A Dash of Insight

The Importance of "Being Right"

A few days ago, Abnormal Returns raised the interesting question of whether it is more important to be right or to make money.  The article cited past work, correctly noted that one could be dollar positive while losing in most cases, and showed behavioral finance literature on the concept of sticking with a thesis, even when it is losing.

This was a great article.  As a front-line investment manager, we know that it is a crucial factor in the thinking of many individual investors, the people we are trying to help.

As an aside, we congratulate Tadas on his new business relationship, and wish him the greatest success.  He has provided an extremely valuable service to investors and deserves some recognition and compensation.

An important bonus from his new approach is that we can now hope to get more such articles -- provocative questions, actually stimulating the rest of us to think and to respond.

The Merkel Response

Another of our featured sites, The Aleph Blog, took a different perspective.  Here is how David Merkel responded:

I’m going to take the other side of this one. This is a bear/choppy market argument. During a sustained bull market, being right makes lots of money.

When I choose stocks, I do all that I can to have the odds tipped in my favor — industry analysis, earnings quality analysis, valuation analysis, balance sheet analysis, free cash flow use, and even a review of the anomalies like momentum, volatility, balance sheet growth, etc.

It’s not perfect, but I typically have 70% winners, and my winners are larger than my losers. Being right helps make money… does anyone doubt that? But hubris destroys.

Does that mean I give up my risk control disciplines? No. I get things wrong, and when I am wrong, I cut my losses. Every 20% move down requires a review — if the thesis is intact, I buy enough to rebalance. If not, I sell.

Also, my methods continually improve my portfolio, selling things with less potential to buy things with greater potential.

Our Take

There was a lively response to the original article, with many good ideas.  It is a timely and complicated subject.

We often approach questions like this by stepping away from the instant question, looking at extreme examples from our own experience.  Let us take companies that are about to go bankrupt.

Experts know that the common stocks in these companies generally go to zero.  The common has no value, since the bankruptcy forms NewCo and the bondholders get equity.

This is very difficult to explain to investors.  The sentiment of the market often is focused on the general business of the company -- often with good potential -- rather than the economic fundamentals of the stock.

We have had several cases where investors wanted to buy a penny stock, about to go into bankruptcy.  We warned that the stock was worthless.

In several of these cases, all high volatility situations, the stock doubled after our advice.  Eventually , it went to zero.

Did we give poor advice?  Our experience and knowledge -- an understanding of the process -- was correct.  Anyone following the advice would have eventually been proven right.  Meanwhile, major gains were missed.

Could anyone predict that the stock of a bankrupt company would double, say from 75 cents to a dollar fifty?  Perhaps, but that is not our method.

The story of being right versus winning is far more complicated.  The emphasis on last year -- a single point in history -- has a special significance since the results were so dramatic.

We plan to revisit that question.  For now we wish to highlight a single point:

What is the long run?

A casino has a small edge, but makes money because there are many relevant bets.  It is more difficult for the individual investor.  The edge might be significant, but the occasions for testing it are smaller in number.  When does one see the "long run?"

Put another way, how many major financial crises have there been?  What constitutes a good record?

There is an obvious advantage to methods that get quickly into the long run.  Is there a way for the individual investor to participate in this approach, controlling risk, while getting good returns?

More examples and discussion to come.....

Investment Implications of the GM Bankruptcy

The GM news is a big business story, the largest industrial bankruptcy in history.

Is it a big investment story?

We encourage investors to be politically agnostic, to distinguish between interesting political stories and their own investment decisions.  We acknowledge, with thanks, the comments from Abnormal Returns on this distinction, as well as reader emails.

The Business Pitch

Those doing business stories -- television, print media, or online, have an audience.  Their consumers are more affluent, more educated, and more conservative than the average reader.  One result of the current economic downturn is that every media source is playing to the existing audience in a quest for hit count and ratings.

The result is predictable.  Here are the main business themes (sources omitted since there are so many):

• This is a huge government bailout, destined for failure;
• The union is getting a gift, bondholders are getting shortchanged;
• Obama is setting a precedent for future actions;
• The government will be deciding which cars should be built;
• The taxpayer will lose this investment, and perhaps more.

