Charlie Munger: A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business

Tuesday, February 21st, 2012

I’m going to play a minor trick on you today because the subject of my talk is the art of stock picking as a subdivision of the art of worldly wisdom. That enables me to start talking about worldly wisdom—a much broader topic that interests me because I think all too little of it is delivered by modern educational systems, at least in an effective way.

And therefore, the talk is sort of along the lines that some behaviorist psychologists call Grandma’s rule after the wisdom of Grandma when she said that you have to eat the carrots before you get the dessert.

The carrot part of this talk is about the general subject of worldly wisdom which is a pretty good way to start. After all, the theory of modern education is that you need a general education before you specialize. And I think to some extent, before you’re going to be a great stock picker, you need some general education.

So, emphasizing what I sometimes waggishly call remedial worldly wisdom, I’m going to start by waltzing you through a few basic notions.

What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ‘em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form.

You’ve got to have models in your head. And you’ve got to array your experience—both vicarious and direct—on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head.

What are the models? Well, the first rule is that you’ve got to have multiple models—because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models, or at least you’ll think it does. You become the equivalent of a chiropractor who, of course, is the great boob in medicine.

It’s like the old saying, “To the man with only a hammer, every problem looks like a nail.” And of course, that’s the way the chiropractor goes about practicing medicine. But that’s a perfectly disastrous way to think and a perfectly disastrous way to operate in the world. So you’ve got to have multiple models.

And the models have to come from multiple disciplines—because all the wisdom of the world is not to be found in one little academic department. That’s why poetry professors, by and large, are so unwise in a worldly sense. They don’t have enough models in their heads. So you’ve got to have models across a fair array of disciplines.

You may say, “My God, this is already getting way too tough.” But, fortunately, it isn’t that tough—because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And, of those, only a mere handful really carry very heavy freight.

So let’s briefly review what kind of models and techniques constitute this basic knowledgethat everybody has to have before they proceed to being really good at a narrow art like stock picking.

First there’s mathematics. Obviously, you’ve got to be able to handle numbers and quantities—basic arithmetic. And the great useful model, after compound interest, is the elementary math of permutations and combinations. And that was taught in my day in the sophomore year in high school. I suppose by now in great private schools, it’s probably down to the eighth grade or so.

It’s very simple algebra. It was all worked out in the course of about one year between Pascal and Fermat. They worked it out casually in a series of letters.

It’s not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it’s fundamental truth. So you simply have to have the technique.

Many educational institutions—although not nearly enough—have realized this. At Harvard Business School, the great quantitative thing that bonds the first-year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They’re amazed to find that high school algebra works in life….

By and large, as it works out, people can’t naturally and automatically do this. If you understand elementary psychology, the reason they can’t is really quite simple: The basic neural network of the brain is there through broad genetic and cultural evolution. And it’s not Fermat/Pascal. It uses a very crude, shortcut-type of approximation. It’s got elements of Fermat/Pascal in it. However, it’s not good.

So you have to learn in a very usable way this very elementary math and use it routinely in life—just the way if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn—to have a certain grip and swing in a different way to realize your full potential as a golfer.

If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an asskicking contest. You’re giving a huge advantage to everybody else.

One of the advantages of a fellow like Buffett, whom I’ve worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations….

Obviously, you have to know accounting. It’s the language of practical business life. It was a very useful thing to deliver to civilization. I’ve heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention.

And it’s not that hard to understand.

But you have to know enough about it to understand its limitations—because although accounting is the starting place, it’s only a crude approximation. And it’s not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn’t make it anything you really know.

In terms of the limitations of accounting, one of my favorite stories involves a very great businessman named Carl Braun who created the CF Braun Engineering Company. It designed and built oil refineries—which is very hard to do. And Braun would get them to come in on time and not blow up and have efficiencies and so forth. This is a major art. And Braun, being the thorough Teutonic type that he was, had a number of quirks.

And one of them was that he took a look at standard accounting and the way it was applied to building oil refineries and he said, “This is asinine.”

Tags: Agriculture, Array, Art Of Worldly Wisdom, Carrot, Carrots, Charlie Munger, Dessert, Educational Systems, Extent, General Education, Grandma, Human Psychology, Investment Management Business, Latticework, Models, Modern Education, Notions, Psychologists, Stock Picker, Stock Picking, Topic That Interests
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An Approach to Fixed Income that Isn’t Fixed (Video)

Monday, November 14th, 2011

Many investors used to approach fixed income ETF investing with the goal of buying one fund that offered broad and diversified exposure to the market. But as ETFs have evolved, so too have investors.

In this video blog, Matt Tucker, Head of iShares Fixed Income Strategy, sits down with iShares Managing Director Sue Thompson to discuss how some investors are no longer using only the Barclays Aggregate Bond Fund, or AGG, to manage their fixed income exposure.

Instead, Matt explains how some investors are choosing among the array of fixed income ETFs offered by iShares to craft customized portfolios that help meet their investment goals – whether that goal is to seek more yield or manage interest rate sensitivity.

