A Dash of Insight

A Lesson from Dad

The "Dad" I am talking about is Bill Miller.  No, not the one you already know, although we admire the Legg Mason fund manager.  I lost my Bill Miller last year, but the lessons are still there.  Some of them are quite relevant for investors.  (We did a little father/son bonding at Chez Dash this weekend.  Missions accomplished with only one circuit breaker kicked and a couple of buckets of water.  Dad was smiling.)

A Famous Miller Family Story

Here is a signature moment from the young Bill Miller.  I am quoting the key elements, but the tale is told in more detail in this article, Respect versus Arrogance.

The passing of my father, William H. Miller, last week, and some hours of thought on the road have sparked some introspection.  What we try to do at "A Dash" bears his mark.  In a way, that is strange.  Dad went to war instead of to college.  Growing up in the Detroit area, he understood engines.  The principles are simple:  Fuel, Oxygen, Ignition.  It is amazing how people can get this wrong.

As a sailor on his first ship he found himself in an interesting situation.  The engines had been overhauled, but would not start.  Experienced machinists could not figure out the problem.  Officers were hovering and complaining.  The young sailor asked if he could try something.  There was a lot of skepticism, but he was given his chance.  He knew that the fuel and air were OK, so he removed the spark plug and tapped it on the deck, narrowing the gap.  When the plug was replaced, the engines started!

If you could see a picture of the young sailor, cap tilted at a jaunty angle, you might guess the mixed reaction.  The officers were delighted at a problem solved.  Those in charge of the engines were less enthusiastic.

This story was repeated many times over in his Navy career.  While he never got all of the promotions he deserved, he was a fixture on the boats deployed by his Captains.

No Substitute for Knowledge

A crucial lesson from this is that there is no substitute for actual knowledge about a subject.  It does not matter what your rank is.  It does not matter how many years you have served.  It does not matter how many other people call you "Sir."

If you do not have the knowledge, you cannot make the engine start.

The Investment World

There is an interesting difference between social science and engines.  When a theory about an engine is incorrect, the results show up right away.  When a theory about social science is incorrect, the idea may persist for many months -- even years.

This makes it much more difficult for the consumer of information. How do you know when the engine is not going to start?

Here are some red flags.

Misuse of the word "rigor."  A long causal chain with a lot of unsupported assumptions may seem powerful, but it does not meet the definition of rigorous.  A strong argument begins with an assumption that everyone would share, and then provides evidence at each point.  The longer the chain, the more evidence that is needed.  Whenever someone makes a big argument about "rigor", make sure that he has some credentials for each step in the chain.  Big hint:  Rigor usually means peer review.  Those with thin skins about criticism of their work are usually not rigorous.

Selection Bias.  This happens when one starts with a pre-conceived notion of the world and distorts evidence to fit the conclusion.  It is a characteristic of many of the leading investment blogs.  Ironically, many of the same bloggers talk frequently about behavioral economics and the dangers.

The "Slick" Factor.  Many of the top-ranking pundits are there because -- well -- because they are top ranking pundits.  They are cited as "friend/buddy/pals" of someone, or called "doctor" or "professor" to amplify credentials.  Most of them are good with sound bites on TV.  None of them could actually start the engine.  Most of these guys have never created a quantitative model, and would have no idea how to begin.  They do not know SPSS from American Idol.  Their charts come from others -- those with a world view they want to sell.  Many become famous by making a prediction that works--eventually.  There is no real accounting of the investment impacts.

The "Big Money" Managers. Statements from the "big-time" fund managers carry a special warning.  Does it really need to be stated that these people always have an agenda?  If a manager has a fiduciary responsibility to clients and a fund, and then gets a spot on TV, what do you expect him to say?  It would be irresponsible and deceptive to talk against his own book.

Conclusion:  Strong Voices are Leading You Astray

Here is Bill Miller's lesson, some great principles applied to investing.

• Don't take some long-winded analysis to be "rigorous."  Check whether the author has the relevant expertise -- research methods, economics, government, etc.
• Check your sources.  It is pretty easy.  If your favorite source dishes up a constant stream of one-sided commentary, you should already know the answer.  You can enjoy reading your source for entertainment, but not for investing.
• Look beyond the "talkers" and check the actual predictions.
• Do not conclude that someone in a uniform with braids really knows how to start the engine.

And finally,  realize that everyone is an expert on something.  Learn to listen instead of pretending that you already have all of the answers.  Be willing to challenge, but do not be arrogant.

Thanks, Dad.

Warren Buffett's Strange Bet

Almost anything Warren Buffett does attracts attention.  A bet for a million dollars certainly qualifies!