We are not going to disagree with these positions, since that is not our mission.  Each point is hotly contested by Obama supporters.  We shall leave it as that, although regular readers know that we believe in free markets and generally support only government actions that create useful private incentives.

The Investment Implications

The first question is obvious.  Did any skepticism about the expected GM bailout help an investor?  If it caused you to sell short GM stock, the answer is "Yes."  If it caused you to sell short the rest of the market, the answer is "No."

Why the disparity?

The market critics are relying upon a long causal chain, where something bad is going to happen many months in the future, often requiring several different events.

Meanwhile, the immediate impact is that fewer jobs will be lost, auto parts suppliers will stay in business, and the general adverse economic impact will be mitigated.

Thirty billion dollars was viewed as a lot of money at the time of the Bear Stearns buyout.  Here at "A Dash" we think it is still important, despite the massive scale of other government interventions.

Our own time horizon is one year or less.  This viewpoint is widely shared by investors, so it is no use fighting it.  Most people see the immediate economic impacts as positive, despite the pounding criticism from the punditry.

Perhaps it will all play out badly in a year or so.  We will have time to adjust our positions as the story plays out.  If Obama and Barney Frank start dictating the details of auto production, there will be time to react.

Meanwhile, investors must decide whether they want to use their politics as the basis for their investments.

Irony of the Day: S&P Opinion on Sovereign Debt

US Equity and Bond investors had a tough day.  The reason?  According to most pundits, the proximate cause was the S&P downgrade of UK debt.  Many observers decided that the US might be next.

Bill Gross of PIMCO weighed in. 

The United States will face a downgrade in "at least three to four years, if that, but the market will recognize the problems before the rating services -- just like it did today," Gross told Reuters.

Accrued Interest writes in this article, Bill Gross:  Do you trust him? as follows:

Enter Bill Gross, always eager to talk his position. He stokes the fire by saying that the Treasury market is selling off due to ratings fears. Maybe. Indeed, I've heard that Asia is selling today. But always remember, when Bill Gross talks, he is always always always talking from position. So I'm assuming Gross is short Treasuries and today is adding.

No one outside PIMCO knows their position, but Gross is a savvy guy, so he is not speaking to hurt his own fund.

Jon C. Ogg points out that none of this is new information.  Writing in his article, Did Bill Gross Short Sell Stocks & Bonds Via U.S. "AAA" Rating Comments?, he notes the following:

It is easy to add panic to the fire when you get an actual downgrade as we saw today from S&P on the U.K.  Technically, that is just a bias downgrade, but that is still enough.  The notion that someone with the clout of Bill Gross bringing this risk to light is troubling for investors who have been preparing for the next wave of the economy and credit to be better rather than worse.

The Irony

There is an exquisite irony in worrying about the S&P downgrade.  This is a company vilified by nearly everyone for the failure to recognize the subprime risk, lamely giving AAA ratings to assets now viewed as "toxic waste."

All of a sudden, we are viewing these guys as the brilliant analysts who know the potential for nations to pay back debt.  Really?

There is a serious public policy issue about government "bailouts" and the debt required.  It is a matter of discussion among many serious economists.  We do not pretend to offer an answer--not yet.  At "A Dash" we are (informed) consumers of such information.

While we are still evaluating the arguments, we can state a preliminary conclusion:  The S&P ratings will not be our first choice.

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.

Successful Financial Blogging

Let us suppose that one wants to start a successful financial blog.  The start up costs are low, so many will take a shot at this. What defines success?

Part of our experience is advising early-stage companies.  It is a good model for a blog.  What should one do?

• Learn the market.  The blogger needs to understand the readers -- who they are, their viewpoints, and what they want to hear.
• Understanding behavioral finance.  Most readers track on what worked most recently.  That is how the heroes are found.
• Go for the rankings.  The various ranking services start -- and mostly end -- with traffic.  If you write something that appeals to the online audience, you have a better chance of success.  Most of those doing rankings are not qualified to evaluate the content, so ratings dominate.
• Post frequently.  The more you write, the more people visit your blog.  Many raters use frequency of posting as a filter.
• Exchange links.  Be willing to trade links with nearly anyone.  Offers abound.