For more on iShares Fixed Income, see our complete list of funds. In Canada, see iShares Canada complete fixed income list here.

Tags: Array, Barclays, Blog, Bond Fund, Canadian Market, Complete List, Customized Portfolios, Diversified Exposure, Fixed Income, Income Investing, Interest Rate Sensitivity, Investment Goals, Investors, Ishares, Managing Director, Matt Tucker, Sue Thompson
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Fixed Income ETFs and Yield: A Game of Catch Up (Tucker)

Tuesday, October 4th, 2011

by Matt Tucker, iShares

One of my favorite fixed income topics is yield. Really, it is. What’s amazing to me is how many different types of yield exist — for a bond or bond fund you could quote the yield a half dozen ways and each would be different. My theory is that bond geeks invented this array of yields to make their jobs seem more complicated or mysterious.

But understanding which yield to use can be confusing. It’s easy to be enticed by what looks like the highest yield in the bunch, especially in this low rate environment where investors are searching for ways to extract extra income from their bond holdings. I want to highlight three of the most common yields investors see for fixed income ETFs, explain how they are connected and show how they have a tendency to “catch up” with one another over time.

• 30-day SEC Yield: Providers may calculate other yields differently, but everyone must follow the same formula for SEC yield. This is a standard yield calculation developed by the SEC for fairer comparisons among bond funds. It is based on the most recent 30-day period. It reflects the interest earned during the period after deducting the fund’s expenses for the period. It is backward looking – telling investors what a fund distributed in the past.
• Distribution Yield: The most recent fund distribution, divided by the most recent fund price, minus management fees. It is the annual yield an investor would receive if the most recent fund distribution stayed the same going forward. It represents a single distribution from the fund and does not represent the total return of the fund. It is backward looking – telling investors what a fund distributed in the past.
• Average Yield to Maturity (YTM): The weighted average yield of the bonds held by the fund based upon the fund’s net asset value, or NAV. Fund management fees are not included and must be deducted when comparing to other yield measures. It represents the market weighted average YTM of the bonds in the fund as of the measurement date — it essentially tells you what the YTM would look like if you purchased all of the bonds in the underlying portfolio today.

For the purpose of this blog, we’ll focus on Distribution Yield, although these general mechanics apply to the 30-day SEC Yield as well.

Now, what happens to these yields when interest rates fluctuate? The Average YTM is first to react because it is a marked-to-market yield for the bonds in the portfolio. If the Average YTM stays at its new level, the Distribution Yield will eventually “catch up” to it as the fund rebalances and acquires bonds at the new market yield. How quickly this occurs will be based on the growth and turnover of the fund. The greater the growth and the higher the degree of fund turnover, the faster the Distribution Yield will catch up to the Average YTM. The opposite is true if growth is slow and turnover is low.

Let’s look at an example: The Distribution Yield for AGG as of August 24 was 3.27%, while the Average YTM was 2.04% — the difference in yields was due to a decline in interest rates that was immediately reflected in the Average YTM. If market conditions stayed the same, an investor could expect the Distribution Yield to decline and move toward the Average YTM. Indeed, as of September 22, AGG’s Distribution Yield was 2.50%, while its Average YTM was 1.82%. Past performance does not guarantee future results. For standardized AGG performance, please click here. For AGG’s most recent yield information, including the 30-Day SEC Yield, please click here.

Of course, things aren’t quite that simple because Average YTMs change every day based upon trading in the bond market, and the fund may be growing or shrinking daily as well. Nonetheless, the relationship between the Average YTM and the Distribution Yield is a good starting point for investors who are trying to understand where a fixed-income ETF’s distribution may be moving over time.

Bonds and bond funds will decrease in value as interest rates rise.

Tags: Array, Asset Value, Bond Fund, Bond Funds, Bond Holdings, Bonds, ETFs, Extra Income, Fixed Income, Fund Distribution, Fund Management, Geeks, Investor, Ishares, Management Fees, Many Different Types, Matt Tucker, Rate Environment, Tendency, Yield To Maturity
Posted in Bonds, Brazil, ETFs, Markets | Comments Off

Jeremy Siegel: “The Market Will Stage a Comeback”

Tuesday, July 14th, 2009

Jeremy Siegel, Wharton School prof and Director of Wisdom Tree ETFs, says “Now that it’s clear the recession will not turn into a depression, stocks are poised for a recovery.” Siegel recently was the subject of an interview conducted by Knowledge@Wharton. You may listen by clicking the player below, or read the edited transcript of the interview below.

Click Play to Listen:

http://knowledge.wharton.upenn.edu/audio/KW_Siegel20090624.mp3

Here is an excerpt:

Knowledge@Wharton: The market just had its first weekly [decline] in a number of weeks. What was driving that?

