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Book Review: George Lindsay and the Art of Technical Analysis - by Matt Temple

2011-10-12T22:27:00.000-05:00

Every so often there comes along someone willing to think outside of the box, someone who takes a different perspective. In Ed Carlson’s newly published book, George Lindsay and the Art of Technical Analysis, we are reminded of one such man. George Lindsay was a profound market analyst that was on the brink of obscurity before Ed Carlson compiled what was left of Lindsay’s old newsletters and what he could gather from the personal accounts of Lindsay’s peers and family.

Carlson has four parts to the book and begins part one with a biographical chapter, describing Lindsay as an eccentric and private man. In the latter half of part one, Carlson includes a chapter on Lindsay’s only published book, The Other History, based on a technical analysis of rhythmic patterns in history. Although not integral to the main discourse, it is a quite interesting concept that provides color to the man and his methods. Before his work as a market technician George studied art and engineering, working as an engineer for McDonnell Douglas during WWII. It is uncertain where George developed his interest in markets, but by the early 1950s he had started his own advisory service and began distributing his weekly newsletter, George Lindsay’s Opinion. These old newsletters are the source of most of the content for Carlson’s book. Lindsay spent much of his career studying historical market movements and identifying pricing patterns. Carlson does a remarkable job of presenting a couple of Lindsay’s best methods, the “Three Peaks and a Domed House” technique, and the “Lindsay Timing Model.

Lindsay’s “Three Peaks and a Domed House” technique is discussed in part two, a four-chapter segment. In it, Carlson describes the method as a whole before delving into the particulars. The technique is used to time bull market peaks, though the pattern does not always develop. He goes on to walk the reader through identifying the components of the formation through the use of graphs and historical examples. In addition, Carlson includes answers to how one would handle irregularities in the formation of the pattern. He also includes a discussion of Lindsay’s “Tri-Day Method” of calculating the level of lows that can be expected in the subsequent bear market.

Part three covers another of George’s methods called the “Lindsay Timing Model.” The method is based on “counts” and can be applied to individual stocks, indices, and commodities futures. The model has three basic concepts that use short-term intervals, or counts of days, to indentify turning points in the market. The model relies heavily on the ability of the analyst to identify key dates and ranges, which the author describes very clearly in the text supplemented with use of graphs and examples. These counts and key ranges can vary depending on the movements of the market. It is important to know how and when to use these techniques, and Carlson does a thorough job of describing them. This method is more focused on timing short-term movements in the market, as opposed to the methods discussed in the fourth and final part.

In part four, Carlson describes how Lindsay applied the concept of counts to longer duration intervals, or cycles, and in the last chapter he provides a case study conducted using interval counts during the 1960s. It’s very helpful that Carlson includes a case study, as the methods are somewhat complex, even though he effectively demonstrates them to the reader. He again describes in detail the different lengths of intervals and how and when the reader can apply them.

Carlson has done a fine job in both his research and presentation. It is obvious that these are not simplistic methods, so it is easy to appreciate the reader friendly style Carlson used. It is clear that he took the time to learn and understand Lindsay’s methods before attempting to write the book. Anyone interested in the direction of markets can benefit from learning the unique techniques presented in George Lindsay and the Art of Technical Analysis.

Sam Debio, Artio Global Investors - by Aaron Socker

2011-09-28T22:03:00.000-05:00

We are seeing a flight to quality. These are the words of Senior Portfolio Manager, Sam Debio, of Artio Global Investors during the CFA-sponsored lunch-in at the Milwaukee Athletic Club on September 28. Mr. Debio has been with the firm since 2006 and manages a small cap core equity portfolio with the ability to tilt the fund’s investment style towards growth or value stocks based on market conditions and fundamental bottom-up analysis. With ever increasing macroeconomic concerns, the portfolio manager is seeing “short term volatility”. But as a long term investor, Mr. Debio sees potential upside to current valuations over the next 3-5 years.

One of the key components of Debio’s presentation revolved around economic trends and the future outlook of domestic equities. He states “corporate earnings are growing, but stock prices are declining”, which begs the question, why? The market is telling us that valuations are going lower and there is poor appetite for riskier assets as investors are moving into safe havens. There has been a trend over the past 6-8 months of money being pulled out of micro, small, mid and large cap stocks, respectively, as this asset allocation shift plays out. This is the natural process of investors curbing their risk appetites. However, he feels that stocks are starting to look cheap at current levels as media coverage has created a negative feedback loop and spooked investors. Negative sentiment has overwhelmed the markets.

The next portion of Debio’s presentation focused on the Fed and inflation. He talked about how the Fed may want higher inflation because nominal debts are repaid with cheaper dollars. Additionally, nominal wages and tax revenue should rise as a result, leading to increased sales growth for corporations. This would lead to a positive wealth effect which should be good for stocks in future quarters. As this scenario may play out, investors should start to diversify and not try to time the market as it is very difficult to make market timing bets.

In the short term Debio expects additional market volatility. However, this could present attractive entry points for investors with longer term horizons.

