A Dash of Insight

Street Fighters: Good Information and Good Fun

Kate Kelly's book, Street Fighters:   The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street,  now on our recommended reading list, is a great source of information and fun to read.  It is well-sourced, authoritative, and always interesting.

Does it provide, through a look at Bear, the answers to our financial crisis?  We think not, but that is part of the fun.  The reader can collect information -- raw data -- with real confidence.  There will be many accounts of the financial crisis.  Anyone seeking a complete understanding should consult many sources.

The Approach

Street Fighters tells an engaging tale focused upon how a mighty firm was reduced to rubble in three days.  You know the ending before you start reading, but it is no less engaging.  The author has a nice sense of the characters and has done extensive research into backgrounds.  We not only learn about the major players, we learn what everyone else thought about them.

Such an approach is open to challenge.  Kelly provides footnotes for sources, and acknowledges disagreement.  It is convincing support  for her narrative.

The Result

The reader is treated to a view from several perspectives.  It is an insider's take on the politics within an investment bank.  There is genuine conflict over risk and which products to feature. Even the most jaded reader may have some sympathy for a wealthy guy who spent a lifetime building up his company and his position, only to lose it all in a few days.  This is "inside baseball" at its best.

The story is dramatic and well-told.

Assorted Insights

The reader has raw data to draw conclusions on several interesting points.  Here are some that stood out for us.  Yours might be different.  Please consider the following:

• Significance of CNBC.  David Faber had a story about firms not trading with Bear.  It was big news, but it was later denied by those in question.  The damage was already done.   The issue is how much information one needs to go with a story like this, when the story itself can affect the outcome.  Should Faber have verified more completely before going with this story?  Would it have made a difference?
• Significance of Kelly and the WSJ.  Many readers will already be familiar with the three-part series in the Wall Street Journal.  In the book, Kelly asserts that the series itself -- criticizing Cayne's leadership -- had an impact within the firm.
• Hank Paulson's Role.  Paulson is portrayed as dictating a punishingly low stock price for Bear.  Historians will combine this information with additional information, includeing his reversal on the use of TARP funds, the decision to force TARP on all of the major banks, and other similar decisions.  From our perspective as public policy experts, this is an extraordinary and arbitrary use of powers.  It is on a scale that is without precedent for a Treasury Secretary.
• The Fed Role.  The decision of the Fed to expand lending to include investment banks, only two days after the Bear failure, was extremely arbitrary with respect to timing.  We should all be concerned when public officials make decisions about which firms (and which investors) live or die, and do so without clear rationale.  Bear was allowed to die while others were saved.

Conclusions

Kelly's conclusion is that Ace Greenberg built a firm on some principles and Jimmy Cayne violated those and lost it all.  We are not convinced.

We can now see what happened to many other firms.  It would not have mattered if Bear's leverage and risk had been a little less.  Kelly is probably right in suggesting that Bear was an unloved firm on the Street, and therefore first to be challenged.

It was beyond her scope to consider other causes, although there is a paragraph or two on the trading in Bear stock.  This was something we watched daily on our trading screen.  Those betting against the firm could trade in the thin Credit Default Swaps market (CDS), buy puts (where premiums exploded in issues that were far out of the money), short the stock, pull your hedge fund accounts, and spread rumors.

These events were all taking place.  The sequence of causation will never be determined.  What we do know is that any business depending upon confidence and credit can be destroyed in three days. Those aiding the destruction can make millions as it happens.   If that is a verdict on a business model, the entire banking industry is in question.

Final Take

The book is fun to read and has plenty of raw data with authoritative sources.  You should read it, and combine what you learn with other information.  The story of the 2008 crisis is complicated.  We look forward to reviewing other books on the subject.

Looking Back, Looking Ahead

Today marks some important changes both in market fundamentals and in psychology.  On such occasions we interrupt our regular writing agenda for more specific market commentary.  This is an occasion where readers unfamiliar with our recent work should take some time to follow the links.

In recent days we have tried to provide some perspective on the market turmoil and what to watch for.  Some of these ideas are starting to play out, but there is more to come.