Siegel: I think there are two principal concerns in the market. One is the rising commodity prices — particularly energy prices and oil. And the other is the rising interest rates, which are in turn caused by fears of huge deficits, as well as rising commodity prices. My feeling is, the market would have been up last week, too, if it didn’t have to contend with those. And now, it’s concerned that those [factors] might push the economy down. Today [June 22], we had a decline in energy prices and in the market. But … energy prices and interest rates [are] our main concerns.

Knowledge@Wharton: Are the energy prices being driven by demand?

Siegel: Demand in China is rebounding very rapidly, although there are some experts who say that there’s still a lot of speculation in it, and that the price … has run a little bit ahead of itself. But China and India are recovering quickly. There are a record number of applications for new cars in China, and those generally use gasoline and oil. So, looking forward, over the next couple of years, those bulls in oil are saying there’s going to be a big increase in [consumption].

Knowledge@Wharton: Doesn’t the rise in demand [indicate] an improving economy overall?

Siegel: Certainly … a good part of the rebound in oil and in interest rates is because the depression scenario has basically been taken off the record. It’s now considered an extraordinarily low probability. So, we’re dealing with a severe recession, and [the question of] how fast we are going to improve from that. And once you’re into that mode, you don’t accept 2% to 3% bond rates any more, and oil won’t stay down at $35 a barrel. But I think some of [the movement has occurred] in anticipation of strong demand from China, particularly for oil, and, on the bond side, from the huge deficits, trillion-dollar-plus deficits that are going to cascade down on the market.

You may read the whole transcript here.

Source: Jeremy Siegel: ‘The Market Will Stage Another Recovery’, Knowledge@Wharton, June 24, 2009

Tags: Array, Bulls, Commodities, Commodity Prices, Consumption, Decline, Depression, Emerging Markets, Energy Prices, ETF, Excerpt, Fears, Gasoline, India, Jeremy Siegel, Kw, Little Bit, Mp3, New Cars, oil, Principal Concerns, Rebound, Recession, Rising Interest Rates, Speculation, Stocks, Upenn, Upenn Edu, Wharton School, Wisdom Tree Etfs
Posted in Emerging Markets, ETFs, India, Markets | Comments Off

Michael Lewis: The End of Wall Street

Tuesday, June 16th, 2009

Michael Lewis, the trenchant author of Liar’s Poker, Money Ball, and Home Game, discusses what he calls “The End of Wall Street,” in this 5:33 minute segment. It’s an enlightening discussion, I promise. Don’t miss it. Click play to see it.

Lewis explains how he went out of his way to talk to the people who seemed to have known the crisis was coming, and discovered that they were the less sophisticated, net-long breed of hedge fund investors, and not the genius financial engineer cum alchemist types.

In essence, these were, as in one case, portfolio managers who poked holes in the ratings system. In his example, Lewis tells of the story of the investor who asked Standard and Poor’s to explain how a whole whack of BBB mortgage paper could fetch a AAA rating? This was followed by the question, “What would happen if housing prices start falling?” to which the S&P official responded, “there is no place in the model to insert negative numbers.”

Lewis does a great job of explaining what the critical factors were that contributed to “the end of Wall Street.”

Read the whole article here.

Tags: Array, Ball Game, Bbb, Critical Factors, Financial Engineer, Fund Investors, Genius, Hedge Fund, Holes, Home Game, Investor, Liar, Liar Poker, Liar S Poker, Michael Lewis, Minute Segment, Money Ball, Money Game, Mortgage Paper, Negative Numbers, Poker, Poker Game, Portfolio Managers, Wall Street, Whack
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Jeffrey Saut: Long Emerging Markets and Raw Materials

Tuesday, May 12th, 2009

Raymond James’ chief investment strategist, Jeffrey Saut, has published his newsletter of May 11, 2009, in which he posits a discussion on investing in emerging and frontier markets and raw materials, and corroborates his thoughts with those of Thomas Melendez from MFS, and Jeremy Grantham, GMO.

You may read, as well as print, this weeks entire letter in the slidedeck below by clicking on the ‘full screen’ radio button at the top right hand of the frame.

You can download the entire document here.

Jeffrey Saut’s Bio:
Jeffrey Saut is Chief Investment Strategist and Managing Director of Equity Research at Raymond James & Associates.

Mr. Saut began his career on a trading desk in New York City. In 1973, he joined E.F . Hutton, where he began following equities and writing research. He subsequently worked as a securities analyst for Wheat First Securities, and then Branch Cabell, where he ran the equity research group as director of research and acted as portfolio manager for the firm’s affiliate, Exeter Capital Management. As director of research, he built the research and institutional sales departments for the regional brokerage firm Ferris, Baker and Watts, Inc. and subsequently Sterne, Agee & Leach, Inc.

Mr. Saut is well known for his insightful and colorful commentary regarding the stock market, and he makes regular media appearances.