Background

For some time, Warren Buffett has expressed skepticism about hedge fund performance beating the broad market averages.  He has frequently offered to bet a million dollars that a basket of ten hedge funds would not beat the market.

Protégé Partners LLC has taken up the challenge.  Carol Loomis, a journalist close to Buffett, broke the story today.  It will take ten years to setttle the bet, which involves each side putting up $320,000 to buy zero-coupon treasuries.  The stake, held by a firm specializing in such long-term bets (who knew?!), will be worth a million dollars in ten years.

Mr. Buffett's Unusual Position

Warren Buffett, about whom we have written fondly and frequently, rejects the efficient market hypothesis.  We wrote about his opinions and included some typically colorful quotations in this piece from two years ago.  He famously notes that he would be selling pencils on a street corner if markets were efficient.

In fact, all of us in the investment management business expect to beat the market averages by  a wide margin.  If not, how could we justify charging a fee?

Our Conclusion

Surely Mr. Buffett does not believe that he is the only manager who can beat the market.  He must be doing one of two things.

First, he could be shooting at a very narrow window.  He might agree that others can generate marginal advantages, but not enough to overcome the fees charged by hedge funds.

Second, he could just be generating some publicity and money for some good charities.  After all, he is giving nearly all of his money away anyhow, so why not stimulate more charitable interest.  It is a good way to use his high profile for the greater good.

And Protégé?  We wish them well. We would take their side of the bet.  In fact, we would make the bet ourselves, but our advertising budget is not big enough!

Government Conspiracies and Your Money

At "A Dash" we are amazed almost daily by the haughty and high-handed disrespect from Wall Street when it comes to the everyday workings of government.  So many powerful voices are so confident, and simultaneously so wrong.  This is typical when an expert switches subjects from something he really knows about-- stocks, trading, technical analysis, etc.-- to something he knows nothing about.

CNBC stimulates this with their "guest hosts" who are encouraged to offer an opinion on whatever topic comes up that hour.  Of course, some of their journalists are already participating in that way.  Looking to the frequently-cited wise men, Jonathan Berr runs down a short list, but there are many more good candidates.

When we see the errors, it is a "kid in a candy store" feeling.  Start with a bunch of traders, fund managers, and lawyers.  None has ever developed a quantitative model, and many cannot construct or interpret simple tables or regressions with statistical controls.  They have not taken (or do not remember) the beginning classes in government, economics, statistics, or research methods.

These pseudo-experts cite actual data, developed with great care by the strongest experts, as "a work of fiction."  As if they knew the difference!  Why?  Two reasons.

First, they do not like the result they see.  It does not agree with their own daily experience.  They confuse their own compartmentalized view of the world with reality.  It is also a message they can sell to their audience, often a niche group who share their world view.

Second, diminishing the real experts increases the influence of the pretenders.  If these powerful voices can convince most to ignore data, then anecdotal evidence rules.  It is an alternate data universe.

And the pseudo-expert is also the master of the anecdote.

The most prominent media voices support them.  Why?  It is a good story.   There are very few who choose to educate readers rather than to play to their existing biases.  It is a good business model.  Readers can understand anecdotes, but not statistical methods.

There is a symbiotic relationship between media and the pseudo-expert community.

Conspiracy Theory

Taken to the extreme, the pseudo-expert actually suggests that "government" is acting in a conspiratorial fashion.  It is pretty easy to recognize such superficial analysis.  It is the work of people who have seen too many movies and read too few books.

The biggest red flag?  Look for those who discuss the U.S. "government" as if it were a  unitary actor.  This is seen only in a ruthless dictatorship with a small inner circle.  Those who conclude, for example, that the President is "cooking the books" on inflation or employment data make this mistake.  They do not understand that the actual work is being done by a non-partisan senior executive service.  (Those interested in how government decisions are actually made should consult our summary article.)

A Failed Conspiracy

Actually, conspiratorial moves are rare and for good reason.  Even closely held secrets, like the original Watergate plan, have a way of leaking out.  The recent suppression of the global warming report provides a nice example.  Menzie Chinn at Econbrowser, one of our featured sites, discusses the report that the Bush Administration thought was too dangerous to release, now available after four years.

This Washington Post article shows what happens when the echelon of political appointees tries to tamper with the work of those who serve government regardless of the party in power.

This is an important example to remember the next time someone is selling a conspiracy theory that you should not be buying.

Investment Effect

One of the strongest things an investor can do is to discover information that is poorly understood or appreciated by everyone else.  It is especially ironic that the commonplace viewpoint is offered as "contrarian" by those taking it!

Briefly put, one can gain an investment advantage simply by identifying and believing information from the real experts on various economic topics.  How simple!