A Review

Here is a brief review of the last few days.

We reviewed a number of popular myths and provided a brief assessment.  We then showed how some shallow thinking was leading many to be excessively negative.

We made timely shifts from bearish to neutral to bullish via our TCA-ETF system.  Investors in the program had a gain of 9.7% today.  Being in the right sectors means a lot.  Our current holdings seem to capture the rapidly revised thinking of market strategists.

We wrote about possible catalysts, including this suggestion:

Housing initiatives.  The Treasury is hinting at a new plan to reduce mortgage rates.  The Fed has already acted.  We expect the market to be skeptical of both, so it may take some real evidence to change opinions.

In addition to the Fed statement today, there was other important news, setting up the rally.  The Obama Administration seems to be embracing a major plan to cut mortgage interest rates to 4.5% for everyone.  We have the full story on our sister site, ElectionStocks.com.  This story is very big in many ways and for many sectors.

Being Modest

We are very cautious with a period of success.  There are so many who think they know so much.  In fact, investors should look not to a single market call, but to long-term history.  We tried to illustrate this with our football analogy.  In our own methods, we try to emphasize the long run.

Looking Ahead

Today's trading could represent a change in market psychology. There are plenty of fund managers who are either caught short or under-invested.  The negative sentiment has been palpable.  The news of scandals and the market declines have tested the resolve of many long-term investors.  We expect some managers and investors alike to shift gears.

There are more catalysts to come.  We continue to collect ideas on this front.  More to come, with several interesting ideas.  Briefly put, those making negative forecasts on the economy, on corporate earnings, and on stocks have a doubtful platform.  They are not just fighting the Fed.  They are also fighting the Treasury and the incoming Obama Administration.

Investors do not understand government policy, and have expected immediate reaction from the many programs.  They have been dazed by acronyms and have lost focus as a result.

There is a firm determination to avoid a major recession.  The market will look ahead, beyond the recession that is now a year old.  This may already be starting.

Conclusion

We have ridiculed strategists calling for a five-percent gain in the next year.  This is silly, when intra-day moves are frequently greater.  The only reason to invest in stocks is an expectation for a major rebound.  Few are willing to talk about valuation, when the consensus mentality disparages earnings prospects.  We note some courage on this front from Morningstar, where they see the Dow as 30% undervalued. (Hat tip to Abnormal Returns, helping everyone see what otherwise might be missed.  None of us can check everything!)

We shall comment further on valuation issues, with a focus on expected and trailing earnings.

Wrong Turn for TARP

A few days ago we wrote our top suggestion for President-Elect Obama.  Several blogging colleagues took up the theme, and we sincerely thank them for their interest and for stimulating discussion.  We plan a more complete review of opinion, but events have, once again, overtaken the schedule.  The current Administration is moving in the opposite direction.

Secretary Paulson announced that the TARP program would not purchase troubled securities, at least not in the way originally envisioned.  He stated that direct investment in financial institutions was a better use of TARP funds with more impact.

A Discouraging Turn of Events

Here at "A Dash" we try to analyze markets rather than to offer prescriptive advice.  The "Letter to Obama" was a rare excursion for us.  While others stray far from their expertise, we like to stick to our "happy zone."

Here are two takes on the wrong turn in TARP.

Market Take.  Market participants, rightly or wrongly, now see the program as a funding source for anyone who claims a need.  They see it as socialism.  Most importantly, they interpret the failure to purchase distressed securities as an acknowledgment that these holdings are worthless.  Briefly put, the Treasury has undermined the very assets they hoped to support, and the leadership has lost the confidence of investors.

Political Take.  The decision to invest in preferred stock instead of troubled assets is an easy course.  It sounds great to the taxpayer.  The companies are held by private investors, so there is an inference of value for preferred shares.  This is better than buying what is perceived as "toxic waste."  It has an easily-understood causal mechanism -- a direct injection of capital.  The downside is that it has eliminated an clear public-interest distinction, inviting nearly anyone to apply for TARP funding.  It fails to address root causes.