Hat tip: Marketfolly.com

Tags: Add new tag, Array, Branch Cabell, Brokerage Firm, Chief Investment Strategist, Colorful Commentary, Director Of Research, E F Hutton, Emerging Markets, Equity Research, ETF, Ferris Baker, Frontier Markets, Hat Tip, Institutional Sales, James Jeffrey, jeffrey saut, Jeremy Grantham, Media Appearances, Radio Button, Raymond James, Raymond James Associates, Regional Brokerage, Securities Analyst, Sterne Agee, Sterne Agee Leach, Writing Research
Posted in Commodities, Economy, Emerging Markets, ETFs, Markets, Outlook | Comments Off

Seth Klarman (Baupost Group) Speaks to Ivey School of Business

Sunday, May 3rd, 2009

Seth Klarman, Legendary investor, founder of Baupost Group, and author of the $1,200, much sought after, and out of print, now classic investing book, Margin of Safety, recently spoke to the Ivey School of Business sharing his thoughts and wisdom on investing as well as his methodology. This is a rare and valuable lecture, a must listen, and contextually relevant as it is very recent, recorded on March 17th, 2009.

You may view the video courtesy of Ivey School of Business’ Ben Graham Centre for Value Investing.

Bio (Wikipedia):

Seth Klarman is the founder and president of The Baupost Group, a Boston-based private investment partnership, and the author of a book on value investing. Klarman is notable for his willingness to hold significant amounts of cash in his investment portfolios, sometimes in excess of 50% of the total^[1]. In 1991, Klarman authored Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor, which since has become a value investing classic. Now out of print, Margin of Safety has sold on Amazon for $1,200 and eBay for $2,000.^[2] Before founding Baupost, Klarman worked for Max Heine and Michael Price of the Mutual Shares fund (now a part of Franklin Templeton Investments).

Klarman is a graduate of Cornell University and Harvard Business School. ^[3]

Tags: Amazon, Array, Bachelor Of Arts, Baker Scholar, Baupost Group, Book Margin, Chestnut Hill, Cornell University, Distressed Debt, Ebay, Franklin Templeton Investments, Global Opportunities, Harvard Business School, Individual Investors, Investing, Investment Portfolios, Investor Group, Ivey School Of Business, Magna Cum Laude, Margin Of Safety, Max Heine, Mba Graduate, Methodology, Mutual Shares Fund, Private Equities, Private Investment Partnership, Safety Risk, School Of Business, School Of Management, Seth Klarman, Seth Speaks, Wikipedia, Willingness, wisdom, Worrier
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Jim Rogers isn’t buying a US stock recovery (Barron’s)

Sunday, April 26th, 2009

“Legendary investor Jim Rogers is skeptical of the latest rally in equities – as well the health of the global economy. As such, he is scorning stocks and bonds while embracing commodities as his investment vehicle of choice. Barron’s John Kimelman got the chance to interview the CEO of Rogers Holdings, with the following excerpts appearing on the website yesterday:

Q: When you last did a lengthy interview with Barron’s magazine a year ago you were lightening up on emerging markets investments. Well, you called that one right. But now that many of those markets have fallen from their highs of recent years, are you more optimistic?

A: No. I’ve sold all emerging markets stock except the ones in China. I bought more Chinese shares in October and November during the panic, but I have not bought China or any other stock markets including the US since then. I’m not buying anything in China right now because the Chinese market ran up maybe 50% since last November. It’s been the strongest market in the world in the past six months and I don’t like jumping into something that has been that run up. Still, I’m not thinking of selling these stocks either. I think if it goes down I’ll buy more. I think you will find that it’s the single strongest market in the world since last fall.

Q: That being said, you currently think Chinese stocks are bid-up now, so you’re not buying at these levels. So what have you been buying lately?

A: I have been buying commodities through the Rogers commodity indexes I developed because my lawyer won’t let me buy individual commodities. I recently bought all four Rogers indexes – the Elements Rogers International Commodities Index (ticker:RJI) as well as the three specialty indexes, the International Metals (RJZ), the International Energy (RJN), and the International Agriculture (RJA.) That’s how I invest in commodities and that’s what I bought last week. I have been buying these shares since last fall and up to last week.

Q: Now despite the recent stock-market rally that started in March, many US stocks are trading well off their 2007 highs. How come you see no value to this market?

A: I am not buying US companies mainly because I think we may have seen a bottom but I don’t think we have seen the bottom. I am skeptical about the rally, the world economy for the next year or two or three. But if stocks go down, I can make money with commodities. In the 1970s, commodities went through the roof even though stocks were a disaster. In the 1930s, commodities rallied first and went up the most long before stocks pulled it together.

Q: Can you summarize the reasons for your bullishness about commodities?

A: It depends on the supply and demand. And we have had a dearth of supply. Nobody has invested in productive capacity for 25 or 30 years now. The inventories of food are the lowest they have been in 50 years and you have a shortage of farmers even right now because most farmers are old men because it has been such a horrible business for 30 years. And as for metals, nobody can get a loan to open a mine as you know. Who is going to give you money to open a zinc mine? It takes at least 10 years to open a mine so it’s going to be 15 or 20 years before we see new mines come on. Nobody has been opening mines for 30 years and they are not going to. And in the meantime reserves are declining. As for oil, the International Energy Agency came out recently with a study showing that oil reserves worldwide were declining at the rate of 6% or 7% a year.