Identifying the Online Audience

Here is a dramatic example of what works online.  The best example is the recent online poll by Time.com.

In a stunning result, the winner of the third annual TIME 100 poll and new owner of the title World's Most Influential Person is moot. The 21-year-old college student and founder of the online community 4chan.org, whose real name is Christopher Poole, received 16,794,368 votes and an average influence rating of 90 (out of a possible 100) to handily beat the likes of Barack Obama, Vladimir Putin and Oprah Winfrey. To put the magnitude of the upset in perspective, it's worth noting that everyone moot beat out actually has a job.

This tells us very little about who is most influential, but a lot about those taking the poll.

The frequent polls on CNBC and other sites tell us a great deal about the trading audience -- what they believe, their positions, and what they expect.  These polls are mostly skeptical of any government program, the future of our country, and the prospects for the economy.  They are widely divergent from polls that use a scientifically selected group.   These polls show a wide acceptance of Obama and his policies.  This is not a political statement, but merely a look at some facts.

It pays to cater to the online audience.  Andrew Leonard's Prophets of Doom list is also a list of the most popular blogs and commentators (with a few prominent omissions).

Popularity Pays -- for Someone....

Popularity clearly pays for the bloggers.  They are wisely following a successful model for an early-stage effort.

Our mission is quite different.  We attempt an objective interpretation of data, an effort to find the best sources, and a willingness to alter short-term perspective.  In particular, we are skeptical of sources swinging outside of their "happy zone" (hat tip to Ted Williams -- click through to see the famous strike zone picture).

For the individual investor trying to find help from the Internet, this is a minefield.  The information from the popular sources is unrelentingly negative.  Meanwhile, the real story is not so clear.

Investors should pay attention to data, not opinions -- and especially not political opinions.  There is a time lag in the impact of government policies.  It is time to start monitoring the lagged effects of lower interest rates, innovative Fed policies, and the stimulus package.

Does Blogging Enable Market Manipulation?

The greatest strength of financial blogs is also a potential weakness.  There is so much information that readers frequently rely upon the interpretation of the writer.  Most people do not click through to the supporting links.  They go to their favorite sources for information, and generally rely upon the interpretation of the writer.

We know this is true from our own stats, even when we strongly encourage readers to check out an entire article.  Readers rely upon us to make accurate representations of source material.  We are expected to provide a fair summary and accurate illustrative quotations.

Fair enough.  No one has time to check out all of the sources, no matter how carefully we try to document.

This is in sharp contrast with mainstream print sources, where editorial procedures review material before it is published.  Not so in the blogosphere.

The issue can be simply stated:

Blogs with a wide following have a special responsibility to check and re-check accuracy before posting.  If the authors do not do so, there is an easy means of manipulation.

Step one:  Get a dubious story out there somewhere -- anywhere.

Step two:  Get a noted blogger or pundit to mention the story.

Step three:  Mainstream media sources race each other to be first with this news.

Trust in link sources is vital.

Strong Sources

We feature several blogs where the authors provide plenty of links and summaries.  Some of the sources are anonymous bloggers.  We believe this conveys a special responsibility, since the reader does not know the background or skill of the writer.  It takes more evidence to be convinced of these sources, but the proof is evident in the work.  If one checks out the links, the accuracy proves out.

Here are examples of sources where the links are fairly interpreted with very high reliability:

• Abnormal Returns.  The summary tells you what you will see.  You can choose whether to read it.
• Charles Kirk.  Always interesting, always accurate.  Many interesting links.
• Alea.  Anonymous, but with special insight on credit markets.
• Calculated Risk.  Respected by everyone -- earned through accuracy.
• Paul Kedrosky.  Especially useful in finding interesting academic papers.
• The Big Picture.  Barry has a viewpoint, but his sources are always carefully documented and accurate.
• Muckdog.  We like the "everyman" viewpoint, which often captures the spirit of the market.  The links support his statements.
• Dr. Brett.  Unchallenged authenticity, with widely varying interests.
• David Merkel.  What you see is what you get in links at The Aleph Blog.
• Adam Warner.  The quotes are always representative.