Where to start?  Here's a hint.  The "government" as represented by the diverse Congressional and bureaucratic interests has no unified position about the measurement of inflation.  Many members of Congress, for example, would like to increase Social Security benefits and labor cost-of-living increases.  They would be happy to see inflation measurements that would aid these constituent groups. The BLS employees have tenure and are not subject to political pressure.

Meanwhile.....

Big-name fund managers like Bill Gross have a strong financial interest in public perception of inflation and the economy.  Like any smart manager, he talks his book.  Should you be listening?

More later on Bill Gross versus the BLS, now in its fifth year, but still playing on a blog or TV station near you.

Scooped by Muckdog

On our blog agenda there is a discussion of the "alternate data universe."

There is a rich and thriving discussion of economic data among economists -- that would be the "real economists".  We are talking about those who are (preferably) in the academic world or working on Wall Street.

There is another discussion.  It occurs mostly in the cottage industry of those making a business of criticizing the official government data.  As we have noted, government is an easy target.  The only representatives who speak in public are the political actors.  The hard-working, non-partisan, intelligent staffers do not have any access to the media.  That makes organizations like the BLS an easy target.  They are not paid to go on CNBC.

Attacking the non-farm payroll report, GDP, or inflation data is an inviting target for the gonzo-economists, the non-economists, and those with a paid-site business model.

We were looking for a way to describe this "alternate universe" and even had the Twilight Zone in mind, but we were scooped by Muckdog.  (Regular readers of "A Dash" sometimes ask why we recommend Muckdog, with whom we have never spoken, when his source seems to lack the official credentials we admire and is also anonymous.  The answer is simple.  We are not advocates of credentialism.  We do hold anonymous sources to higher standards of helpfulness.  We include them among featured sites when there is a real investment payoff.)  Muckdog gets to the point much better than we would:

From Barry Ritholtz:  GDP Alternate Measure. It's the whole conspiracy theory thing about understating inflation and overstating GDP.  Maybe "alternate universe?"  Sure, but those make for good Twilight Zone and Star Trek episodes, no?  And Barry's always a good read.

The Choice for Investors and Traders

It is pretty simple.  One can go into the Twilight Zone where no official report means anything -- there is always something wrong.  The prime source for this, which we will not link to, is a paid site on a mission.  The serious economists do not cite this source.  The bearish non-economists frequently do so.  The mainstream media, with a couple of exceptions, do not travel this path.  It is a trail which requires certain dubious assumptions:

• "Government" is some unitary actor, like the manager of a business, with a mission of punishing certain people -- mostly senior citizens, in an effort to cut costs and balance the budget.
• The Boskin Commission was some sort of conspiracy with this aim in mind.
• Various Administrations and the Fed have joined forces to foster this approach.

In the beginning government classes students learn that we have a pluralistic society.  Many different interests are represented, and quite effectively.  Senior citizens have a special  pull with Congress, since they represent a powerful voting block.

In fact, the Boskin reforms, discussed in a bipartisan Commission, have been reviewed by economists.  If anything, the adjustments to CPI are still inadequate.  CPI remains overstated.  As we have noted, that is what the Fed believes.

Investors have a simple choice.  They can choose to follow the alternate universe, where  everything has gotten  much worse over many years during a time when wealth increased.  This is an ideological choice, not an investment choice.

Alternatively, investors can accept the debate among real economists, those trying to generate accurate data, and those offering real public policy alternatives about economic issues.

Conclusion

Like the many economic sources available on the Internet, we are not going to engage in a debate on specific calculations.  It is too time-consuming  to fight this battle when the alternative universe has this as a single-minded mission.

A trader or investor who wants to profit is well-advised to deal with the data generally accepted in the economic and investment community.  If no one with real credentials chooses to engage in a discussion of the findings, that is meaningful and should be respected.

An Anecdotal Afterthought

Our mission at "A Dash" is helping investors and traders.  We were in some doubt about whether this was an important issue until we had a recent visit from one of our most intelligent and informed investors.  He asserted that some of these issues were "controversial."

We were surprised.  We suggested an analogy of the debate over cold fusion.  This theory, suggesting a potential for vast energy creation, was almost universally disputed by a broad spectrum of scientists.  Nonetheless, it won popular support, some grant money, and some academic followers.  This was a controversy principally among non-scientists.

There is plenty of room for debate over data and findings.  Unless you are yourself an expert, your mission should be in discovering and following the real experts.

That is what we do at "A Dash."

Investors Seeking Foreclosure Riches

One of the ingredients for "bubbles" is the quest for the home run.  Investors look to how much they wish to gain rather than to risk and reward.

What happens when this quest intersects with a major downturn in an asset class?