Andrew Barker, Artio Global Investors - by Dan Leibforth

2011-09-28T21:43:00.000-05:00

This time is completely different. Those were the words spoken by Andrew Barker, Senior Portfolio Manager at Artio Global Investors during the CFA sponsored lunch-in at the Milwaukee Athletic Club. He was referring to the current economic conditions in comparison to the financial crisis of 2008. In 2008, it was a very dangerous time to “stick your neck out” due to the unpredictability of both the markets and the actions of policy makers. Now, he argues, is time to take a completely different approach.

Emerging markets have been a popular asset class, but
Barker argues that we have been focusing in the wrong areas of the emerging markets. He believes we need to be looking at domestically focused companies in the emerging economies. Consumer growth has been the largest area of market expansion and an area where we should be focusing. Emerging markets in the past were held “hostage” by consumers in developed economies. There was too much emphasis on exports and not enough on domestic growth and infrastructure spending. Specifically, he mentioned a number of countries whose consumer growth stories present areas of future investment. China is the most appealing because of the sheer size of the domestic market and the rapidly growing population. Additionally, Barker argues, the Chinese have the most capable policy makers in place who have already made strong structural improvements to the Chinese economy and have the lowest risk of making a policy mistake when compared to other emerging markets. While China does present potential upside, Barker criticizes the Chinese because they are still a long way from becoming innovators within the global marketplace.

Other areas of the global economy that he believes present strong opportunity are Russia, Africa and India. Of these, Africa appears to be the most intriguing due to extremely high growth as well as high barriers to entry. There has finally been a development of the middle class which presents opportunities for businesses and, in turn, investors. Barker focused on the development of a supermarket business which has proven to not only be sustainable, but has created quite an economic moat versus competitors. One of the reasons for its success are the extremely high barriers to entry which, Barker argues, will remain in place well into the future. Barker also believes that India could potentially be stronger than China in the long run, but currently has structural issues that must be addressed. India needs to focus on manufacturing to support their already established service export industry.

Finally, Barker, who manages an international equity portfolio, gave his thoughts on the situation in Europe and how to best position your portfolio. He believes that people didn’t fully understand the implications of grouping all of the European nations together and the amount of structural challenges the group would encounter. He believes that the current situation was an inevitable outcome that people are now finally beginning to realize. Barker claims that there needs to be clarity to the prevailing solvency issue and that injecting liquidity will not solve the problem. He believes we need to look through the short term noise and focus on the near term (3 – 5 years). Portfolios should avoid any exposure to domestic Europe and focus on finding companies that have a sustainable business and a technological edge versus competitors. Furthermore, one should find companies that provide strong dividends and have strong management teams that can direct the company through the current environment and emerge as market leaders in the near term. Barker concluded by outlining a hypothetical portfolio that he believes would outperform in the next 5 years. The portfolio contained direct exposure to emerging markets and large cap names with a strong reputation, proven history of success and a sustainable business model.

Marc Faber Dinner Presentation - by Matt Alexander, CFA

2010-06-29T22:11:00.017-05:00

The presentation could have been titled, “the unintended consequences of US monetary policy.” Marc Faber, Fed critic and publisher of The Gloom, Boom and & Doom report, roughed-up the usual suspects on March 11th at the Madison Sheraton. The annual dinner event was hosted by CFA Society of Madison and co-promoted by CFA Society of Milwaukee.

The central theme in Faber’s commentary is that recent Federal Reserve policy, while attempting to address prominent domestic concerns, has unwittingly created huge distortions in the global economy, largely to the detriment of the United States. From an investment standpoint, he makes a compelling argument for recognizing the future consequences of high US inflation and uncontrolled debt growth while recognizing the sheer size and potential that the new world of emerging economies now holds.

Don’t you know how the money flow
Faber walks us down a familiar path of Fed Funds rate changes over the past decade, highlighting some of the key motivations and fallout of Fed actions. This groundwork helps Faber construct two main conclusions, summarized below, that cast doubt on the efficacy of Fed policy. First, please bear with some of the detail...

In response to fears of recession and, later, deflation following the collapse of the TMT bubble, the Fed began rapidly slashing the Fed Funds target rate from 6.5% in January, 2001 to 1.75% by year’s end, eventually easing to 1% by July, 2003. This historically low level was held until July, 2004, almost three years after the recession ended in November, 2001. Yet even as the Fed gradually tightened from mid-2004 through mid-2006, Faber claims that monetary policy was still highly expansionary. He offers some statistics below on the continuing credit expansion to support this claim.

By June, 2004, credit growth in the US was running rapidly at a 7% annualized rate. Yet, despite tightening, by August, 2006, credit growth had accelerated to an astounding 18% annualized rate. Between 2000 and 2007, total US credit expanded by $21.3 trillion while GDP grew by $4.2 trillion, indicating that each dollar of economic growth during this period was financed by $5 of credit. From this discussion, Faber aims to illustrate that a complete picture of the neutrality of monetary policy must be construed in the context of its effect on credit growth – a consideration Faber believes is given short shrift in Fed policymaking.