We are leaving out many, of course, but this is designed to illustrate.  The WSJ blogs, for example, are carefully sourced.

The Jury is Out for Some

Like many others we follow the work of the anonymous blogger "Tyler Durden."  Seeking Alpha assures us that this person is an authority. He has rocketed to a high level in the new Seeking Alpha rankings -- a position of influence and responsibility.   Many of the articles display interesting and informative insight concerning the inner workings of big firms and hedge funds.

Since there does seem to be a viewpoint in the Durden work, we have great interest in the sourcing and evidence.  Let us look at an example of links from the prolific Durden.

Must read on CNBC propaganda: "Immelt and NBC Uni CEO Jeff Zucker supposedly told top CNBC executives and talent to be less critical of President Obama and his policies" This explains why nobody with half a brain watches CNBC anymore (THR hat tip Guest)

Since we have opined on CNBC politics, this was of great interest.  Our viewpoint is that opinion shows like Kudlow's in the evening are interesting and informative.  Viewers know what they are getting, and it is a lively debate.  We do not like the intermingling of politics and journalism during the business day, when CNBC anchors get to interview authoritative guests.  We are not very interested in the opinions of the journalists, and viewers should not be either.

If one reads the link, one can readily see that the quoted section does not accurately represent the article.

First up was a woman asking about a reported meeting in which Immelt and NBC Uni CEO Jeff Zucker supposedly told top CNBC executives and talent to be less critical of President Obama and his policies.

Immelt acknowledged a meeting took place but said no one at CNBC was told what to say or not say about politics.

During the woman's follow-up question, her microphone was cut off.

The key point is that Immelt denied the charge in the Durden quote.  Perhaps he suggested that journalists should be journalists in non-opinion shows.  We do not know, of course, but that would be a good thing.  Helping investors to separate political decisions from their finances is good advice, as we have frequently suggested.

Even more telling is this section from the rest of the article:

Later, during the umpteenth question about MSNBC, another shareholder's microphone was cut, according to multiple attendees.

"The crowd was very upset with MSNBC because of its leftward tilt," one attendee said. "Some former employees said they were embarrassed by it."

One specific complaint about MSNBC concerned Keith Olbermann's interview of actress Janeane Garofalo, who likened conservatives to racists and spoke of "the limbic brain inside a right-winger."

We spend very little time on MSNBC, but from what we have seen, we can understand the criticism.  Once again, the key is whether the program purports to be journalism or opinion.  This part of the article is exactly the opposite of the theme of the Durden quote.

Briefly put, we do not think that the Durden summary of the link is a fair and accurate representation of the article.

Another recent  example is the unsourced claim that SPY is hard to borrow.  This was challenged by Doug Kass (full disclosure -- Kass is a valued colleague at TheStreet.com).  Kass checked this out and found no problem with a borrow.  Here is the Durden response:

Update 4: Doug Kass disagrees:

I have received emails from several trading sources, stating that the market is rising because the SPDRs (SPY) are hard to borrow now and arbs are being squeezed.

This story is hogwash, as I just tried to borrow 500,000 SPDRs and had no problem doing so!

Position: Long SPY; short SPY puts and short SPY calls

Maybe Doug can disclose at what term and rate he got the borrow. Doug - I am dead serious - can I borrow 5 million SPY right now at 0% from you? Hell, will give you 1%

We expect to hear more about this dispute.  Meanwhile, anyone wanting to short the market can do so through a futures account.  There is no problem in "borrowing" e-mini's to go short, the method favored by those of us in Chicago.  There is an arbitrage opportunity with SPY.  The claim of a problem in shorting does not have face validity, so we look forward to some evidence.

Our Take

It is easy for investment readers to be swept up by apparent authenticity, especially from a source that everyone seems to follow.

We hope that "Tyler Durden" will balance frequency of posting with accuracy in representing links.

We have a continuing concern about the "leaked stress test" story, where he is a supporter of a dubious source.  That is a question for another day.

Jim Abbott and the Wall of Worry

Regular readers of "A Dash" are familiar with our loyalty to the University of Michigan and also our notion that sports can provide valuable insights for investments.  Here is a good example.