The Foreclosure Boom: Donald Trump

Our local papers have featured ads from Donald Trump, explaining how you can profit from the foreclosure explosion.  This article, while a few months old, is typical of what is happening.  It is from Seattle, a pretty strong housing area which we visit four times a year for board meetings.

But not to fear, capitalists, because one man's misery is another man's meat. In the same issue of the P-ITrump University"," a class where Trump promises "If you're not a millionaire by December 2008, you didn't attend my foreclosure workshop." Yes, that's right. Your struggling neighbors who are losing their homes in the subprime fiasco, are easy prey. The ad enthuses that "Foreclosures soared 94% in 2007!" What a paradise for the entrepreneur. The ad features a full-length Trump (who won't actually be at the seminar, by the way) staring you down, challenging you to become as rapacious, amoral, and loathsome as he is. If you don't have the guts to let Donald make your rich at the expense of the suckers of Pottersville, well, you're fired!

The LA Times also reports on the Trump approach:

An ad in this very newspaper showed a picture of The Donald and quoted him as saying, "Investors nationwide are making millions in foreclosures . . . and so can you!

"I'm going to give you 2 hours of access to one of my amazing instructors AND priceless information . . . all for FREE."

OK, I know what you're thinking. You're thinking there has to be a catch, such as the fact that the ad doesn't mention anywhere that the free two-hour seminar is only a "preview" of the three-day workshops that Trump offers for $1,495.

The reporters are skeptical of the Trump seminars, but we are offering no opinion.  We merely suggest this information as an interesting piece of information about identifying market bottoms and investor behavior.

Books on Foreclosures

There were a number of books on foreclosures in the last real estate bust, and now we see some new ones and also some revisions.

• Foreclosure Investing for Dummies is a year old now, so not a good bottom call.  Nonetheless, we are always interested when dummies get into the game.
• Here is one that came out in April.
• This "insider's guide" is almost a year old.
• This "complete guide" came out in January.
• If you want something that no one else knows, and only a couple of months old, this is your choice.
• And finally, here is something for "dummies" who want to fight foreclosure -- with or without help from Barney Frank and Congress!

What Does it All Mean?

We do not know!  When will the wave of foreclosure buyers intersect with the foreclosure sales?  Perhaps we need to wait for the cover of a major magazine before we have a clear contrarian signal.

While we are confident of the knowledge base of our regular readers, let us make it clear that we are neither endorsing the foreclosure course nor the books cited.  It is information for investors to consider -- that is all.

Informational Power: Interpreting the Payroll Employment Report

What is the market impact from the interpretation of data?

It is an open and free debate, but there is a problem.  The results follow from advanced statistical methods and processes.  Even the smartest hedge fund managers, columnists, and pundits cannot draw independent conclusions.  They did not take the right classes.  They never did any time series modeling or survey research.  Briefly put, they lack the necessary skills to evaluate most data.

The result:  Nearly everyone relies upon the analysis of those accepted as experts.  What choice is there?

This is a recognized principle in social science, called the two-step flow of communications.

Application to the Monthly Payroll Employment Report

When do we know that data interpretation has a market impact?  One test might be the widespread citation of a conclusion.

Our "go to guy" for those on the NYSE floor is Art Cashin.  In his daily comment (very valuable and available to UBS customers) he wrote as follows:

Payroll Numbers – Three pros, Dennis Gartman, John Mauldin and Greg Weldon each deconstructed the non-farm payroll data. Their conclusions were that the data was, actually, anything but bullish. Things are not always what they seem at first glance.

So the perception on the floor relies on these influential interpreters of data.  What are their sources?

John Mauldin

John Mauldin does a number on the number!  Even though this is an extended excerpt, readers need to check out the entire analysis.

Without that addition from the birth/death number, total private employment would have dropped by 296,000. Now, if that had been the headline number, the market would have tanked. Now, I have no doubt that the economy did create a lot of new jobs last month. But when the final revisions are in, we will see that job losses were well south of 100,000. If memory serves me correctly, the BLS had to add about 800,000 jobs that they missed during the recovery in 2003-4. (The birth/death model misses job growth during recoveries, the opposite result of the miss in slowing periods.) They did this just last year, in a major revision of the data. We will see the same type of revisions in 2010, only this time it will be downward.

And even the BLS says that the birth/death numbers have little statistical meaning. The following is from their own website (courtesy of Dennis Gartman) [emphasis obviously mine]:

“Birth/death factors are a component of the not seasonally adjusted estimate and therefore are not directly comparable to the seasonally adjusted monthly changes. Instead, the birth/death factor should be assessed in the context of its effect on the not seasonally adjusted estimate... The components are not seasonally adjusted separately because they do not have particular economic meaning in and of themselves.”

Mauldin also cites Gartman and The Liscio Report.