Public Policy Take

Quite frankly, the investment and political types are not doing clear-headed public policy analysis.  This involves understanding the following points:

• Focusing on the cause of the problem.  The cause was originally troubled housing loans.  We could have addressed this directly at less cost than the current plan.  Instead, we have allowed mortgage securities to have an ever-decreasing mark-to-market value, and now face similar issues with Alt-A loans, student loans, and securitized credit card debt.  As long as this spiral continues, the need for additional government investment will continue.
• Recognizing the error of using a club instead of incentives.  The government is now instructing financial institutions to do more lending.  We are not learning the lesson of Fannie and Freddie, where the government tried to combine public interest with a private company.  It did not work there, because the government asked private companies to behave more aggressively than their financial statements warranted.  We are going down the same road.  If you were a bank manager with TARP funds, would you choose to strengthen your balance sheet in the face of declining assets, or make more loans?  Simply instructing them will not work.
• Failure to develop and implement a coherent plan.  The current "plan" seems to change weekly.  Everyone sees this, so confidence is lost.  It is the country's misfortune that our leadership was far too slow to address the relevant issues.  We hope that the Obama Administration will carefully develop and implement an incentive-based approach,  but the President-Elect does not yet have control.  Our tradition of transition in government is being tested in a way that has no historical precedent.

The best hope for investors is that the new administration will quickly develop and announce proposals that get to the root of problems.  Their key appointments should reflect this.  The Bush Administration should cooperate during the transition.

It is a major burden for an incoming President.  Never before has a President-Elect had such a responsibility before actually gaining the reins of power.

How NOT to Think about Your Investments

Many stocks, perhaps most stocks, are trading at prices that do not reflect fundamental value, as determined by traditional methods.  The excellent team at Bespoke Investment Group, one of our featured sites, provides a great list of stocks trading at "crazy" P/E ratios.  (Since P/E is only part of the story, perhaps you should subscribe to their premium service.)  Unfortunately, we own a few stocks on that list.  Our cheap plays got even cheaper.

Bob Pisani's CNBC reports -- a good reflection of floor trader opinion -- pointed out the disjunction between the fundamentals and the price in stocks like IBM.  Great earnings, good prospects, no proximate link to subprime, but the stock is down 25% from the highs.

Briefly put, current prices are not a matter of analysis, but one of psychology.

It is time to check out our "go to guy" on such questions, Dr. Brett Steenbarger.

Great Advice from Dr. Brett

In any big event, whether it is a football game, the election, or the stock market, there is a nearly inevitable feeling that you "should have known."  He writes as follows:

When markets become unusually volatile, they make unusually large moves. To the short-term trader or the active portfolio manager, such moves look like phenomenal opportunity. This creates a kind of dissonance when their results do not reflect such opportunity. This dissonance is often expressed as regret: the word "should" becomes a prominent part of traders' thinking.

Underneath this regret is what behavioral finance researchers call "hindsight bias": the exaggerated sense of predictability in retrospect.

After some typical wisdom, which deserves to be read completely, he concludes as follows:

Given the limits of what we know and what is ultimately unknowable, not all movement is opportunity. The key to trading success is finding the patience to capitalize on those things you do know and the wisdom to accept what is uncertain.

Applying Brett's Advice

The most important step an investor can take is to understand what is happening.  Here is our analysis.

• Our system has created a climate where banks will not lend with each other.  Why not?  After Lehman was allowed to fail, no one knows which financial institutions will get government support.  Why lend to an institution that might not deliver?
• We are de-leveraging at Warp speed, since any write down at one institution ripples through the entire system as required by FAS 157 mark-to-market rules.
• The lenders to hedge funds, all becoming regular banks, now have more conservative business models.  Leading fund manager Ken Heebner  made this point tonight on Kudlow.  See the video here and here.  The hedge funds can no longer take a strategy that makes 5 or 6 percent a year and leverage it five times.  This means that hedge funds are selling -- forced selling -- the good with the bad.
• Individual investors are dumping their mutual funds, as they always do in times of stress.