Jim Abbott

Truth is stranger than fiction.  Who would think that a person missing the fingers on one hand could be a successful big-league pitcher?

Jim Abbott is the implausible hero.  This weekend his number "31" will be retired by the Wolverines.

When Abbott was still in grade school, one opposing coach ordered his batter to bunt, forcing Abbott to field the ball. Abbott pitched with his glove resting on his right hand. After he released the ball, he slipped his left hand into the glove, fielded the ball, then performed a nifty maneuver where he'd stick the glove under his right arm, let the ball fall into his left hand, and throw it to first base.

"I don't ever remember it being something I had to master," he says. "It was just something I did." He made the play as smoothly as a magician pulling a nickel out of your ear. One down.

Thinking it was a fluke, the coach ordered the next batter to bunt—and the next. Finally, after six batters had bunted, and Abbott threw all six out and the coach called off the experiment—making the coach the only embarrassed person in the park.

Abbott's career included the following highlights:

• Winning the 1988 Gold Medal Olympic game against heavily-favored Japan.
• Vaulting directly to the major leagues, one of a handful of players to skip the minors.
• An 18-11 record and a 2.89 ERA in his third year in the majors.
• A no-hitter in 1993.
• Providing an inspiration to handicapped kids everywhere.

Investment Implications?

We see Abbott as a symbol of the Wall of Worry -- the current market condition.  In January we wrote the following:

We expect that market skepticism will be a "wall of worry" and that market gains will require actual evidence of improvement in housing, the economy, and corporate earnings.  The market will anticipate improvement, but some evidence is needed.

There are many economic problems -- all well noted and discussed by many (including us).  Most observers seem to believe that this means that markets should always move lower, with no particular destination in sight.  The skeptics tell us to ignore any evidence to the contrary.  Consider some examples.

• Wells Fargo pre-announces good earnings.  The punditry rushes to tell us how wrong this is.  Check out Tom Brown for some detailed analysis of the critics.
• Goldman pre-announces good earnings.  The punditry rushes to tell us about the "hidden month" as they shifted, as expected for their new role as a bank holding company, to a calendar year.  Writing about this shift generated a lot of page views, but those looking ahead might have a better grasp of the earnings potential.
• Intel announced good revenues and earnings, and suggested that there was a bottom in the PC market.  Pundits complained and the market weighed to the sell side.  Why?  The company did not give "hot" guidance.  Is this a surprise?  Companies will remain cautious in guidance until well beyond the economic turn.
• The stimulus will not work, say the political critics.  They are confident about this even before they see any data.
• The PPIP will not work, say the pundits.  They are confident before the participants are even announced.
• Anyone who booked the 20% gain in the last month has enjoyed a "sucker's rally."  If you Google this term you will see 500,000 hits, all telling you how stupid you were.

Our Take

We have no illusion that every story will turn out to be wonderful.  Our own position has varied both with economic events and the tape.  Over the last several weeks there have been many positive signs and we have identified many profitable sectors.

The media and the blogosphere remain skeptical of any positive news.  This is the definition of the Wall of Worry.  The average front page at Seeking Alpha has a rash of featured bearish bloggers.  The links from Abnormal Returns now include many sassy skeptics.  The comments everywhere tilt heavily bearish.

It is like Jim Abbott's opposing coach in Little League.  It seems implausible.  It is how sustained market advances occur  -- one step at a time, with setbacks.  Each new piece of evidence is greeted with skepticism.  It may take several good plays in a row before the many skeptics get on board.

(Full Disclosure:  Long INTC and GS)

The Wide-Ranging Thoughts of Dan Niles

We always turn up the sound and back up the TIVO when we see  Dan Niles on financial television.   He has a well-deserved reputation for great knowledge of what is happening in technology, especially semiconductors. He combines this information with superior analytical skills.

We were treated to several of these conclusions in his CNBC interview today with Maria Bartiromo.  Niles continues his bullish stance on technology for the remainder of 2009, while allowing for some pullbacks.  In particular, he suggests that we look for companies that have already guided down significantly on revenues -- 50% or so -- since these are the firms that will now be guiding higher.  Watch out for those that did not reduce earnings forecasts enough.