Barry Ritholtz

Barry Ritholtz did his regular review of the employment numbers, with, as usual, a special focus on the birth/death adjustment.  The overall conclusion is that employment growth is overstated and the BLS methods are seriously flawed.

He also quotes at length from Alan Abelson, doing his monthly bearish take on the BLS report.

David Merkel

David Merkel undertakes his typical thoughtful analysis of the problem, well worth reading in the entirety.  David looks at the addition of jobs from the B/D adjustment and compares these to the net job change over time.  He graciously notes our dissent on some of the key issues.

Importance

The significance of these analyses is demonstrated by Art Cashin's citation.  The notion that the BLS methodology is wrong has become accepted as conventional wisdom.  Nearly everyone thinks that these are "phantom jobs", added by a flawed methodology, and that "turning points" in  the market are missed.

It is not part of the job description for BLS employees to write on blogs or to appear on CNBC.  As a result, there is no spokesman for their method.  It is a one-sided debate.

All of the sources cited in this article have significant power.  Their arguments have influenced active traders to believe that economic data have been artificially inflated.

Our Approach

After many months of attempting to refute specific claims about the BLS approach, we have decided to take a different tack.  More to come....

Sell in May?

There are many Wall Street adages.  Some seem to have predictive power, including the idea that one should "sell in May and go away."

Such slogans have extra influence because of the catchy, alliterative qualities.

When Indicators Conflict

There are a number of conflicting adages at the moment.

There is the Presidential Election Cycle. We have not been big fans of this because the causal model is elusive.  This year, however, we have both the Fed eases and the stimulus package.  If ever the theory were to work, this might be the time.  We also note that the popular bearish commentators embraced the theory when it suggested market weakness, but have fallen silent during the period when it suggested strength.  This should be interesting to contrarian investors.

There are technical considerations.  Can the market break through apparent resistance?  That is the current battleground for traders.

There is the question of earnings forecasts and targets.  First quarter earnings and outlooks were not as gloomy as expected.  Financial writedowns?  Yes.  Other companies?  Not so bad.  It was an unexpected double-digit gain for non-financials.

Summing up the Prospects

Two of our favorite sources provide some insight.

Bespoke Investment Group notes as follows:

Bespoke readers might remember that Goldman got rid of bullish strategist Abby Cohen when the market was cratering in March.  Cohen had a 2008 price target of 1,675 for the S&P 500, and after replacing Cohen at the market's bottom, Goldman's new strategist (David Kostin) lowered the firm's year-end S&P 500 price target from 1,675 to 1,380.

Readers should check out the entire article.  The Goldman economics team is very bearish and that has now expanded to their strategist team.  These are often quite different within a single firm.  This is a classic case of "global strategists" versus bottoms up analysts.  It bears watching, but regular readers of "A Dash" know that we think the bottoms up guys are under-rated.  Everyone is still fighting the old war of the 2000 tech bubble when companies and analysts hyped.  When will we learn that the world is different now?

Muckdog wisely highlights some research from Sy Harding via Mark Hulbert.  The gist of the story, which you should read for the full account, is that the "sale date" might be delayed this year.

That is consistent with our current model output, and our sense of the fundamentals.  To check this out, readers might wish to revisit this article, from April 3rd.

And by the way ---

What happened to "Don't Fight the Fed"?  We highlighted this as a "top secret" investment opportunity -- early, but not wrong.

Doug Kass on Housing Predictions: An Update

At "A Dash" we have frequently cited the work of Doug Kass, a colleague at TheStreet.com.  Even before we contributed to RealMoney, we were paying customers to get Doug's work.   We found it to be a source of trading profits, as long as you understood the perspective.

We were therefore a bit surprised when Doug, writing on RealMoney Silver (where we can make no reply), took issue with our conclusions in an article about a survey.  Discussing reasoning and conclusions is fine, of course, but his comment was completely lacking in substance -- nothing about the article in question!

Instead, Doug engaged in an ad hominem attack.  Here is a key quote:

You (and many others) have been dead wrong on the magnitude of the drop in housing while the housing Cassandras have been dead right. (Just go back to your site and reference your reaction to my housing "hyperbole" several years ago.)

Those are the facts. They are not debatable.

We are delighted to see this statement of the issue.  Since we have no ability to reply where Doug wrote, we will have to write here.  As we have often done in the past, we invite Doug Kass to write something in response.  We promise to publish it without any edits.

Let us examine the quantification question.  But first, a bit of background on the housing issue.

Our Position on Housing

In the days before we were writing on this blog, we sent a quarterly newsletter to our investors.  Here is a quotation from the issue of June, 2005:

Housing

Is there a bubble? We see some disturbing facts, all signs of market tops.
People who were formerly day-traders in stocks or had good jobs in software development are now going into real estate.