What not to do

Do not just make a knee-jerk reaction.  Think clearly.  Think about what is happening and the causes.  That is the only way to spot opportunity.

Somewhere between Miss Moss's Latin class in high school and Neil Browne's excellent instruction in critical thinking, we learned about a prominent logical fallacy.  Once you know it you will see it every day.

Post hoc, ergo propter hoc.

You can look it up, but it means "after this, therefore because of this."  It is one of the most common errors in logic.

The most important application right now, also pointed out by Ken Heebner, is that the market keeps going down after each new government move.  The cause of this has nothing to do with government policy, except perhaps that it was too slow for rapidly changing conditions.  We should have started sooner, since government moves slowly.  It is the de-leveraging, especially in hedge funds.  To those who do not understand, it seems to be an instant verdict that the government plan does not work.

And this verdict is being rendered before the $700 billion has even been deployed.....We suspect that legislators who voted for the Rescue Plan feel somehow betrayed by the market.  It will take some time before the impact of the plan is felt.

And finally, what you should do

Understanding the factors behind the decline is important in finding opportunity.  If one accepts Ken Heebner's observation of reality, there is one set of conclusions.  If one believes that the market is correctly signaling the next Great Depression, there is another.  We shall revisit that dichotomy.  It depends on solving the problem of counter party risk, which we described last month.

Meanwhile, let us consider more great advice from Brett Steenbarger:

The ability to adapt to changing conditions and maintain the search for opportunity amidst market panic is a great example of how times of crisis can also be times of opportunity.

We will follow up with more about how we are positioning our clients to take advantage of current conditions.

The Academic Stereotype

The study of behavioral finance has exposed many of the heuristics and biases of investors.  While financial pundits are aware of this literature, they are just as susceptible as the average investor.

At "A Dash" we believe that opportunity knocks when too many rush to over-simplify.

Pundits and the  Academic Stereotype

Here is a test that readers can try at home.  When some financial writer or trader dismisses someone as an academic, take an extra look at the argument offered.  Our experience is that those using such stereotypes do so to mask hasty arguments.

These writers reveal their own naivete' , since any sophisticated person knows better than to reason from stereotypes.

Inhabitants of the Ivory Tower

Academics come in all shapes and sizes.  These include many who fit the stereotype of the ivory tower dreamer just perfectly.  Our colleagues have included one who could name the leader of virtually any foreign nation.  "Let's see," he said, presenting a little test for his colleagues at lunch one day in the 80's, "are we allies with the South Yemeni's or the North Yemeni's?"  He was great on facts, but not as good on political and economic processes.  Another was an expert in sociology and political theory, but he did not know what a linebacker was, and certainly could not name eone.  Another joined us for a Packer playoff game at Lambeau Field.  After the first score he  inquired how many points were awarded for the kick after a touchdown.  At least he knew when to cheer!

By contrast, there are professors who are quite interested in both theory and application.  In science and engineering, their work is the basis for much of our progress - things like new drug discoveries, new software, advances in computing, and better manufacturing processes.  In the humanities one would be surprised by the many practical questions from speech, language, and literature.  Any reader who does not understand this missed some great classes.

In public policy analysis there are academics whose work is directly relevant to the study of existing policies and possible improvements.

Dismissing someone as an "academic" is a disparaging stereotype that is no more accurate than any of other, including the insults rejected by any thinking observer -- those based upon race, ethnicity, or gender.

The Natural Human Tendency

We conducted many classes that had team teaching with professors from different fields.  The biggest single problem was to get each of these experts to appreciate the contributions of the others.  In a seminar on environmental policy, for example, the scientists had an attitude of "zero tolerance."  The economists favored incentives that encouraged pollution reduction.  Political scientists looked for solutions that could garner the coalition of political support necessary for adoption.

What traders and market pundits do is much the same thing.  They dismiss the relevance of knowledge they personally lack.

Why Should We Care?

In general, investors can profit from mistaken viewpoints that are widely shared in the financial community.  (Yes, we know.  It does not happen overnight.  This is a recurring theme at "A Dash.")