The interview then continued with a list of his biggest concerns. He offered opinions about how much further home prices would decline, the amount of "toxic assets" remaining to written down and long-term debt issues.

Everyone is  familiar with these issues, but there was nothing special in the analysis.  It is a story that one can read anywhere.  Does it make a difference that Dan Niles believes this everyday story?

Perhaps.  To the average listener he sounded just as much an expert on housing as he did on technology.

Six months ago we had an article featuring the famous picture of Ted Williams and a strike zone filled with baseballs. It showed his batting average when he stayed in what he called his "happy zone" and what happened when he did not.

(Full disclosure -- we are long INTC in personal and client accounts).

With the start of the baseball season, fans might enjoy a look at this, but the article is more about how to parse information. Everyone is entitled to an opinion, but why listen if the expert is reaching for a pitch in the dirt?

The Pundits Strike Out

Here at "A Dash" we try to focus on the implications of public policy for investors.  We have opinions about the best policies.  We also try to distinguish between the citizen role and the analyst role.

Most of the punditry has been unrelentingly bearish for months.  Nothing was working.  Nothing would work.  All solutions would fail.

Meanwhile, there is a key question:  What will get the economy back on track?

Everyone agrees that 30-1 leverage at investment banks and the unregulated CDS market were mistakes.  From this, some conclude that all mortgage investments are "toxic" and that we must return to some historic debt/GDP ratio of olden days.

Perhaps that will happen, but it need not happen at WARP speed.  The combination of  FAS157 and the interminable delay of the Presidential transition and the development of the Obama Administration plan created a sense of doom -- a self-fulfilling prophecy.

A weak economy means lost jobs, little housing demand, more foreclosures, lower home prices, declining asset values, and no incentive for lending.

A solution to economic problems needs to break this cycle.  Anything that restores normal and sensible lending will help the economy.  Business activity depends upon a normal commercial paper market.  It also means that qualified borrowers can get loans for homes, cars, and education.

The so-called "toxic assets" are central to this problem.  The mission for Obama and Geithner was to address the issue in a way that restored normal and sensible lending.

The Plan is in Place

There is a simple strength to the plans now proposed:  Flexibility.  The Administration does not pretend that there is a single solution.  There is no presumption about the value of assets now on the books of financial institutions.  There is the ability for some institutions to hold assets, probably with mark-to-market relief.  Other institutions may choose to sell assets to the new public private investment partnership (PPIP).  No one knows how many  banks will choose one method over the other, but both will help.

The outlines of the plan have been known for weeks.  The federal government is providing non-recourse loans to investors, allowing a high degree of leverage for those bidding on distressed assets.  This removes the illiquidity stigma and provides an imbedded "put option" for new investors, as John Hussman notes here, and as we have predicted would occur.

Is This a Good Policy?

The true answer is that no one really knows.  It depends upon whether it works.  If it succeeds in stabilizing the economy and restoring normal and sensible lending, the government guarantees will not come into play.  Investors and the government will profit.  If it does not work, the government will experience losses.

Whether this is good policy depends upon the risk of the guarantees compared to the near certainty of further economic declines in the absence of action.

In typically excellent fashion, Abnormal Returns noted yesterday that "the Treasury’s new plan for toxic assets is hopelessly complex and overly generous.  Check out the many links in the post.  Following up today, Abnormal Returns observed that "the stock market loves the toxic asset plan. Every one else pretty much hates it. Who's correct?"  Once again there are many pundit links.

The Pundit Error

The problem for investors is that pundits often stray into long-term opinons about public policy.  They often begin with an idea of what assets are worth.  They speculate about who will participate, generating over-simplified stereotypes about how financial institutions will react.  They look far into the future about possible inflation (not the current issue) and confuse normal lending with excessive leverage.

Briefly put, everyone has been writing bearish posts to be in line with the market and to get visibility.  It seems wise.

Only a few observers, like Doug Kass, who called a "generational market bottom" were willing to look ahead at the possible impact of the collection of proposals and the likely impact.