If you tried to look at housing like a stock, using a PE ratio (rent/price), the number is about 35, 75% above the historic norm and double that of the major stock market averages.

Average folks with absolutely no real estate experience are buying properties with interest-only mortgages expecting to make their profits on appreciation.

We can smell some toast burning here.

We advised our clients against over-investment in real estate and those who followed our program for individual investors did quite nicely in stocks.  Doug Kass was not the only one seeing a problem in housing; he was just too early -- way too early -- in predicting the impacts.  (Check out Doug's timing here).

The "Batman" Chart

Since the issue is quantification, not direction, a great example to consider is Doug's prediction about personal consumption from a year ago.  He had this impressive chart with a distinctive pattern that we called "Batman" around our office.  The time period and the scales had been adjusted to give a false illusion of a strong correlation.  Here is the original chart.

Doug highlighted this chart in his column multiple times and took it on CNBC calling it a .9 correlation.  Charts of this sort are very dangerous for investors.  They do not understand statistics and causal modeling.  They are especially susceptible to visual evidence.

We reconstructed the data and did the calculations.  In one of the best articles we have ever written, we showed the problem in this analysis from a causal modeling perspective.  We expect this article to have a prominent place in our forthcoming book in the "Misleading Charts" chapter.

The obvious implication was that PCE would rapidly decline to below the 2% growth rate.  We analyzed the intermediate results in this article where we showed that the prediction had failed.  We think that Doug was a victim on this entire story.  Someone sent him this chart -- someone with dubious quantitative skill -- and convinced him to go with it.  He should have renounced it at some point.

Current Chart Update

The most recent evidence, one year after the original article, is even more dramatic.  As one might expect, the lending restrictions of banks have increased dramatically.  The changes are actually off of the scale.  The Fed altered the question to split out lending on qualifying mortgages versus subprime and Alt-A.  Bending over backwards, we have used the prime mortgage series in the chart.

Conclusion

As one can readily see from the chart, the precipitous change in lending standards (Doug used an inverted scale so that tighter standards would match lower PCE) did not result in a similar decline in Personal Consumption.  The direction was correct.  As we stated in the original article this is called a "spurious relationship" by those who do causal modeling.  A weakening economy causes all sorts of effects that do not have a causal relationship.

Doug Kass never cited this chart again, nor did any of the other blogs who picked it up.  The conclusion from this chart is inescapable:

Kass grossly overestimated the impact on Personal Consumption in March, 2007.  As he says, "Those are the facts.  They are not debatable."

 

Another Gift from the Financial Accounting Standards Board

Try this line:  "I'm from the Financial Accounting Standards Board and I'm here to help you."

Not very persuasive?  We are not surprised.

Background

FAS 157 is a well-intentioned attempt to clarify derivative accounting and increase transparency.  Had it been introduced at a different time, the transition might have been smoother.  Instead, the major Wall Street firms adopted the new rules early in 2007, just as the impact of the various mortgage derivative issues was becoming clear.  It might have made sense to delay the implementation for a while, but the conspiracy folks were already out in force.

There were many predictions from your favorite bearish media sources and blogs that November 15, 2007 would be a Doomsday of reckoning.  That prediction was wrong, and so has the rest of the scaremongering about illiquid assets.  There is an element that wants readers to believe that anything in Level 3 (no comparable trades) is suspect and probably worthless.  These same sources want you to think that the SEC is out to mislead the average investor while allowing companies to do whatever they want in valuing assets.  We were surprised, and a bit discouraged, to learn that a very astute group, the regular commentators of "A Dash," have fallen for this rhetoric.

Here are a few facts:

• The SEC is trying to assist investors by making sure that accurate information is available.  They have delegated accounting rules to the Financial Accounting Standards Board.
• FASB is trying to do the same thing.  They are a bunch of accountants.  They are not conspirators.
• Companies and their accountants have legal obligations under these rules.  They are following them.  Each move is noted and publicized.  The notion that this reduces visibility is silly.  For the record, none of them want to go to jail, and they all watched the 2000-era events.
• Those who pull a single sentence from SEC rules, ignoring the visibility requirements, and creating far-fetched schemes of what companies will do ---- well --- they are mistaken.  (We cannot seem to summon up the colorful and quotable language of others.  Modest language does not mean "wrong.")

The Issue

Despite extensive discussion, many market participants do not understand the FAS 157 rules.  A subtitle on CNBC today highlighted Level 3 assets as illiquid and subject to write-downs.  It fanned the flames of sentiment -- that companies are hiding something, and that these assets are overstated in value.  Since by definition they are difficult to value, a defense is nearly impossible.  Since the models used have funny names and are complicated, everyone disparages the theoretical work done to evaluate the holdings (i.e., mark to myth).  Shoot first!  Don't bother to analyze the method, since that would require work instead of a slogan.