In this case we believe that the financial punditry has done a poor job of anticipating and explaining Fed actions.  This is partly because they dismiss the Fed members as "academics" while they are "realists."

Getting this right can be profitable.

Discovering Relevant Academics

Here is a simple lesson that any financial pundit should be able to grasp.  When looking for relevant academic expertise --

....let the market do it for you.

There is a very simple rule that we learned long ago in our own (extensive) consulting work.  Those who are doing something relevant are in demand -- working as consultants and sometimes moving into government.  Those whose work is strictly theoretical stay in the university.

Applying this Principle to the Fed

Last week we highlighted the excellent discussion of David Merkel, who described various attributes of Fed members.  He went so far as to highlight the relevance of academic research from some, getting most of the way to a conclusion.

We wrote as follows:

Some months ago when the FOMC membership was criticized as a bunch of academics we did our own check of the backgrounds.  We were looking for a very specific credential which gets no respect in the financial community.  Even in the astute Merkel analysis, this credential is not mentioned;  in fact, it is given short shrift.

Any guesses as to what this might be?

Let us turn to the Merkel summary and find a few highlights.  It is pretty easy because virtually every FOMC member has something relevant.

The key ideas are under "political" dealings.  (Kudos to reader Chris who spotted the point from our earlier article).   Public policy analysts distinguish between "political" and "policy formation."  David would not know this, but it is not nit-picking.  It is just as significant as any technical term from his own insurance experience.

The FOMC members have a range of relevant experience including the following:

• Membership and chairing the Council of Economic Advisors -- perhaps the most important role in economic policy formation;
• Under-Secretary positions at Treasury.  Once again, these are the positions sought by academics who seek to have some impact on the world;
• World Bank, IMF, and other consulting;
• Experience at money management firms including Morgan Stanley;
• Associations with an wide array of policy-oriented think-tanks.  These are places where research is expected to be policy-relevant.

Briefly put, nearly every member of the FOMC has extensive experience in policy formation and implementation, far from the theoretical world of the ivory tower.  This experience is much more relevant that that of someone who has worked on a trading desk or (for example) run a trucking company.  It is more relevant in breadth and in method.

Conclusion

Most Fed observers in the financial press have been slow to grasp and appreciate Fed policy.  As a result, their predictions and explanations have been poor.  They have been more interested in criticizing the Fed and offering their own opinions of what should be done, rather than helping investors understand what is actually happening.  They have looked only at the level of the Fed funds rate and the money supply.  Meanwhile, the Bernanke Fed has looked more carefully and deeply into the problem.  The result is a set of policies that has (at least partially) made up for the broken "mark-to-market" accounting methods by addressing the most acute liquidity needs.

ETF Trading is a Key to Sector Rotation

The rise of ETF's has caused a major change in trading, particularly in sector rotation strategies.  There are several good current articles on this subject.

The Float, which does a nice job of covering developments in ETF's, cites an article by Michael Sesit on how ETF's threaten actively managed funds.  This is a very significant development.  The regular mutual funds can outperform only by making big sector bets, but turning the positions is a slow process.  For the big funds, changing sector weightings is like turning an oil tanker.  ETF trading is much more subject to "hot money."  Market participants, including individual investors, financial consultants, and hedge fund managers, switch ETF's in a heartbeat.  Transaction costs are low.  There is often no detailed analysis of fundamentals.  If someone has the idea, for example, that energy is "toppy"', it is easy to sell anything related to energy.  Individual stocks, whatever the merits, go along for the ride.  Long-term investors must understand and ignore this, while traders need a faster trigger finger.

Abnormal Returns also frequently covers the ETF universe.  In an important article, the author provides a valuable insight on the birth and death of ETF's, and why investors should be paying attention to fund assets and potential liquidations.

Bill Luby at VIX and More shows what has been working, and what has not.  We always compare Bill's listings to our own model results, posted weekly with a one-day delay.

Conclusion

Investors trying to achieve superior performance through sector rotation must use the following criteria:

1. Does the ETF have real liquidity?
2. Does it overweight a few names, providing little overall exposure?
3. Does your strategy provide an element of anticipation?
4. Does your approach exit in a timely fashion?