By July, 2006, the Fed stabilized the Fed Funds target rate at 5.25%, citing a cooling housing market and dampening effects of higher energy prices in its rationale. By September 18, 2007, the Fed acknowledged that deteriorating credit conditions (a result of indiscriminate credit expansion) would have the effect of intensifying the housing correction and restraining overall economic growth. Fearing a housing collapse and overall economic contraction, the Fed began a new campaign of monetary easing, citing improving core inflation as part of its rationale.

However, the measure of core inflation excludes some volatile price series, notably food and energy prices. Oil prices, which roughly tracked credit growth this past decade, had steadily escalated to a peak of $80 by May, 2006 (up 8x from 1998 lows). By the eve of September 18, 2007, oil prices had stabilized near $75 and credit growth had slowed. But, as if the renewed easing campaign were a cue, credit growth reaccelerated and oil prices nearly doubled to a new peak of $147 by July, 2008.

To drive home the significance of these price movements, Faber quantifies the additional burden of higher oil prices on the US economy: Annualized US outlays for oil had grown from $75 billion in 1998, to $500 billion by May, 2006, to over $1 trillion by July, 2008. If one accepts the link between interest rates and oil prices, as a net importer of oil, these additional US outlays were clearly an unintended burden on the US economy. Other commodity prices, including agricultural commodities, experienced movements of similar magnitude in this period.

Because the availability of additional credit creates incentives for further investment, or multipliers, asset booms, such as those recently experienced in housing and commodities, are created or intensified by credit. The root problem is that the Fed can control neither the intensity nor the sectors in which future asset booms will occur. Thus, Faber stresses that credit driven asset booms are not innocuous events but, instead, are sources of economic instability that create distortions in markets. As the latest example, he believes that the magnitude of the recent run-up in equity markets (some 70%) is also a direct result of a near zero Fed Funds rate policy.

Faber has two main points to take from the above detail. First, over the past decade, the Fed has unwittingly created a succession of imbalances, cropping up in various sectors, in its attempts to manipulate market adjustments to prior imbalances. Second, this game of whack-a-mole has also had an expansionary bias on the money supply and credit growth over the whole period.

Faber then turns to how US monetary policy has affected the global economy and the Unites States’ relative standing in it.

I didn’t mean to turn you on
We have just experienced the first global synchronized boom. Faber spends some time describing why a global synchronized boom had not been possible prior to this latest expansion, but it boils down to two main reasons: higher international trade and capital barriers (due to lack of participation by closed economies), and the relative lack of capacity in industrializing nations (due to small size and lack of infrastructure in relation to Western economies). These barriers had been largely brought down by the turn of the century, a process that had been more than 20+ years in the making, typically marked by the opening of China in the 1970s and reinforced by the subsequent fall of the Soviet empire. Faber illustrates that the pieces were in place, as never before, for industrializing nations and resource producing nations to meaningfully participate in the next expansion.

So far so good, but as you might have guessed, Faber believes that the global expansion, which should have been more gradual and organic over the past decade, was turbo-charged and distorted by US monetary policy.

The credit boom in the United States created extensive current demand at the expense of future demand, leading to domestic overconsumption by the private sector. This is reflected in the growth of the US current account deficit, from $150 billion in 1998 to over $800 billion by 2007. Overconsumption in the US was matched by overproduction in foreign economies. This trade accelerated growth in capital spending, employment and incomes, primarily in emerging Asia and, especially, China.

Historically, the terms of trade had been unfavorable for resource producing nations (Faber cites 1980 to 2001); raw materials/commodities prices had steadily declined while prices of imported goods had increased. Rapid industrialization in emerging Asia created new long-term demand for raw materials and energy as well as a new supply of finished goods to resource producing nations. The magnitude of industrialization in Asia effectively reversed the terms of trade to resource producers, leading to rapidly higher export prices and lower import prices – a positive reversal of fortune.

But the party ended badly. When increasingly dubious credit growth finally buckled under its own weight, the entire global supply chain was affected, resulting in a global synchronized bust. The ensuing unwind has laid bare some distortions created by the boom.

The world is awash in dollars. The US current account deficit has led to an eye-popping increase in international reserves, from $1 trillion in 1996 to over $8 trillion currently, 70% of which is held by Asian central banks. With vast reserves and strengthening currencies, emerging industrial economies are on a sounder financial footing, better able to compete with the West for political, strategic and economic influence. Faber believes the sheer magnitude and speed of industrialization, often driven by competition to be first-mover, contributed to an unintended transfer of technology and know-how from developed to emerging industrial economies. Another positive legacy for emerging economies is gleaming new infrastructure, even if there has been inefficient investment, likely leading to future positive externalities. Faber believes these positive legacies in emerging industrial nations are some of the building blocks that will create future investment opportunities for investors. On the other hand, the turbo-charged industrialization in Asia has accelerated competition for resources, exacerbating global tensions.

The legacy of the bust for Western economies is a bit more challenging. Consumers’ balance sheets are in terrible shape. Having heavily financed bad housing investment and frivolous consumption, consumers are now forced to save and deleverage. Corporations saw pressure on revenues from reduced spending coupled with evaporation of corporate credit, forcing drastic cuts in employment and investment, a further blow to consumers. Meanwhile, the bloated public sector has yet to tighten its belt (Faber offers more on this later).