That does not mean that if suddenly the US goes bankrupt that everything won’t collapse in price. But I would rather be in commodities because it’s the only thing I know where the fundamentals are improving. They are not improving for Citibank or General Motors but the supply situation in commodities is such that when demand comes back, then commodities are going to be the best place to be in my view.”

Click here for the full article.

Source: Barron’s, April 20, 2009.

Hat tip: Investment Postcards

Tags: Array, Barron, Barron S Magazine, Chinese Market, Chinese Stocks, Commodity, Emerging Markets, Global Economy, International Agriculture, International Commodities Index, International Energy, International Metals, Investment Vehicle, Jim Rogers, Last November, Lengthy Interview, Rja, Rjn, Rogers International Commodities Index, Stock Markets, Stock Recovery, Stocks And Bonds, Stocks Bonds
Posted in Bonds, Commodities, Emerging Markets, Markets | Comments Off

Hugh Hendry: Citywire Interview

Saturday, April 11th, 2009

Hugh Hendry, the outspoken CIO and co-founder of Eclectica, one of the UK’s most successful hedge funds during the last 4 years, and in particular the last 2 years, appears in a full length interview, speaking on a variety of issues, including his thoughts on contrarianism, quantitative easing, deflation vs. inflation, his outlook for the market, and future of the hedge fund industry.

As usual, Hendry is both enlightening, and controversial, and his remarkable accuracy about the nature of the market and course during the last year make him worth listening to. Click play to view:

Part 1: The Eclectica co-founder explains why he is sticking to his guns despite having ‘my tail between my legs’ after the recent banking sector rally, and why the dollar could approach parity with the euro.

Part 2 : The outspoken hedge fund manager argues that the majority of his peers ‘have no future’, and explains his fear that tighter financial regulation will mean two decades of deflation in the second of a two part series.

Here is a complete transcript of the interview:

We have had an unprecedented period, unprecedented. Its never happened before. It’s never been the case that the stock market has gone up almost 30 times in just one movement. What I’m saying to you is that the Dow Jones in 1975 was around 590 points, and in 2007, we got to around 14,200 points. I round down, you know. That’s never ever happened. That is unprecedented prosperity. And the people who gained the most from that, are the fund managers, like me. Except, I’m aware of it. A lot of people are just not aware of it, to be lucky to be in the right place at the right time. But as you know, equity markets have done nothing for the past ten years, and if you look at the example of Japan, you’re stretching 25 years, and you’re seeing lows that we recorded in the 1980s. And I think that’s coming, that’s encroaching on our path.

When I go the major cities of the world, I say, hey, “Where do the fund managers live?” “Where do they work?” I want to short people like me; I’m very fearful about my profession’s career. So to lay it off, I want to short these guys. “Who has the biggest portfolio of assets?” ’cause all assets are coming down, coming down. So, you’re going to go from being the luckiest and the chosen, to being the unluckiest and the reviled. So, fund management franchises, insurance companies; I don’t care if you’re composite or if you’re life. I worry about the opacity of it. The ability to see in and the ability to test the value of their portfolio. I worry about what’s this mark-to-market. The banks have had the discipline of it, and we’ve seen what that’s done to their share price. The insurance companies haven’t. That’s my premise, the same thing applies with General Electric, GE, GE Capital. That’s a huge investment manager: $660-billion in assets and they’re coming down, but they’ve only marked 2% of the assets to market. To my mind, if you gave that business an appropriate hair cut, it would suggest that that business is insolvent, and yet its deemed to be one of the most credit worthy companies in the world today. Nothing makes sense today.

Will the Dollar Maintain its Strength?

Whatever I say now, no one will understand, so with that caveat, I don’t say that as a conceited man, I’m not talking down to anyone, its just a difficult theory, nevertheless its a theory postulated by one of the great economists of the twentieth century, Irving Fisher, and its [the kind] along the lines of paradox of thrift. And what’s happening is that, or what’s happened again in America is that like everyone else we took on too much debt, and at its peak we had $53-trillion, think about that, that’s a lot of zeroes, $53-trillion of debt outstanding. People went crazy, they had these liabilities and they hoped that on [the other] this side, they had $53-trillion of assets, and indeed, three years ago, they probably had $80-trillion of assets, and they were looking kind of funky.

The problem is the assets, house prices have fallen 25% in the US, that’s a big haircut, equity prices, they’ve fallen 50-60%, that’s a huge haircut. Commodity prices, they’re down 30%-40%-45%, that’s a huge haircut. Suddenly, you’re finding that as you come to create dollars [convert assets in to cash], because you own things and you sell things, you’re getting less dollars. So what I want to tell you is that there is a scarcity of cash, there is a scarcity of dollars, and that sounds absurd, because here we are today, and they’re announcing they’re bank bailout scheme, and they’re talking about $50-100-billion of government money and leveraging it, they can’t break the link with the past, they want to leverage it up to half a trillion dollars. That’s why I want to say to you…if you think about all of the government’s announcements in the US…its small change out of $53-trillion of debt. That’s why I say to you, the economy will weaken, because they’re not being heroic enough, actually they believe the consensus that if you print enough money you create inflation.