Meeting all of these tests is essential for successful ETF trading and investing.

Interpreting Market Action

A principal mission at "A Dash" is developing a guide for the intelligent individual investor.  (We are eager for more comments and emails from any readers who qualify, since you are the target).  Sometimes our interest intersects with that of more active traders, and this may be one of those times.

Our Current Posture

As we have indicated, our investment posture varies with the time frame.  Since we have different products for different investors, our positions may seem to be at odds.  It is actually quite consistent for those with different time frames to have different perspectives.

The main point is that we have no market bias.  We have different methods for different investors, as we should.  We follow our methods with rigor, always watching changes in our indicators.  We are willing to vary our position according to circumstances,  just as we did in the 2000-01 era for long-term investors.

Drivers of Current Market Action

Looking at the behavior of stocks and sectors over the last two weeks shows a very unusual pattern.  There is certainly a problem, centered in securities related to subprime mortgages, and then  apparently spreading to other mortgage-backed assets.  Many observers (too numerous to cite, but all astute)  have pointed out that the problems are affecting stocks that have absolutely no relationship to the mortgage markets.  Ben Stein's article in today's New York Times points this out, and attempts to provide some overall quantification.

Investors should attempt to profit from deviations from the efficient market hypothesis.  If Ben Stein has an accurate read on the overall problem, why is the general market experiencing such selling?  There are two divergent theories:  Economic collapse and hedge fund activity.

Economic Collapse

Regular readers of "A Dash" know that we do not endorse the theory that this is the first of many dominoes leading to a recession.  There is plenty of economic data suggesting that this is not the case.  It is a subject to which we shall return -- but not today.

Hedge Fund Activity

There are many quantitative "black box" hedge funds, developed by people with PhD's, that seek to exploit small differences between two securities.  Some of these strategies involved monthly yields of 30 bps or so -- not enough to generate an attractive annual yield.  By convincing banks of the wisdom of these approaches, the funds applied leverage.  This turned the annual yield into rates of 15% to 30%.  For a time, these yields were uncorrelated with the overall equity market.  This was extremely attractive to  investors who bought into the backtesting methods, the debt ratings of mortgage securities from major firms, and the general concept that something with a yield was safe.  We cited James Altucher concerning some of these strategies, showing how the leverage proved fatal to the hedge funds involved.

Ripple Effects

Let us now turn to a different hedge fund strategy.  Suppose the fund buys senior debt and sells junior debt, a process nicely described by John Mauldlin.  (We recommend reading the entire article carefully -- twice if necessary.  While Mauldin has been incorrectly bearish for some time, he often shows a strong understanding of relationships in his comments.  We do not agree with his assessment of the time frame for sorting this out, but no one really knows).

Next suppose that the junior debt halts trading, so it cannot be evaluated.  Some hedge funds are selling senior debt, since they face redemptions and margin calls.  The result is that a fund with a sound strategy faces apparent losses based upon current marks.  This is caused not by the fundamental relationship between the securities, but by a loss of liquidity for one of them, a topic covered nicely by Bill Rempel.

Exacerbating the problem is that many funds have a combination of "sound" and unsound strategies.  Facing redemptions and margin calls, the funds are forced to sell what they can.  This includes unwinding many  theoretically good pair trades  of one  stock or sector versus another.

Our observation of stock and sector trading is that many attractive holdings have been caught in this process.  We advised our investors that this was an opportunity, with timing still a bit uncertain.

The End of Hedge Fund Forced Selling?

It may be difficult to spot the exact end of this process.  Goldman Sachs today held a conference call where they stated that the deleveraging was, in their opinion, more than 75% complete and perhaps approaching 100%.  They invested in one of their (losing) funds and brought in new investors to the tune of $3 Bilion.  This was a statement that they preferred to hold on to strong strategies until the relevant markets achieved normalcy.  The market was skeptical, so the end has not yet been reached.

David Merkel has a typically excellent article with many links discussing how far the process has gone, and what future prospects might be.  The conclusions vary, but provide plenty of food for thought.