It would be dishonest to say that there are no painful adjustments that accompany a globalizing economy. Painful adjustments in some sectors are accepted because economists expect they will be outweighed by net gains to the overall standard of living. However, the Fed-fueled credit boom created such huge distortions, and the credit bust created such wrenching pain, that capitalism and free trade have been made scapegoats. This legacy is ironic.

If Faber would like us to remember one thing from his presentation, it is that the Federal Reserve, in its manipulation of the most important price in the global economy – US interest rates – unleashed a credit binge on the world economy. The credit boom and its damaging distortions are the end-result of government intervention in markets, not free markets. Faber believes that, even now, the Fed leadership has not acknowledged the role that credit growth contributed to the crisis. Below, Faber sheds some light on why this may be the case.

Do that to me one more time
While the private sector has acted rationally by deleveraging, government credit growth has gone “through the roof” via fiscal deficits and monetization by the Fed in attempts to offset private sector retrenchment. While Faber didn’t offer statistics on the Fed monetization, I looked it up just for curiosity’s sake. The Fed balance sheet has grown from just under $900 billion in early Sepember, 2008 to over $2.2 trillion at the time of Faber’s presentation (source). As a result of public sector debt growth, total credit as a percentage of the economy is still expanding at present. Below, Faber puts the magnitude of debt growth into historical context and then offers some frightening projections.

In 1929, total debt as a percentage of GDP was 186%, up from 120% in 1921. Following the deleveraging during the Depression, the US went into WWII with a ratio of 140%, and the ratio fluctuated but remained fairly stable until after the Volcker tightening in the early 1980s. Since then, the the debt to GDP ratio has grown rapidly and steadily to its current level of 375%. However, this measure does not include unfunded liabilities from Medicare, Medicaid and Social Security, all entitlement programs that didn’t exist before the Depression. Adding in these liabilities gives a debt to GDP ratio of 800% (which would also exclude any forthcoming entitlements). While Faber didn’t offer sources or methodology on his projections, he believes deficits under the current administration extend as far as the eye can see. He cites unnamed third party projections at over $1trillion, but Faber believes deficits may reach $2 trillion annually. There may be debate about debt levels and future deficit projections, but Faber makes a compelling case that the trend is leading to uncharted waters. But here’s the gratuitous double-whammy.

Interest rates peaked on September 21, 1981, with the 30yr Treasury yielding 15.84%. Yields declined steadily and achieved a generational, secular low on December 18, 2008; 2.08% on the 10yr, 2.53% on the 30yr. Rates have since risen from these levels and Faber believes they will continue to rise while total debt increases. In 10 years, some research services (Faber didn’t elaborate) believe that 35% of tax revenues will be used for debt service – Faber projects 50%. In such a scenario, Faber believes you can’t raise taxes, cut spending or grow enough to get out – the only option is to default, likely by rolling the printing presses.

Faber segues into a discussion of inflation vs. deflation. He cautions against notions that a weak economy with deficiency in demand necessarily leads to deflation. There are hundreds of cases where a weak economy with a high output gap (GDP below potential) and high inflation coexist. For example, Faber offered Zimbabwe which has a 90% output gap and hyperinflation.

Faber offers the 1980s petrodollar crisis as a more realistic cautionary tale. In the 1970s, OPEC countries had huge dollar surpluses which were deposited with American banks and recycled into loans to Latin America, creating a boom in Latin America financed by foreign lending. Early in the '80s, oil prices declined, OPEC surpluses declined and petrodollar loans dried up, threatening a meltdown in Latin American economies that had thrived on a supply of foreign credit. Faber said that, in response, Latin American governments at that time did exactly what the current administration and the Federal Reserve are doing now; create large fiscal deficits and print money, which had the effect of decimating local currency. For example, the value of the Mexican Peso declined 98% from 1979 to 1987.

What do you do for money
From the above discussion, Faber hopes to make clear that Treasury debt is a bad investment. He recommends shorting it if you’re aggressive.

Referencing the petrodollar crisis again, Mexican equities held up reasonably well as a store of value. The Mexican index ended the measurement period up 139x in local currency, up about 29% in dollars. Extending on this, Faber believes that the Fed can make US equities reach any level, depending how much money they intend to print. As such, investors probably won’t be as damaged in US equities as they will in US bonds. Still, Faber believes gold will outperform equities. Agricultural commodities are at 200 year lows in real terms, particularly wheat. Continuing the agricultural theme, Faber suggests that farmland would be particularly valuable if global tensions escalate to apocalyptic scenarios.

Faber believes 50% of assets should be allocated to emerging markets. Offering some sector ideas, only 2% of Chinese leave the country on tourism every year compared to over 100% of English. Asian banks are relatively sound due to deleveraging from the Asian crisis, intensity of city traffic and few toxic assets on their books. Infrastructure in Cambodia, Laos and Mongolia (which Faber calls the Saudi Arabia of Asia), is neglected. India will eclipse China in population and will have favorable demographics. Urbanization in China in 1995 was still 29%, now standing at 44%. Urbanization in India is still 30%.