Every one believes in Friedman, everyone is being slow to deal with the fact that there’s this legacy of $53-trillion and its like a heavy object, just pressing the life out of the entrepreneurial spirit, and therefore keeping the economy down. Look, that’s my presumption, and under that presumption, the dollar should be strong, and the dollar has been strong. Its been a frustration to the many people, the strength of the dollar. Now in the last two weeks with the quantitative easing announcement, the dollar has weakened, but I think in the process of the next month or two, you will see the dollar bottom and then go on, and I wouldn’t be surprised if we got close to parity vis-a-vis the Euro within the months and years to come.

The Paradox of Contrarianism

Expert after expert lines up to tell you that the future’s inflationary and you should be selling conventional government bonds. Government bonds have been in an uptrend, so that is an intellectual conceit which is not supported by the price trend, and therefore I am invested in government bonds, I’m trend following, but I’m contrarian. The dollar over the course of the last 3 years has risen. Every investment counsellor will advise you to sell dollars. I will advise you to buy. I pursuing the trend, yet I’m being contrarian. You see how it works out? So first principals are 1) identifying the idea, the opportunity, and then 2) testing it against the market. I got a computer screen on the wall and I say to my kids, Mirror, Mirror on the wall, who’s the prettiest of them all? When I’m stuck, I ask the market. And if the market’s trending higher, then it says I should be trying to buy them, and if its trending down, I should be trying to avoid it.

What people forget is that a successful contrarian is only contrarian 20% of the time. Less than 20% of the time do you ever dare to go against the trend. So most of the time we are pursuing trend. And yet, being contrarian.

A Bear Market Rally – A Test of Faith?

Last March, my hedge fund, we lost 16% percent. That’s a hefty decline. The preceding two months, we made 25% and then we lost 16%, then we lost money in April and May, and June. I have to say, I was quite suicidal, but remember, for the year we made 32%.

So, I tell you, we could sum it up, the stock market was captured by the biblical story. It was St. Peter or St. Paul, but he was the most fervent believer. He’s seen the almightiest Jesus Christ, he’s there in the garden, and he says’s “You’re the man!” And Jesus says, “What are you talking about?” Before the cock crows three times you’ll have rejected me not once, but three times. And he says “Impossible!”

That’s what stock markets are all about. Here I am with my deflationary notions of what might happen. Here I am believing that there’s no intrinsic value in banking stocks, and the cock’s crowing and its kind of “Have I changed my mind?” I haven’t. Have I changed my mind? Markets are set up to take you away from the purity and the sanctity of sensible thinking. And because of that I spend my time talking to you. I spend my time; I’m just back from China, I hug trees, I do anything but sit in my office and watch the portfolio go like that [he makes a fluttering motion].

People claim that I get very cocky. I read some of the correspondence that goes on when they’ve seen me on television and they were saying after my last appearance, I really was a bit cocky, so you know what? Yeah, I get my head handed to me by these people. I sober up, you’re quite right, It’s a lesson that has to be relearnt over and over again, that no one person is bigger than the market, that no one person has a divine right to be right. There, I hear you, I hear you [motioning hand to ear to God].

The hedge fund industry in its construction, as we know it from like, a year ago or 18 months ago is finished. Its finished, I think, yeah. And it was a disfiguration of the spirit of hedge funds. Hedge funds in the 1970s, there weren’t many, they were kind of kooky, kind of maverick, eclectic people. The kind of thing that I’ve tried to emulate, probably with less success. And because of all those characteristics, you can never give them much mind. That’s why they’re alternative. You kind of respected them, but it was just too much, they were just too mad. And then you spent of the rest of your life wishing you’d given them more money. I think we go back to that environment. There are too many hedge fund managers, and not enough kooky brave independent thinking spirits out there like them. I  think the mechanism that will take us there, is all these non-kooky individuals losing money. The average hedge fund lost money last year. 

The average hedge fund has imposed gates and locked their clients in. They’re finished. They’re finished. There are hedge funds out there and they have gated, what I mean is they’re denying their clients withdrawing their money. They’re writing to their clients, the good news, is that we’ve made money in January, and February, we’re making money in March. Absolute tripe! Okay, you have not made a penny, when you’re denying the clients their money. So these are people who have no future, who are walking around pretending that they have a future. That time will catch up with them. Lastly, the point I want to make to you is that the common thread of these funds like Madoff, which have failed, and the example of one unveiled last week in London, this Global Macro fund, the commonality is the very low volatility. These are funds that made money in a reasonable consistent manner; it was almost linear, linear, linear, year after year after year. I never believe in linear progression.