It is not the end of model-based trading, and there is nothing wrong with having a PhD.  (Some of our best friends have the degree!)  It has more to do with balancing strict mathematics with sound research methods and simulation -- something that many of the big-money funds did not do.

Where to Learn?

There is so much conflicting interpretation and advice that it is confusing for the average investor, no matter how smart she is.  There is so much bombastic comment, loaded with symbolic language, that the average intelligent investor may not know where to turn.

The problem of finding good sources of information -- analysis as well as anecdotes -- is the major challenge for an investor making his own decisions.  An incorrect choice of sources means that a little knowledge can actually be dangerous.

One of our ongoing missions is how to find dependable sources, especially in a multi-year climate where perma-bear blogs regularly hit the top of the ratings charts, even when their forecasts have been quite wrong.

The Three Stooges and the Seven Dwarfs

A recent poll by Zogby International showed that 75% of the people can name the Three Stooges, but only 42% can name the three branches of government.  80% could accurately name two of the seven dwarfs but only 30% could name two Supreme Court justices -- and Clarence Thomas was the most frequently named.  There is more fun:  Harry Potter or Tony Blair, Krypton or Mercury.  The inescapable result is that the people polled lacked relevant knowledge of a pretty basic sort, while possessing knowledge from television and other entertainment.

This is nothing new, of course.  I used to give a basic knowledge quiz to Poli Sci 101 students.  About half of them (based upon a multiple choice question) thought that the Electoral College was "a small liberal arts school in Minnesota."  Many polls have shown that about half of U.S. citizens cannot name their own Congressperson.

The Zogby survey reflects all of U.S. society.  The people questioned are not stupid and many of them have college degrees.

In upcoming posts we will pursue this theme a bit, since it provides a tremendous opportunity for investors. It is one that has been explored at some length in non-economic social science studies and more recently in the study of behavioral finance.  Two major themes of our work here at "A Dash" are as follows:

1. Investors, like voters, are poorly informed and subject to various psychological influences.
2. Investment managers and pundits are subject to the same influences.  Reading a book about behavioral finance does not innoculate one from the effects.

In the political world, there are mechanisms that allow us to have a great democracy despite widespread voter ignorance and apathy.  In the investment world, the mechanisms that might accomplish this are seriously flawed.

In democracy, you and I cannot take advantage of a poorly informed electorate.  In a poker game, poorly informed opponents make it much more attractive to play.

Trading or investing provides a similar opportunity.  While investing is not gambling, the poker game is a good analogy when it comes to knowledge.  You cannot profit from people not knowing who is on the Supreme Court, but you can profit when the the market does not accurately reflect information about investments.

Hedge Funds and ETF Trading

Jeff Macke is a very intelligent man, a sharp trader, and someone with a lot of good ideas.  So is Doug Kass.  That makes them two excellent examples of a strange phenomenon in hedge fund management.  It has important implications for those trading the individual stocks within ETF's.

Macke was on CNBC tonight and described his trading in ETF's.  He said that he often had opinions about the price of oil or precious metals and did not want to deal with the eccentricities of individual stocks.  He just bought or sold the ETF based upon his opinion of oil futures or gold futures.  Doug Kass recently described a similar trade where he took a synthetic position in SPY with options.

This raises a question:  Why don't these big-time, highly visible traders have futures accounts?  The futures are deep and liquid markets with favorable margin treatment, low commissions, and little slippage.  For those steeped in the tradition of the Chicago options and futures markets, this is second nature.  When trying to implement it in my fund, I learned that prime brokers did not even have the accounting set up right.  It took a little work to get it going.

Why is this important?  Well suppose that you trade in the upstream end of the energy market.  Exploration and production stocks and oil services names should be mostly geared to expectations some years out.  The biggest factors are long-term energy demand, future bookings, and capex spending by the integrated oil firms.

But that is not how they trade.  If the big shots do not trade the futures, imagine what is happening with investment managers and individual investors.  The latest example is the TV commercial of the construction guy in the Jaguar who "has a feel" for sectors, trading them on a laptop from the job site, even though he does not follow individual stocks.  Sheesh!