Brian Wesbury Luncheon - by Matt Alexander, CFA

2010-04-19T12:52:00.020-05:00

Brian Wesbury, Chief Economist at First Trust Advisors L.P., offered his latest commentary on February 24th at the Milwaukee Athletic Club. His key points are summarized below:

Don’t blame capitalism, please
A failure of capitalism? There would not have been a housing bubble or problems with subprime lending if the Federal Reserve hadn’t held interest rates at 1% for an extended period. Wesbury believes that, among other government meddling, this is the number one cause of the crisis.   He is quick to point out that market participants, from financial institutions to purchasers of homes, were often driven by greed. However, the private sector was merely obeying the distorted price signals generated by an expansionary monetary policy, the way motorists obey green traffic lights.

Using a simple framework to flesh out his point, Wesbury plots the Fed Funds rate vs. 2-year annualized % change in nominal GDP. The idea is that when interest rates roughly track the nominal growth rate of the economy, there is a systematic incentive to invest only in opportunities with above average return prospects. Following the TMT bubble, the Fed Funds rate gapped far below nominal GDP growth for an extended period, creating conditions friendly to a gravy train of leverage and sub-optimal investment. According to Wesbury’s chart, this period marked the widest divergence between the two trend lines since the long inflationary period of the ‘60s and ‘70s. Wesbury did not explicitly detail why loose interest rate policy manifested itself in a housing boom, but he implied that direct government involvement in underwriting, tax subsidies and policies targeting expanded home ownership created powerful incentives to channel dollars into housing investment. There were many players involved, but it is clear from Wesbury’s remarks that Alan Greenspan was the conductor of this train. Point number one: don’t blame markets and capitalism for this “made in Washington” crisis.

But it’s not as bad as you think
Monetary policy is still loose. Using a similar framework as described above, but stripping out housing’s recent negative effect on nominal GDP growth since 2007, Wesbury shows that a gap persists to the present day. To be neutral today, he suggests that interest rates should be 1.5 to 2%, similar to the current reading of 2-year annualized % change in GDP ex-housing. Loose monetary policy is now manifesting itself in a sharp turnaround in a broad set of economic indicators.

To illustrate, Wesbury presents several charts showing growth rates and price levels that have strongly reverted to pre-crisis levels, indicating the tell-tale “V” shape in each case, from US real GDP growth ex-housing to retail sales and manufacturing output, copper futures prices and ISM indexes of new orders and production. He joked that everywhere he looks, he sees V’s.

With a strong recovery under way, Wesbury believes that some issues, frequently cited by commentators as causes for deep concern, are likely overblown. He challenges the severity of three of these problems, including:

Commercial Real Estate: Vacancy rates are 17.5% currently, but they were 20%+ in 1991, and current vacancy rates relative to unemployment are low by historical standards.

Marginally Attached Workers: If this measure were utilized in the early ‘80s recession, it would have peaked near 20% vs. today’s 17%. Furthermore, because of the high correlation between the official unemployment rate (U3) and the broadest measure that includes marginally attached workers (U6), Wesbury suggests the broader measure, while more shocking, is of little added informational value.

Greece: A foreign example of fiscal imprudence, Wesbury believes that the recognition of Greece’s budget and financing difficulties may be a positive development in the sense that, “maybe this is the beginning of some kind of sanity.” He hopes that Greece won’t be bailed out but will instead be forced to adopt measures of austerity. In any event, Greece is far less important economically than is, say, California or Illinois. Problems in Greece will not threaten the Euro.

Instead of focusing on these commonly cited problems above, Wesbury suggests that another issue is cause for deep concern, discussed below.

Fess-up and stay clean
Wesbury asks, are Keynes and Marx right, or are Hayek, Smith and Friedman right? In other words, is capitalism stable over time? Keynes and Marx believed it is not, and that government should have a role at taming the animal spirits – fixing things and then letting them go again. Conversely, Hayek, Smith and Friedman believed that capitalism is stable over time and that crises are caused or deepened by bad government. While the problems in commercial real estate, unemployment and Greece are not trivial, Wesbury believes they are sideshows or symptoms of a core problem; namely, a lack of faith in capitalism over time. This lack of faith naturally leads to government interference in markets. This mindset, having played itself out in the '60s and '70s, has again gained traction, even among the traditionally business-friendly elite.

Politicians who voted for TARP or the Bush stimulus but who criticize Obama now are facing a credibility crisis. Whether speaking against regulating pay in the financial industry, opposing auto company bailouts or resisting the takeover of health care, valid arguments ring hollow for politicians that supported market intervention in the past. Marking a watershed moment, Wesbury points to a George W. Bush quote from a December, 2008 television interview during the heart of the crisis - “I’ve abandoned free market principles to save the free market system.” Notable for its contradiction in terms alone, it also encapsulated the ebbing faith in free markets that marked that time. In effect, it served to endorse a bailout blueprint. While it’s easy to forget the intensity of the panic, Wesbury believes that Republican leadership blinked and misdiagnosed the problem (which Wesbury identifies later).  TARP was the wrong solution.

