogmatic value investing, which Aswath Damodaran demolishes quite effectively here and here.) And ironically, the decision to return investor capital could look very bright in retrospect for exactly the wrong reason, i.e. a concerted tightening by the Fed and the PBoC while the ECB dithers. But part of the challenge of investing, or analyzing its success, is trying to be right for the right reasons. It would be equally disappointing if value investors resorted to what I've called "the Zhou Enlai theory of monetary policy." It's often reported that Zhou, when asked in 1972 what he thought of the French Revolution, responded that it was too early to tell. Ignoring the fact that this story is almost certainly apocryphal, it's disingenuous to say "we don't know yet what the results of Fed policy have been" unless you set up an explicit counterfactual, or provide a prediction of what you think will happen and in what timeframe. At some point, no doubt, the economy will turn down and financial crisis will ensue... but sorry, you don't get any prizes for stating the obvious.
My question is, why do value investors hate the Fed? One answer that I'll reject out of hand is that Klarman and his friends are rich hedge fund types who are indifferent to the suffering of the unemployed and luckless. Klarman, for example, is renowned for his philanthropy,as is Elliott Associates' Paul Singer. I believe Klarman, Singer, Chanos et al when they say they are genuinely concerned that Fed policy will harm the economy. Perhaps the question I mean to ask is "why are value investors more predisposed to look unfavourably upon Fed action?" Here are some possible answers:
1) The correlation is not between value investors and Fed-haters, but between conservatives and Fed-haters. Despite the best efforts of David Beckworth, Ramesh Ponnuru & Jim Pethokoukis (among others) , conservatives still seem more likely to view Fed policy as pernicious. It just so happens that many value investors are conservatives (although we should then ask why...) - Jonathan Haidt and Miles Kimball would probably suggest that value investors/conservatives have strong leanings towards karmic retribution.
2) It's a subconscious response to stocks becoming fairly valued. Buffett once said he was like "an oversexed guy in a harem" when stocks became cheap in the 1970s. I assume that means that when equities are fairly valued, he feels like, well, every guy of average libido. Perhaps this is a variation of Benjamin Cole's criticism that Richard Fisher gets upset when a strong economy raises rare book prices.
3) Value investors are broadly mean reversionists, and are trained to look for cycles & bubbles (unlike growth investors, who are more interested in secular stories). The Fed is an obvious contributor to the business cycle, and is therefore particularly odious to value investors. The existence of investor favourites like Tesla and Netflix is merely anecdotal, but reinforces value guys' belief that the cycle is turning.
Frankly, none of these seem like particularly strong theories to me. I'd appreciate comments with other theories - please, no comments saying "if you're so smart, why aren't you rich?". But let me end by saying that whether they like it or not, successful value investors owe the Fed. Those who have made their names buying at "cheap valuations" have profited from the fact that the Fed didn't pull a 1929 or a Japan. I can only assume Japanese value investing was a fool's errand for 20 years. And some of those who made their names shorting overvalued securities from 2006-2009 (whether it was the homebuilders, the bond insurers or banks) profited from the Fed's failure to stabilize nominal GDP. Not all of them, mind you - lots of these securities were over-valued given the industry conditions. But bearish bets were made to look much better by the economy's unimpeded march downwards. Sadly, the investors just don't seem to know it.
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