Most importantly, people ignore the fact that Level 3 includes many standard assets that do not trade, and may even include offsetting holdings.

Today's Trading

We have written extensively on FAS 157 and complained that the mainstream media has not done a good job of explaining the issues.  We are therefore delighted to cite a first-rate article from Bloomberg's Yalman Onaran which provides a balanced and careful account.  The article begins  with a factual account of an announcement from Goldman Sachs, and a description of the market reaction.  Anyone interested in successful investing should give a very careful read to the entire article, but here are a few key excerpts, with our comment in brackets:

``Just because an asset is defined as Level 3 doesn't mean we're uncomfortable with the value of the asset,'' said Lucas van Praag, a spokesman for Goldman Sachs. ``It also doesn't provide any insight into the relative risk of the underlying asset.''  [If one thinks that all companies lie, do not bother reading further.  If one believes that companies recognize legal obligations, this has some meaning.]

Under accounting rules, Level 1 assets are those for which market prices are readily available. Level 2 holdings are valued based on ``observable inputs,'' or prices of similar assets traded in the market. Assets are placed into the Level 3 category when there are hardly any observable inputs, and the firm has to rely on in-house models to calculate potential gains or losses.  [A good, objective explanation.]

The new standard doesn't change the way firms value their assets. It only creates clear-cut categories and is intended to increase transparency about valuations. [Well stated, and not well understood.]

``The uncertainty of Level 3 asset valuation is already priced in the stocks of brokerage firms,'' said Steve Roukis, managing director at Matrix Asset Advisors Inc. which oversees $1.8 billion of assets in New York. ``We expect more writedowns in coming quarters, but they're not going to be huge numbers like the past quarters.'' [Some might think that the market has priced in more than the expected write-downs.  Many of the Level 2 assets are market to unrealistic prices from indices with no good arbitrage, like the ABX.]

Trading Reactions

The announcements generated a typical trading reaction, sending shares of Goldman Sachs (GS), Lehman (LEH), and Morgan Stanley  (MS)  lower on the day, along with other financial issues.

This is not a surprise.  Even those of us who find the interpretation mistaken understand what the short-term market reaction will be.  Bids are pulled.  Potential buyers wait for the right opportunity.  The market decline serves as a false confirmation for those with a wrong-headed approach to the issue.

Conclusion

Investment managers face a dilemma of timing.  For us to have a long-term advantage, and many of us do, we must discover and act on market mis-perceptions.  Despite this, we are all respectful of  market forces and the reaction to news.

All of the financial stocks are subject to rumors and gaming by hot-money traders and hedge fund managers.  Many of the blog and media accounts fan the flames.

We have an underweight position in financials, (including Goldman Sachs), but we expect to step up to an overweight posture quite soon.  We noted this week that sentiment is "sticky" and there are many applications.  The catalyst for buying is when the sentiment is confronted with fact.

None of the best investment opportunities come easily.  Those who are willing to do an hour or so of homework -- objective reading and thinking -- about these issues will be richly rewarded.

Your Biases Cost You -- A Lot!

One of the reasons we moved from the academic world to the investment world was the potential for profiting from widely-held misperceptions.  Such situations abound in the current political and market environment.  Investors who understand this can have a field day.

Background

In the study of economics, political science, and public policy formation there is a body of work supported by evidence.  There are also areas of disagreement.  A student entering the first course in these subjects comes without knowledge, but with plenty of biases about "how the system works."

It is easily demonstrable (and the subject for more articles) that those who study these subjects find agreement on a wide range of topics.  The experts may seem to disagree, and they do on many theoretical offshoots and specific implications.  It is more interesting for them to debate the disagreements.

Meanwhile, the average reader (or investor) did not take these classes, or long ago forgot what they learned.  This provides an interesting opportunity for the Internet age, where bloggers and mainstream media alike are hungry for content.

One simply takes some plausible "everyman" idea, then takes some development in the news, and spins it to the lowest common denominator of understanding.  Since most people share the underlying value bias, they uncritically accept the conclusion.  Your blog or column is popular.  You get acclaim and high ratings.  Life is good!