The problem is that the policy implications are difficult to forecast.  When you are swinging out of your "happy zone" you are likely to have a lower batting average.  Hat tip to Ted Williams.

A Flexible Solution

Regardless of our opinion of the specific solutions, the key question is whether they will work.  We like the flexibility of the plans.  Some will work better than others, but the collection offers promise.

Our TCA-ETF model picked up the growing market support for these initiatives last week, helping us to a good position for today's market action.  The market reaction includes many voting with dollars rather than writing articles.  It is meaningful.

We repeat our frequent message:  Investors should put aside policy opinions and focus on the immediate effects.

Mark-to-Market: Prospects for Change

There is a lot of buzz about a Congressional hearing on mark-to-market accounting, scheduled for Thursday.  Much of the information is inaccurate or misleading.  Astute investors should understand the purpose of the hearing and what might happen.

Background

When Congress passed the original TARP legislation it required the SEC to study the  possible link between accounting rules and bank failures, reporting within 90 days.  They complied with a series of round tables, public commentary and a report.  This was the last action of the Christopher Cox Chairmanship, with Cox and senior staffers leaving immediately thereafter.  The recommendation was to keep the rule and do minor tweaks.  This is not what Congress expected or hoped for.

The Obama Administration

We have watched closely for a sign of interest from the Obama team concerning this issue, but there has not been much.  Paul Volcker, a senior advisor, favors a change, but there is no sign from anyone else.

Few seem to understand the rules.  Tonight on Kudlow, Steve Forbes, a strong advocate for suspending the mark-to-market rules, stated that the President or the Treasury could change this with a stroke of the pen.  This is not correct.

The accounting rules, as we have frequently written here, are determined by the Financial Accounting Standards Board (FASB), a group that strongly embraces using market prices.  The oversight of FASB is completely under SEC control  The new SEC chair, Mary Schapiro, showed little interest in this subject during confirmation.

This is not something that Treasury can change or the President can change.  The President cannot even fire Schapiro.  He had his chance in making the initial appointment, and it apparently was not an issue on the front burner.

The Hearings

Thursday's hearings are in front of the House Financial Services Subcommittee on Capital Markets.  What does this really mean?

In the legislative process this does not mean much.  A sub-committee has hearings and perhaps reports a bill to the full committee.  There is then another vote.  The bill needs a "rule" from the House Rules Committee.  Perhaps it gets one and a vote on the House floor.  Then the process is repeated in the Senate.  If a bill is passed in both houses, it goes to a conference committee to reconcile differences.  The final version, if passed, goes to the President for his signature.

We are astounded at the lack of information about basic political processes from everyone covering this story.  It is all the material from an introductory class on American Government.

The Real Message of the Hearings

Most Congressional hearings are not really about passing new legislation, although that is always the stated purpose.  Sometimes it is just intended to send a message.  Readers who are sports fans might remember Congressional interest in the BCS and football playoffs, baseball and steroids, or similar topics.  Congress uses the power to conduct hearings to create a body of information and to focus attention.  By threatening legislation, they move others to change behavior.

In this week's hearings we expect testimony from accountants who will emphasize the significance of market-based pricing to ensure visibility for investors and to avoid future Enron's.  This will include official SEC accounting experts.

There will also be some who explain the pro-cyclical nature of the current accounting experiment, conducted in real time.

The issue cuts across partisan lines.  Many Republicans prefer relief on mark-to-market accounting to additional TARP-style investments.  The destruction of regulatory capital via the FAS 157 rule has proceeded far more rapidly than the government can or will provide new investments.  In addition, the system has discouraged any private investors.  Many free-market adherents would prefer some regulatory relief rather than a system where Barney Frank tells  private companies whether they can conduct golf tournaments.  It is a philosophical position.

Democrats are mixed in their viewpoints, which should make entertaining viewing for policy wonks.

Investment Insight

Anyone looking for an investment angle can ask two very simple questions:

1. Are the most important Committee members trying to send a message to the SEC?
2. Is Mary Schapiro listening?

Unless the answer to both questions is "yes", investors have a long wait for any relief on the FAS 157 rules.