His advice to Republicans; admit your mistake today and “clear the decks” in order to reverse course and fight against more big government intervention in the future. Wesbury notes that this strategy worked effectively for Democrats in the ‘60s when they successfully reversed their support of the Vietnam War.

Mark-to-market was the problem
While it sounds strange for a person with such faith in markets to come out against mark-to-market, I surmise that Wesbury is referring to changes in fair value accounting mandated by FAS 157. One change introduced in the new standard mandated that banks mark assets to a bid price, if available. While this seems a conservative approach and reasonable in normal market environments, its drawbacks were exposed during the recent crisis. The bid/ask spread is not static. The spread in a transaction is naturally wider for thinly traded assets, becoming much wider still during a liquidity crisis. In the most recent crisis, the bid on some assets dropped out of the market completely. This accounting treatment, introduced in 2007, forced draconian valuations on banks’ assets during the crisis, creating technical insolvencies and domino effects across the financial system.

To look a little closer at the issue, consider a hypothetical example. If an asset’s expected cash flows haven’t deteriorated significantly over a two week period, but its bid price has fallen from, say, 50 to 5 cents on the dollar in the same period, does the bid price truly reflect a 90% drop in economic value, or is the bid price merely a technical feature of how the asset trades during a liquidity crisis? A reasonable argument could be made for alternative accounting treatments that will reduce the role of unusual market conditions in determining fair value of assets. Indeed, in March, 2009, revisions to mark-to-market rules were introduced that allowed banks to value their assets at fair value assuming an orderly market environment – this had the desired effect of ignoring unreasonably harsh valuations forced by actual bid prices in a crisis. But, by the time this change was made, much damage had already been done.

To summarize, Wesbury believes that mark-to-market is really a debate about accounting methods rather than informational transparency.  The latest crisis revealed the pro-cyclical bias of this accounting method in the form it was originally released. Wesbury offered an historical example to drive home the point. In 1983, eight of the largest US banks had $54 billion lent in Latin America, representing 260% of their collective capital. Every Latin American country defaulted and debt traded at 10 cents on the dollar. The banks were insolvent. Wesbury believes that if mark-to-market had been used at that time, it would have destroyed the economy. In the current crisis, by pricing all assets to liquidation value, a problem was turned into a crisis by “throwing gasoline on the fire.” Offering another anecdote, Wesbury cites Jacob Frenkel, Vice Chairman of AIG, who claimed AIG would not have needed government money if mark-to-market accounting were not in force.

Who do you trust?
Wesbury believes that Republicans, assuming they recognized the problem, had a choice: adjust the accounting method and mitigate government’s role at choosing winners and losers, or throw money directly at the banks using TARP and expand government’s role at choosing winners and losers. Now that the damage has been done to the financial system, the influence of government has rapidly reached into other sectors of the economy. The market for corporate control, once dominated by private enterprise, now has other participants with murkier motivations.

This brings us back to Wesbury’s main question – do you trust capitalism or bailouts? Do you trust the price signals generated by millions of market participants, each transacting for his own profit, who, in aggregate, allow equilibrium prices that reflect natural scarcity and value? Or do you trust the disruptive price signals generated by unpredictable policy actions of a very few rent seekers, power brokers and social engineers that reside at the seat of a command economy?

Welcome to Newsline Online

2010-02-10T15:19:00.003-06:00

Dear Membership,

In keeping with the times, the Board of the CFA Society of Milwaukee is pleased to offer the online version of Newsline. Going forward, this online newsletter will replace the PDF newsletter you had received in prior email communications. Advantages of the new blog format include:

more timely publication of content with minimal prep work
a communication tool that has zero dollar cost to our society
a fixed URL that you can bookmark in your browser: http://cfamilwaukee.blogspot.com/
The potential for feedback directly from the membership (once we learn how to handle comment priveleges)

You will continue to receive email notifications when new posts become available. A continuous archive of prior content will remain available for your reference on this site. You can scroll down now to see some content that has already been posted.

With the changes noted above, the mission of Newsline remains the same: to provide reviews of recent events and promote upcoming events for the benefit of the CFA Society of Milwaukee membership. To this end, I welcome members that would like to contribute future content. Feel free to contact me or other members of the Board if you have an interest in covering an event or taking on a topic that you believe is of interest to the membership.

Yours truly,
Matt Alexander, CFA

Newsletter Chair

Dan Fuss Luncheon - by Matt Alexander, CFA

2010-02-09T15:30:00.016-06:00

Perrenial favorite, Dan Fuss of Loomis Sayles, proffered his latest social and economic commentary in front of a packed house of enthusiastic students and investment professionals at the Milwaukee Athletic Club on January 27th. He delivered his assessment in his familiar framework of “Peace, People, Politics and Prosperity,” finishing with some advice for investors. A summary of key takeaways follows:

Peace: the most important “P” by far.

Fuss asks, “to what degree do you lack peace?” From a social perspective there is, indeed, a lack of peace. From a quantitative/market/budget perspective, things are a bit better. However, there is a tendency to lag funding for budget expenditures “you wish you didn’t have to make.” This tendency is exacerbated when misleading budget projections are made during hyper-strong economic environments, as experienced early last decade. Current budget surpluses tend to lead to overly optimistic expectations of future tax receipts and social spending.