I believe in volatility and the craziness of life as we search for the uncertain future. My returns are volatile. Our only thing is from a calendar year of risk, we never lose much money. One year, we lost 3% and it still gobbles me that we lost 3%., not 33%. On a month-by-month basis it can be crazy. So what we found, we found a conceit in that as a society, we have abolished the business cycle so rather than going up and down with the economy. Gordon Brown told us he had abolished boom bust so that we have a linear progression. Bernie Madoff was a linear progression. We could make money without doubts, hence we elevated the hedge fund community into the premier division. That was all a mistake. And, cyclicality is re-imposing itself, and I’m just warning you that cyclicality, once unleashed, isn’t necessarily 2-3 years, it’s 20-30 years in its formation. 

Can the Regulators Save Us?

This is a big fear, I think its a legitimate fear. The fear is that there’s now an open outcry, by society at large as to the remuneration, and the risk taking that was necessary over the last few years by the financial sector. And, because society has been called in to rescue the financial sector is demanding its pound of flesh. And I don’t take issue with that, I accept that as the natural course of events. But, there is also this law of unintended consequences, so we look at say the British property market, and it now seems crazy. One could get up to 5 times your salary to purchase your house. And now we might impose a low amount of leverage of 2-3 times. The problem with that is that even with the decline in housing prices, no one could afford a house price if you bring down the… so that the credit leverage was only a function of asset prices being very high, and therefore you had to overarch in order to gain a competitive return as a speculator or just get on the housing matter as a regular person. The commonality between those two transaction is asset prices. They were too high.

So the regulator’s coming in and trying to bring down leverage in the market, and they are after hedge funds. I don’t know why… I do know why – They are rich and successful. Fair game – bring down their leverage and bring down the leverage of home buyers, prospective house buyers. The problem with that is it bakes in the notion that house prices and assets will spend the next 20 years deflating, under this more sober and conservative environment.

The Hedge Fund as Investment Laboratory

The last two weeks, nothing has been fun, because all the portfolios, they all go the same way. There’s no product diversification, so one fund’s doing well another one’s not doing well. I don’t understand that word, supermarket, and the difficult thing right now is we have no confirmation for our ideas, we’re taking a pasting. Three weeks ago, we were 11 or 12 points ahead of the index and today, that’s probably now 3 or 4. At the same time, we were up 10-11 points in absolute terms in the hedge fund and that’s come down to 4. So everywhere I look now, my tail’s between my legs. But my message is the same. All my money’s in my hedge fund. The hedge fund, I believe, is as superior product, and if you’ve got that minimal market, those pounds, euros, and dollars, I, we’ve placed within the hedge fund; we use the hedge fund as a laboratory, a test pad. We incubate ideas and once they take root and they gain legitimacy, and once we start to make money on the blasted things, we can then take little transplants and put in to our long [term] holdings. Its a better way, I hope its harmonious and they can live together, one benefits from the other.

What is Eclectica’s Investment Process?

We are very much free thinkers at the macro level. We, through our collective efforts in travel, in terms of information sources, in the way we look at things – you know we’re trading currencies, we’re trading commodity futures, we’re trading government bonds, we’ve got fingers in the all of the pies, so when we come to look at an equity portfolio, we drill down all that wealth of experience, to try and determine the most likely path of the economy and the stocks that benefit from it. Our portfolios have undergone a dramatic change. Up until July of last year, we had up to three quarters of the portfolios invested in commodities, and the majority of that was agricultural commodities. But then, something happened. This deflation shock struck, and it hit, our crisis, and after three or four more months it hit the two year trend, and our portfolio changed. And today our portfolio is defensive. Tobacco, health care,  utilities, staples. In the last three weeks that’s come under enormous downside pressure. But as I say to you its three weeks and we need monthly observations. Now if that downside pressure were to continue, our portfolio would change again.

My ideological preference is that that won’t happen, but I have to remain intellectually robust to change my portfolio if it does need to. As I say to you, it’s not a process of three weeks or four weeks, we’re not high intensity traders. New world, new price. New trend, new portfolio. That’s our mantra, but today, we’re still from the view that the economy is under duress and therefore we’re still sticking to the low end of these trends, close to trends in the defensive stocks. Time will tell if we have to change them. 

Fund Management Without Conviction

Conviction has got no role in my operation. There are concerns about Eclectica, or about, me… The concern is that you see me everywhere, you see me on CNBC, I do Bloomberg in the US, I’m on the BBC – heavens, I made a documentary for Channel Four last year, and its all high falutin stuff and it all gives the impression that there’s all of this conceit and arrogance – Hey, you’re taking on, I am Hugh Hendry taking on the market, but its actually driven by the reverse. I actually very fearful of having ideas that I can articulate and gain your conviction. I’m very fearful of that, and so those first principals that we built up, what we call portfolio management principles. – we developed a series of rules which are there to constrain what I can do. So I can only get involved in the portfolios as I said to you when we have the legitimacy of a positive trend. Without a postive trend, you can take my conviction and you can throw it away. You can discard it. Conviction has to married with discipline, and we’ve always done that, but of course, when you see the odd soundbyte, and I’m going on and pontificating about something, you forget that if the trend changes, we change the portfolio.