For anyone who does want to do some homework on specific names, this ETF proxy trading generates opportunities for both buying and selling when the upstream stocks get out of line.

There are probably other similar chances, but energy seems to be the most obvious.

Steven Levitt and Two Poles of Research

Steven Levitt and his team of researchers made an appearance at the recent North American Bridge Championships in Chicago.  He was conducting research that was vaguely described to some of my participating friends as the transferrability of knowledge from one card game to another.  The experiment was quite interesting, and I look forward to his analysis.  His next stop was to test players at the World Series of Poker.

His appearance reminded me that while I have highlighted his excellent book, Freakonomics, I have yet to comment on it.  It is a very important work for those of my generation who learned and taught research methods.  My guess is that only one in four of those trained in public policy research stayed in the academic world.  Here is why.

The academic world prizes careful scholarship, building brick-by-brick on past work, extensive peer review, and use of the most sophisticated methods.  The result is that it was difficult for the Vietnam-era scholars to achieve their "change the world" goals.  Most policy makers did not share our interest in cost-benefit analysis and most academics did not prize practical policy work.

Wall Street research is a polar opposite.  Those with the most visible jobs crank out some sort of analysis almost weekly.  There is no peer review.  There is an unwritten code about criticizing anyone else's work and no time to get the opinion of peers before floating the latest research product.  (Readers of 'A Dash' know that we are free from this constraint.)

The result is that Street research is of comparatively poor quality.  Even the most expensive services make many mistakes.  Sometimes the researcher looks at a small number of cases without any historic context.  Other times the researcher uses the power of the modern computer and the presence of large databases to look at every case -- regardless of the relevance, the existence of any hypotheses, or a prior idea about a causal model.

Analysts on specific stocks have a different task.  They used to serve investment banking goals and hype the companies that did business with their firm.  Now they are required to find a balance of "sell" and "hold" recommendations, even while the number of firms covered has shrunk dramatically.  This is why we find analysts making macro calls and offering opinions on the economy instead of covering their stocks.

Steven Levitt's work strikes an inspiring balance between these poles.  Many of us are delighted in the academic and popular acclaim he has received.  In our own work we aspire to provide the same practical insights -- using the right data, in the right time periods, in the right way.  We want to be like Steve.  I suspect that many of us would have stayed in the academic world if we could have found both his approach and the acceptance twenty-five or thirty years ago.

While we were not all as good as Steve is, some were.  The world did not seem ready.  For now, my generation of researchers is still trying to improve the quality of understanding in many fields.  Many are working in health policy.

At "A Dash" this work means trying to point out who is doing good research.  Our mission is to spot the data miners, back-fitters,  and the anecdotal story-spinners.

It is difficult to do, since consumers of investment research do not know what to look for.  Most are narrowly focused on what worked in the last year or so.  I have watched those doing great work lose their jobs when their models "did not work" for a a year or two.  Many "global strategists" are constantly scrambling to do "walk-forward testing"  thinking that this will keep them current.  The time horizon is dictated by the individual investor and hot money funds, despite our knowledge that this is a losing method.

Think about it.  The period from late 1998 to early 2000 was an extremely strange time, influenced by Y2K fears and an unprecedented surge in employment and the economy, well documented by David Malpass.  From 2000 to 2002 there was an equally strange plunge from these conditions with a rather shallow recession.  In 2003 there was a delayed economic reaction by businesses (more on this in a future post) because of the expectation of war.

If you were building a model, would you use that time period for your data?  It makes no sense, but that is what most big firm strategists did.  Those who chose more wisely are now with different firms, often with their own name as the corporate identity.  The economics of the Street has  punished good research and elevated back-fitting.

That (and maybe some election-year spinning in 2004) has brought us to a 30-month period where we have had repeated calls for economic collapse in the face of unprecedented economic and corporate success.

Future posts will continue to catalog the many prevalent research techniques that lack predictive power.  Steve Levitt got a prize from statisticians for the correct use of data.  I wonder what they would make of the body of Wall Street research.