The Case in Point

Yesterday we wrote about the SEC opinion letter, which attempted to improve both accuracy in valuation of assets and visibility to the investor.  If anyone takes the time to read the entirety of the letter, it is obvious that whatever method chosen by a company and its accountants must be revealed and described in full.  There is complete visibility of method and conclusion.  Those with a value bias do not quote the key parts of the letter, as follows:

If you conclude that your use of unobservable inputs is material, please disclose in your MD&A, in a manner most useful to your particular facts and circumstances, how you determined them and how the resulting fair value of your assets and liabilities and possible changes to those values, impacted or could impact your results of operations, liquidity, and capital resources. Depending on your circumstances, the following disclosure and discussion points may be relevant as you prepare your MD&A:

• The amount of assets and liabilities you measured using significant unobservable inputs (Level 3 assets and liabilities) as a percentage of the total assets and liabilities you measured at fair value.
• The amount and reason for any material increase or decrease in Level 3 assets and liabilities resulting from your transfer of assets and liabilities from, or into, Level 1 or Level 2.
• If you transferred a material amount of assets or liabilities into Level 3 during the period, a discussion of:    
  • the significant inputs that you no longer consider to be observable; and
  • any material gain or loss you recognized on those assets or liabilities during the period, and, to the extent you exclude that amount from the realized/unrealized gains (losses) line item in the Level 3 reconciliation, the amount you excluded.
   
• With regard to Level 3 assets or liabilities, a discussion of, to the extent material:    
  • whether realized and unrealized gains (losses) affected your results of operations, liquidity or capital resources during the period, and if so, how;
  • the reason for any material decline or increase in the fair values; and
  • whether you believe the fair values diverge materially from the amounts you currently anticipate realizing on settlement or maturity. If so, disclose why and provide the basis for your views.
   
• The nature and type of assets underlying any asset-backed securities, for example, the types of loans (sub-prime, Alt-A, or home equity lines of credit) and the years of issuance as well as information about the credit ratings of the securities, including changes or potential changes to those ratings.

An objective reader of this letter might well question a pundit who suggests that something in this process reduces visibility to shareholders.  The idea that it encourages fraud is just silly.

The Value Biases in Place

There are several easily identifiable biases:

• Markets always yield the correct valuation, regardless of liquidity.  Anyone with actual trading experience knows this to be false.  There can be many reasons for buyers to step back, often based upon a lack of information or guessing that others will not buy either.  The Fed, through a number of measures, and the SEC, have both recognized this, attempting to stabilize markets until there is more visibility and more trading.
• The SEC and the Fed are trying to fool people.  One should recognize this as an assumption, not a conclusion based upon evidence.  Try doing a critical reading of those  taking this viewpoint.  What evidence is there  that this is what these agencies actually do?  We might add that our own  study of government (based upon forty years of experience) yields a quite different conclusion.  Most of the participants are non-partisan, senior officials who are attempting to get it right.  Unlike the pundits playing to an audience, they are genuine experts in their field.
• Companies lie.  Accountants back them up.  This value bias stems from the 1999-2000 bubble experience.  Wall Street pundits can invoke these examples and everyone can remember them.  Did any of these pundits note the passage of Sarbannes-Oxley?  Did they notice the death sentence delivered to Arthur Andersen?  Do they believe that these changes have had no effect upon corporate and accounting behavior?  Our own experience as a member of the board of a public company and as a reader of many corporate reports suggests a very different conclusion.

Evidence

This article from Accrued Interest provides some great information about the liquidity in many bonds and the issues in marking to market (although the author may not share our conclusions).  The CDO liquidity is even worse.

Tonight's discussion on Kudlow has an interesting exchange (starting at 4:15) between Barry Ritholtz, who believes that the SEC opinion promotes fraud, and Vince Farrell who makes an insistent rebuttal.  (Both are colleagues on RealMoney, and frequently offer valuable insights).  Vince invokes the example of AIG and their accountants as refutation, an example we have cited at "A Dash." 

One might also compare the conclusion with Barry's take on home prices.  He seems to feel that this market, despite millions of trades, does not accurately reflect pricing because some homeowners are unrealistic in their offers.  The implication is that distressed trading in CDO's, based upon few trades, is valid, while home prices, based upon many trades, are not.

Conclusion

There are many investors who are currently acting out their biases.  In a world where one is free to reject any piece of data as somehow flawed, the initial value biases govern behavior.

At "A Dash" we have attempted to show a powerful and ongoing effort by various parts of government to deal with the relevant issues.  We expect each of these initiatives to have an effect, with a strong cumulative effect. 

Meanwhile, investors and managers rejecting stocks and going to cash are not just fighting a Fed that is cutting rates, something we warned about.  They are fighting a creative Fed that is willing to employ new tools never before considered.  They are fighting the stimulus package, the SEC, expansion of Fannie, Freddie, and the FHA.  The Frank/Dodd legislation will be the next battleground.  If the Bush Administration agrees to a compromise, it will be another significant effect on housing supply and demand.

It is so easy to point out problems, and so difficult to see the solutions.