Tags: Array, Banking Sector, Cio, Cities Of The World, Citywire, Co Founder, Decades, Deflation, Dow Jones, Eclectica, Fear, Full Length, Fund Managers, Guns, Hedge Fund, Hedge Fund Manager, Hedge Funds, Hugh Hendry, inflation, Legs, Length Interview, Lows, Major Cities Of The World, Parity, Peers, Quantitative Easing, Rally, Remarkable Accuracy, Right Place At The Right Time, Stock Market, Unprecedented Period, Unprecedented Prosperity
Posted in Bonds, Commodities, Credit Markets, Markets, Outlook | 3 Comments »

The Misbehavior of Markets

Monday, April 6th, 2009

Why do markets misbehave? How should you measure market risk? And what’s wrong with academic finance?

These are a few questions that polymath Benoit Mandelbrot addresses in the fascinating book The Misbehavior of Markets: A Fractal View of Financial Turbulence. Mandelbrot suggests all of these questions can be properly understood by rejecting the standard assumptions of academic finance and instead using a “fractal view” of risk and markets.

Fractals are at the heart of this book. Fractal geometry is a form of mathematics developed by Mandelbrot that deals with rough but highly self-similar structures like trees, coastlines, and mountains. Fractals have helped explain a wide range of natural phenomena and revolutionized computer graphics, influencing movies like Star Wars Episode III. There is room for more applications in this early science, and fractals may help explain the jagged but predictably irrational patterns in the stock market, claims Mandelbrot.

In this book, Mandelbrot contends that fractals are the key to modeling the market. The interesting part is that Mandelbrot does not merely explain why he’s right but he goes to great length to explain why others-those using the standard theories of academic finance-are wrong. Mandelbrot offers interesting history, anecdotes, trivia, and beautiful illustrations to make his case. The stock market does not act like a random walk, he says, but rather it’s like the flight of an arrow down an infinite hallway. It sounds a bit abstract at first, but this is exactly where the book shines. There are stories and illustrations that make such abstract concepts easily understandable. I literally felt smarter after reading each chapter…

But back to the subject at hand. What do fractals offer to finance? First, fractal math can help generate realistic stock price series. Mandelbrot graphically illustrates that his fractal-generated prices resemble actual price data more closely than the standard (geometric Brownian-motion) generated prices. Not only will this help for valuation and understanding risk, but it could also help one estimate damages in securities fraud cases.

Second, fractals can help explain why bubbles form and how prices are dependent over time. These are phenomena that every stock trader understands, but amazingly are classified as impossible by standard academic theory. Clearly something is wrong when experience contradicts the sacred cows of the random walk, Efficient Markets, CAPM, and Black Scholes, etc. Although this fractal theory doesn’t offer a complete answer yet, it at least allows for a theory consistent with practical experience.

But Mandelbrot’s fractal view has not taken hold in academia, the author explains, and it is this conflict that drives the narrative. The arguments in the book are about the battle between Mandelbrot’s ideas and standard finance. Mandelbrot elaborates on this in many ways, and after reading the book here are some useful comparisons between the two theories:

If you have qualms with academic finance, or agree with even a few of Mandelbrot’s revisions, I think you’ll enjoy this book.

There are but two reservations I have to this book. The first is that it touches on a lot of different ideas so it doesn’t elaborate on how to put the ideas into practice. Mandelbrot talks about the concepts like alpha (α) for measuring volatility and the H coefficient as an exponent of price dependence, but the book doesn’t offer enough for my liking. This appears to be intentional, however, as the authors admit their motives early in the book:

So caveat emptor. This book will not make you rich…If it fits any genre, it is that of popular science. It explains a new, and important, way of looking at the world-in this case, the financial world. It attempts to do so using common English, with as few formulae as possible-or at least, with no jargon unexplained. (p 23)

The second reservation is that the Mandelbrot makes everything into a battle between himself and academia. It reminded me a lot of the way Taleb wrote The Black Swan: The Impact of the Highly Improbable.(Though to be honest, as much as it annoyed me, there is something fun about reading someone with so much conviction.)

In short, check this book out and prepare to learn a new way of looking at risk and the markets. At a minimum you’ll be more skeptical about the frequently quoted statistics of risk so you can make better investment decisions.

Source: Mind Your Decisions,

http://mindyourdecisions.com/blog/2009/03/31/the-misbehavior-of-markets/

Tags: Abstract Concepts, Academic Finance, Array, Assumptions, Benoit Mandelbrot, Brow, Coastlines, Computer Graphics, Early Science, Fractal Math, Geometric Brownian Motion, Geometry, Hallway, History Anecdotes, Market Risk, Misbehavior, Natural Phenomena, Random Walk, Star Wars Episode, Star Wars Episode Iii, Stock Market, Stock Price, Turbulence
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