Providing a current example, Fuss believes incremental spending on military commitments has not been adequately anticipated. While it is difficult to estimate precisely, Fuss pegs the shortfall at about 2% of GNP, a significant sum but an amount that the US economy can potentially absorb from a budgetary/financing perspective.

People: Demographics don’t change on short-term notice.

The pay-as-you-go Social Security system was created when the age distribution of the population resembled a pyramid, with lots of younger people available to support relatively few older people. Fuss believes the original planners of this system were intelligent, but they failed to foresee the demographic consequences of the progress of modern medicine. Commitments to spending late in life were elevated by entitlement programs introduced in the 1960s. Moreover, people are living longer than ever before.

While it’s difficult to say what will come out of Congress next, Fuss believes it would be unreasonable to expect anything less than a slight increase to these commitments. This problem has been gradual in the making, reinforcing Fuss’ first point: there is a tendency to lag funding for budget expenditures you wish you didn’t have to make, and this is precisely what has happened for Social Security, Medicare and other potential entitlements.

Politics: Older people vote their own interests as a block.

The trial balloon of putting old people “out to sea” by rationing care has been floated in the health care debate and, effectively, shot down. Going forward, the voting power of this growing segment of the population will assure its self-preservation. While retirement ages may be pushed back, deferring distributions and creating an incentive for people to continue to pay into the system, this will prove inadequate to meet commitments. Fuss estimates that real American GNP growth would have to be sustained at 3.5% to 4% to fiscally absorb future commitments, a very unlikely scenario.

The demographic problem is not confined to America but is as bad or worse in the UK, Europe and Japan. Moreover, these advanced social democracies make up the four major reserve currencies. A superficial solution is to call for diversifying reserve currencies, but there are no real alternatives for China and other creditor nations. Alternative currency markets are simply not deep enough.

The main point: the combination of demographics and currency market structure will create the underlying push for continued net issuance of government debt by the advanced social democracies. This will have meaningful investment implications.

Prosperity: Shorthand for the Economy.
The god of markets is Liquidity, and god is back with “bushel-baskets full of money.” The Colossal Corporation (formerly Mega Corporation) is back to old tricks, reinstating the carry trade that it had so dramatically unwound over the course of only 10 days in late August, 2008. Once again, Colossal ore is being mined in Australia, hedged with A$ bonds and financed by Yen, and the business is making money.

More broadly, business is booming and unit growth is above average. Inventories have been building since March, 2009. The most dramatic inventory correction in memory is over. In financial markets, the massive influx of liquidity has brought the bid back on risky assets.

The Prognosis: Preface everything with, “I guess.”

The US economy and North America are in statistical recovery. But jobs and prices for goods and services are not in recovery. There is enormous excess capacity to absorb. It will take a couple years to reach the absolute levels of activity attained in November 2007. Due to a growing workforce, per capita recovery will take even longer. As the recovery progresses, tax collections will begin to ramp up and social spending will begin to come down a bit, taking a little pressure off the budget.

However, in reference to above discussions of spending commitments and market structure, Fuss believes that both the future budget deficit and the estimated issuance of Treasury debt are underestimated. Both will continue to be revised upward. At some point, interest rates will rise as debt as a percent of GNP grows. As public debt requirements increase, we will witness a crowding out of the private sector. Larger companies with access to financing will “clean-up” at the expense of smaller companies unable to obtain credit. We’ve seen the prequel to this movie in the 1970s, as many smaller businesses of that era were vanquished.

Globally, Fuss is more optimistic. In China, people are beginning to accrue some disposable income for the first time. There will be increasing demand for durables and non-durables from new consumers in Asia. Overall, unless something happens to disrupt world trade, there will be a stronger world economy going forward.

How to invest then? In a nutshell, avoid market risk and seek specific risk.
Look for opportunities with low covariance to the broad markets. In equities, covariance tends to run with liquidity cycles. Drawing from Fuss’ outlook above, the ability to access credit or gain exposure to new sources of demand can create some disparity among companies that investors can exploit. By their nature, bonds have a tighter relationship with interest rates. Fuss believes successful bond investors will be able to exploit anomalies, though he didn’t elaborate on the point. He did say that, with some lag, bond clients will be happier with progressively higher reinvestment rates. In sum, while index huggers will likely trail, there will be opportunities for active managers to demonstrate their value.

New CFA Charterholder Recognition and Holiday Networking Event

2009-12-29T16:50:00.006-06:00

The CFA Society of Milwaukee hosted a complimentary networking event on Wednesday, December 9th at the Iron Horse Hotel in Milwaukee, featuring corporate stand-up comedian, Greg Schwem. New Charterholders located in the Milwaukee area were the guests of honor, receiving individual recognition and congratulations for their hard-earned achievement. Also honored were CFA Candidates passing the Level III exam.

The CFASM membership congratulates the following individuals on their substantial accomplishment:

New Charterholders:
Aaron M. Benson, Ryan Patrick Bushman, Charlie C. Chang, Stephen M. Comerford, Matthew H. Domski, Prashant M. Inamdar, Jeremy Phillip Keil, Adam J. Kurkiewicz, Edward Charles McIlveen, Christopher Kinne Merker, Michelle J. Picard, Alexander Noel Rasmussen, Andrew M. Reed, Jason Joseph Schultz, David Michael Silber, and Peter Thomas Speidel.

Passed Level III:
Raymond Auth, Jeremy Baier, Douglas Cartwright, Ian Elfe, Jacob B. Fink, Timothy Fotsch, Amie Hahn, Adam Hirschkatz, Jing Liu, Anthony Marino, Brian R. Meyer, Michael Monfeli, Daniel Stier, Donald Swain, Laura Thorson, Andrew Wittmann, and Timothy Wois.

Jim Paulsen Luncheon - by Chris Merker, CFA

2009-12-28T19:03:00.009-06:00

The CFA Society of Milwaukee gathered October 15th for a luncheon presentation given by Dr. Jim Paulsen, Chief Investment Strategist of Wells Capital Management. An entertaining and engaging presentation ensued as Paulsen showed slide after slide supporting and reinforcing a perspective on the economy and markets that was, simply put, very positive.

For this writer, the mood of Paulsen’s commentary was quite literally 180 degrees from that of Laurie Goodman, mortgage-backed securities analyst of UBS, from almost one year ago to the day. The message a year ago was grim as Goodman demonstrated how the mortgage-backed sector was, as she spoke, sucking the global economy and financial markets into a vortex. At that time, she did not see a silver lining in anything on the horizon.

Paulsen’s discussion began where Goodman left off: last year’s panic was, as he dubbed it, “the depression that wasn’t.” Literally, people had stopped transacting in the real markets as everyone prepared for the worst. The widespread panic was not allayed by our political leaders, he said. He pointedly commented that the president’s decision in early November, 2008, to get up four mornings in a row, stating publicly before the media and the world that we were all veering towards depression, particularly did not help the situation.

If there were anything to learn from the reaction of policymakers last year, it is that the playbook for handling a collapse of confidence in the financial markets should be re-written, focused instead on restoring that lost confidence. Paulsen’s and Bernanke’s grinding appearance for 10 days in October before Congress was both painful and, arguably, a process that did not serve to reinstate investor confidence as volatility spiked to record highs and the equity markets death-spiraled to 6,500 on the Dow.

Paulsen then turned his attention to the recovery. Companies and households had basically prepared for depression. The leanness that resulted has lead to increased productivity and a faster bounce-back than markets had expected. The recent run up in the markets reflects this. Paulsen claims the equity market may go even higher from this point. We may even re-attain 14,000 on the Dow in this recovery cycle. A measure of that recovery could be 4% GDP growth in the U.S. in 2010. The “new normal”, he said, will actually look pretty normal.

Paulsen next talked about the effects of the stimulus programs. It is akin to a barbeque where the coals don’t come to life quickly enough, so the host throws more and more fluid on the fire until… a veritable conflagration. These programs have injected a mighty force into the economy we have yet to see. He also pointed to a mountain of cash that has been built up in a manner not seen since the mid-80s. Private sector cash holdings to GDP stand at about 75%. Paulsen notes that, as he made his career in the mid-80’s on a mountain of cash, so too will many in the audience. He believes that unemployment will keep a lid on inflation for a while and he does not view inflation as a threat even as the economy recovers, longer term.

Two threats he was concerned about a couple of months ago, mortgage rates and oil prices, have receded. While he acknowledged that the consumer continues to be burdened particularly by unemployment (as of this writing, the rate had surpassed 10%), the consumer is not as debt laden as common wisdom assumes, and business investment will begin to fill the gap.

Paulsen overlaid two measures; the household obligations ratio, put out by the Fed, and the energy obligations ratio. This relationship showed how the U.S. household burden is no worse that it was in 1980. He contends that the evidence does not point to housing debt as the culprit. Rather, he points to the shock of oil prices that pushed the consumer over the edge leading up to the recession. The consumer was not as fiscally imprudent as, again, common wisdom would have it. He believes the “worst-ever lending crisis” story is overplayed, too. Annual inflation-adjusted growth in total U.S. Household Debt, while bad, is no worse than 1981, 1975 or 1970.

Paulsen then turned to the emerging world, another positive contributor to the economic outlook. Again, taking a different view on the data, he believes the perennial U.S. trade deficit has served to seed and foster emerging market economies whose internal consumption is starting to take hold. Clearly, a proponent of the decoupling theory, he sees the emerging world as an engine for global economic growth. He is not concerned about the continued trade deficit or falling dollar. He argues that the G7 and the U.S. are in the same boat with China and will, over time, put pressure on China to revalue the yuan, leading to a more balanced global economy.

In short, Paulsen gave many reasons to believe that things may turn out better than expected in the medium term. In the Q&A, however, his responses to questions about other longer-term challenges (the audience asked several questions about the health care debate, as well as welfare, environmental and energy policy), particularly in the developed world, did not give much reassurance.